Take a break

Financial markets are global and closely interconnected. While this is largely beneficial for all market participants, it can also create spillover effects with unintended consequences. An academic study argues that liquidity can affect related instruments and create a feedback loop, or, put more pessimistically, a vicious circle. In simple terms, if liquidity evaporates in a derivative, it can also reduce liquidity in the underlying, which again reduces liquidity in the derivative. While not fully convinced that this is what happens in the real world, it could be an interesting new angle in explaining the 2010 Flash Crash. Maybe it wasn’t caused by faulty technology and reckless traders after all, but by naturally occurring spillover effects across different asset classes. This idea is partially supported by recent empirical work which concludes that the Flash Crash was not caused by any one individual or activity, but resulted from the interaction of multiple traders and events. All of this highlights the importance of proper circuit breakers that stop contagious effects before they spread.

Spillover effects can change not only the trading of an asset itself, but, potentially, the whole market structure. Numerous current regulatory discussions, such as extraterritoriality agreements, highlight their impact on our increasingly interconnected world. The latest example of contagion is underlined in the report by the City of London Corporation which estimates that the European Financial Transaction Tax could add £3.95 billion to the cost of issuing UK government debt – and the UK is not even joining the EU FTT!

Maybe it’s time to call for a regulatory circuit breaker that forces all parties to take a break and carefully assess the situation before making any hasty decisions?

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