A 'flash crash' or two gives needed jolt

"I was flabbergasted, I could not believe it." The veteran portfolio manager at a top US fund was this week recalling the US Treasury "flash crash" exactly six months ago, when yields in the world's largest government debt market swung wildly in a matter of minutes.

Statistically, such events happened only once every 3bn years, Jamie Dimon, chief executive of JPMorgan Chase, noted recently (although he agreed such claims made you doubt the worth of statistics).

But maybe it would help if such events were frequent? As Mr Dimon observed in a letter to shareholders this month, "almost no one was significantly hurt" by what happened on October 15. Instead the "flash crash" triggered a welcome debate about the underlying fragility of the post 2007 crises global financial system . As Mr Dimon pointed out, it served as a "warning shot across the bow" of investors and market participants.

Many this week watching eurozone debt markets - especially for German Bunds - would agree that similar warning shots are overdue. As the European Central Bank has ramped up bond purchases under its quantitative easing programme, prices have soared, pushing yields to ever more ludicrous lows.

Thirty-year German debt now yields less than 0.6 per cent; soon yields on 10-year German Bunds may turn negative. Worryingly, heavy ECB buying could create acute shortages of high quality assets in eurozone markets, raising the risk of serious market failures.

The concern is that while (hopefully) stimulating economies, QE has suppressed volatility in equity as well as bond markets. In the months before October 15, the Vix index of expected US share price volatility - known as the Wall Street "fear gauge" but a proxy for global nervousness - had fallen to lows not seen since before the 2007 financial crisis. Unwittingly or not, investors' risk sensors had been dulled by knowledge that central banks stood ready to support markets.

If complacency is high, it is surely better to have harmless "flash crashes" that act as a corrective, encouraging better behaviour and rulemaking as well as greater investor prudence, than to wait for a much bigger, longer-lasting market event that proves economically damaging?

The US "flash crash" highlighted how little we know about how markets really function in a world of new regulations, ultra-low interest rates and global QE.

This week Simon Potter, a senior official at the Federal Reserve Bank of New York irked Treasury dealers by putting the emphasis on them being "good citizens" at times of turmoil; bankers prefer stressing the impact of rule changes that make it more expensive to maintain market making functions.

But October 15 raised alarm about the dangers of investors crowding into the same positions, and concerns about possible damaging side effects of automated trading.

Against that background, more frequent bouts of extreme volatility would be useful, on similar grounds to Voltaire's satirical principle that it helps to have the occasional Navy admiral shot pour encourager les autres.

The problem is ensuring the right kind of volatility. The face of the US bond fund manager I spoke to this week turned a shade whiter when I suggested it might help to have a few more days like October 15.

Too much volatility could cause permanent damage. In his speech this week, Mr Potter warned that recurring periods of heightened and unexplained volatility in US government debt "could prompt end-investors and market makers to question the superior liquidity of the Treasury market and perhaps hamper the critical roles the market serves". The fallout from a "flash crash" in a smaller, less liquid market - for high-yield corporate bonds, for example - might not be as easily reversed.

Too little volatility, however, and behaviour will not change. While October's US Treasury"flash crash" encouraged a debate about financial market vulnerabilities, disagreement on its causes mean there is a good chance nothing will change. Subsequently, the Vix index has fallen back down near to last year's lows.

Whatever their merits, Mr Potter argued "flash crashes" would anyway become more common. An "unintended consequence" of regulatory changes, he cautioned, could be that "sharp intraday price moves become more common". Short-term, traders and investors should worry. Longer term, they might be to everyone's benefit.

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