Introduction

When things do not go as you expect, it creates uncertainty. If you extrapolate that to financial markets, it creates a collective feeling of uncertainty that triggers panic selling. A flash crash emanates from such an event. Over the years, financial markets worldwide have witnessed several such events. It is usually a sudden drop and a bounce back in share prices triggered by an event like war, political uncertainty, earthquake, terrorist attack or unexpected financial outcome in a significant market.

Historical Context of Flash Crashes

Following are some of the notable flash events that happen in the Indian history:

Demonetisation Impact (2016)

• Event: On November 8, 2016, the Indian government announced the demonetisation of ₹500 and ₹1000 currency notes. The next day, the Sensex fell by over 1800 points in early trading hours due to the sudden shock and panic among investors about the economic impact of the move.
• Impact: Although not a flash crash in the traditional sense, the sudden and steep drop highlighted the impact of significant economic policy changes on the stock market.

Yes Bank Crisis (2020)

• Event: On March 6, 2020, the Reserve Bank of India (RBI) imposed a moratorium on Yes Bank, capping withdrawals and superseding the bank's board. This led to a sharp decline in the bank's stock and created market panic. The Nifty fell by nearly 500 points, and the Sensex dropped by over 1500 points.
• Impact: The crisis at Yes Bank caused significant turmoil in the financial markets, raising concerns about the banking sector's health. It emphasised the interconnectedness of financial institutions and the broader market.

COVID-19 Pandemic (March 2020) ​​​​​​​

• Event: The onset of the COVID-19 pandemic in March 2020 triggered a global financial crisis, and the Indian markets were no exception. On March 23, 2020, the Sensex experienced one of its worst single-day falls, dropping by nearly 4000 points (13%) as fears of the pandemic's economic impact gripped investors.

• Impact: This crash led to massive sell-offs and heightened volatility, prompting regulatory bodies to implement market stabilisation measures. It showcased the profound impact of global health crises on financial markets and the importance of resilience and risk management strategies.

Causes of Flash Crashes

The following pointers explain the causes of flash crashes in the stock market:

High-Frequency Trading (HFT) and Algorithms:

High-frequency trading and algorithmic trading play a major role in flash crashes. These automated systems execute many trades very quickly. They do so at extremely high speeds, often in milliseconds. They add liquidity and efficiency to regular markets. But they can also worsen stress-driven volatility. If an algorithm finds a price anomaly, it can trigger massive sell-offs. This leads to rapid price drops. These trades are fast and many. They can overwhelm the market that makes the crash worse.

Liquidity Issues and Market Fragmentation:

Liquidity issues and market fragmentation cause flash crashes. It makes markets unstable. Low liquidity means fewer buyers and sellers can absorb large trades, leading to sharp price movements. Market fragmentation is when trading is spread across many venues. It can reduce liquidity and slow the market's ability to stabilise prices. During rapid price movements, these factors can cause significant market disruptions. The lack of liquidity and split trading platforms fail to soften the impact of large trades.

Factors Contributing to Flash Crashes

Understanding these factors is crucial. They are vital in developing strategies to reduce flash crashes and improve market stability.

Market Conditions

Market conditions, like low liquidity and high volatility, can cause flash crashes. The presence of leveraged trading can also contribute. When cash is low, small trades can cause significant price swings. This leads to a cascade of automated trades that make the situation worse. High volatility can amplify these effects, making the market susceptible to rapid and severe price declines.

Technological Glitches

Software bugs, trading errors, and malfunctions cause flash crashes. They are all technological glitches. Automated trading systems can make many trades in milliseconds. Any error in these systems can cause sudden and massive sell-offs. Incorrect order entries or system overloads can also disrupt the market. They cause abrupt price drops.

Human Factors

Human factors such as trading errors, panic selling, and the actions of high-frequency traders can also cause flash crashes. Humans make manual errors. For example, they might fat-finger trades by entering an incorrect value. These errors can start rapid market declines. Also, traders' behaviour in uncertain or scary times can worsen market downturns.

Impact and Consequences of Flash Crashes

The following are the impacts and consequences of flash crashes on the financial market.

Financial Losses and Market Confidence

Flash crashes result in significant financial losses, undermining market confidence. Investors and institutions face immediate losses as asset prices plummet within minutes. These events prompt regulation and responses. They lead to new policies. The policies aim to stabilise the market and prevent future occurrences.

Psychological Effects and Investor Behaviour

Flash crashes trigger fear and uncertainty, profoundly impacting investor psychology. The sudden and severe price drops lead to panic selling and heightened market volatility. Even after markets stabilise, the memory of such events can cause long-term caution and risk aversion among investors.

Prevention and Risk Management

Regulatory measures, such as circuit breakers, are essential in mitigating the risk of flash crashes. These mechanisms halt trading briefly during extreme volatility. They give traders time to assess the situation and reduce panic. Better tools for market surveillance and risk management have improved. They help monitor trading activity. They detect potential flash crash triggers, making the market more stable.

Conclusion

In conclusion, understanding the flash crashes is vital. They are crucial for keeping the market stable and investors confident. These sudden market drops are often caused by high-frequency trading and liquidity issues. They lead to significant financial losses and hurt investors' psyches. But, you can lessen flash crash effects with good prevention and risk management, including rules and technology. This will ensure a more substantial financial market.

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