What Lies Behind A Flash Crash: Gold 2
Consider this example, which also offers a hypothetical, possible, sequence of events that happened in gold over the weekend. A trader holds a substantial position in Asian high yield corporate debt, which is not a very liquid market. The position gets marked down by a significant amount overnight, for whatever reason (the reason doesn’t really matter in this example), and the trader has to meet a margin call.
However, the trader can’t sell out of the High Yield position because the market isn’t liquid enough to absorb all that volume without making the loss even worse. As a result, the trader opts to sell some other asset which trades in a more liquid market to raise the cash needed to meet the margin call – gold*.
It is at this point where computer algorithms and liquidity conditions come into play. If the asset, in this case, gold, was dumped at the very first opportunity (Asia’s market open), liquidity is going to be very thin, which causes prices to spike lower immediately. Computer algorithms then react accordingly, either selling and/or pulling out of the market entirely, making the sell off worse.
However, since the crash was initiated by someone being forced to liquidate a position, prices stop falling once the liquidation is done. This pushes anyone (or any-algorithm) that went opportunistically short to quickly cover their shorts, hence the quick snap back in prices.
It is important to note that, while the trader(s) and broker(s) involved know what is going on, no one else does. Illiquid markets really aren’t covered by the mainstream media, and reliable price data is difficult, if not impossible to find online. This leaves everyone focusing on the asset that was sold, in this case gold, instead of what sparked the margin call in the first place, whatever that may be.
Compounding this confusion is the fact that some asset prices move in tandem, and traders/algorithms react accordingly. Gold is highly correlated with silver, and both “flash crashed” together on Sunday.
This raises other possibilities. For instance, what if the flash crash didn’t actually start in gold, but in silver? After all, silver is also used as collateral. The sequence of events could easily have been: trader receives margin call after illiquid securities are marked down; trader sells silver to raise cash; gold prices crash in tandem with silver. As such, it is entirely possible that the Gold “Flash Crash” has nothing to do with gold at all!
*USTs and FX positions are other possible and frequently used alternatives
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