So the flash crash turned out to be a single trade that somehow caused the world’s largest stock market to tumble almost 900 points in the space of an hour. But the SEC’s explanation is scarcely reassuring, and the incident is surely symptomatic of the pervasive market uncertainty. That a single trade could wreak such havoc also raises the intriguing (and frightening) possibility of a deliberately engineered financial crash.
The idea, stemming originally from fiction, may not be quite as far fetched as it sounds. Obviously, there are both criminal and extremist elements who would like nothing better than to disrupt global financial markets—the former for the profits they could make (think of how much a short position would make when the Dow tumbles ten percent in an hour), the latter for the financial and economic damage it would cause (the profits would come in handy also for financing future physical or financial attacks). But would it be possible?
A recent account, Nineteenth Street, NW, describes one possible scenario in which the terrorists use an off-shore hedge fund to launch a series of speculative attacks. The terrorists start with already weak currencies or markets—perhaps an overvalued currency or an under-financed sovereign—and as they succeed in their initial speculative attacks, not only do they gain additional capital to launch their next attack, they also induce other (profit, not politically, motivated) investors to join the bandwagon of the next round of speculative attacks. In the story, the terrorists are also able to learn of the central banks’ FX intervention strategies (an issue of growing salience once more)—and plan a nasty surprise at a meeting of central bank governors and ministers to really spook markets. Eventually, given the interconnectedness of the global financial system, these cascading crises culminate in a global financial crash—costing trillions of dollars, and millions their jobs, homes, and life-savings.
The account is purely fictional, of course, but as George Soros proved when he helped oust the UK pound from the European Exchange Rate Mechanism in 1992, weak fundamentals and jittery markets make for successful speculative attacks against even major central banks. And as the flash crash has amply demonstrated, markets are plenty jittery these days.
So if “financial terrorism” is a real tail risk, what to do about it? The good news is that many of the efforts to make the global monetary and financial system more resilient generally will help protect against any type of crisis—be it spontaneous or deliberately engineered.
National initiatives (such as the Financial Sector Reform Bill in the United States) are the obvious starting points, but modern crises are global, and call for global responses.
Therefore, in addition to stepping up its traditional lending, the International Monetary Fund has been strengthening the global financial safety net—or, to switch metaphors—has been putting in place a sort of “global financial sprinkler system,” including new instruments like the Flexible and Precautionary Credit Lines that provide contingent, but rapidly disbursing, liquidity to help governments douse incipient crises before the conflagration has a chance to catch hold and spread.
Since prevention is always better than the cure, the IMF and the Financial Stability Board (FSB) have also introduced the joint Early Warning Exercise—metaphorically, an “early warning radar system” intended to identify vulnerabilities before they can erupt into crisis. The premise is that financial crises represent the confluence of an underlying financial vulnerability and a specific crisis trigger. While the underlying vulnerability usually takes the form of a balance sheet mismatch (too little capital; unhedged foreign currency exposure; or maturity mismatches), the event that actually triggers the crisis may take many different forms: domestic or external; economic or political (including, presumably, deliberate action by terrorists or criminal elements). Because the specific trigger is almost impossible to predict, crisis prevention efforts are better directed at addressing the underlying vulnerabilities. Quite simply, if there are no vulnerabilities, then a “triggering event” (deliberate or accidental) will have nothing to ignite, and will just fizzle out instead.
Starting from this premise, the Early Warning Exercise draws on a wide range of analytical tools, market information, and expert opinions. A key goal is to “connect the dots”—that is, understand how shocks in one country or market could spread across the global financial system. The findings are communicated confidentially to finance ministers and central bank governors at the IMF Spring and Fall meetings in order that they may take prompt preventive and corrective actions, especially those that require international cooperation and coordination.
The flash crash has reminded us—if we needed reminding—that financial markets remain fragile and jittery. It has also raised the intriguing but frightening specter of a deliberately-engineered financial crash. As such, with delegates now gathering on Nineteenth Street, NW, this incident underscores that, despite significant progress in the last couple of years, much still needs to be done to make financial markets and the global economy more resilient to crises—be they accidental or deliberate.
Rex Ghosh is an economist with the International Monetary Fund and the author of Nineteenth Street NW (www.nineteenthstreetnw.com), a thriller about financial terrorism and a global market crash. The views expressed in this article are strictly those of the author and should not be attributed to the IMF, its Executive Board, or its management.
 See Moghadam “A Big Enough Safety Net?” http://blog-imfdirect.imf.org/2009/09/15/imf-a-big-enough-safety-net/
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