Beyond the Flash Crash: Systemic Risk, Reliability, and High Frequency Financial Markets

Abstract

Extreme events in financial markets can arise from fundamental information, but they can also arise from latent hazards embedded in the market design. This is systemic risk and somebody bears this risk. These events add to risk and their probability and severity must be accounted for by market participants. This paper shows how this risk fits into the finance literature, and that from an engineering perspective this risk in markets has never been lower. The industry is evolving to mitigate this risk. This paper presents an overview of the complexity of the automated market network and describe how market participants interact through the exchange mechanism. It defines new terms and a new framework for understanding the risk of extreme market moves from a reliability and safety perspective.

Keywords: High frequency trading, reliability engineering, systemic risk