Are faster machines making Wall Street riskier?

At 2:42 pm on May 6, 2010, the Dow suddenly fell by 1,000 points, then recovered just five minutes later. The so-called “Flash Crash” has prompted further investigation into such anomalous “black swan” events. And new research concludes that these unexpected, volatile events are happening even more often than we think — or are even able to perceive — and are increasing systemic risk as well. 
(AP )

Authored by a team of physicists, engineers and industry data experts, the research paper points out that technological advances are accelerating market exchanges as fast as possible within “the physical limits of the speed of light”— well beyond the limits of human response times.

They believe this movement is creating volatility on the micro level that may ultimately fuel “long-term, market-wide instability” on the macro level: 

In order to explore timescales which go beyond typical human reaction times, we focus on black swans with durations less than 1500 milliseconds. We uncovered 18,520 such black swan events [between 2006 and 2011], which surprisingly is more than one per trading day on average. ... The scientific appeal of extreme events is that it is in such moments that a complex system offers glimpses into the true nature of the underlying fundamental forces that drive it.

Figure 1 illustrates a crash (Fig. 1A) and spike (Fig. 1B) from our dataset, both with duration 25 milliseconds (0.025s), while Fig. 1C suggests a systemic coupling between these sub-second black swan events in individual stock (blue and red curves) and long-term market-wide instability on the scale of weeks, months and even years (black curve). ...

The coupling in Fig. 1C across such vastly different timescales is made even more intriguing by the fact that the ten stock with highest incidences of ultrafast black swans are all financial institutions — and yet it is financial institutions that have been most strongly connected with the late 2000’s global financial collapse (e.g. Lehmann Brothers filing for Chapter 11 bankruptcy protection on 15 September 2008). This suggests an analogy to engineering systems where it is well-known that a prevalence of micro-fractures can accompany, and even precede, large changes in a mechanical structure  (e.g. tiny cracks in a piece of 4 plane fuselage which then eventually breaks off).

Such findings are part of the motivation for the financial transactions tax that’s being proposed in Europe, which aims to reduce the volume and volatility of trading. Alternatively, perhaps we could program the world’s trading computers to mimic their human counterparts and drop everything when there’s a big soccer match.

(h/t The Physics of Finance)