V Mechanism Stability—Flash Crashes and Avalanche Effects

Flash crashes, perceived as sharp drops in market prices that rebound shortly after, have turned the public eye towards the vulnerability of IT-based stock trading. In this paper, we explain flash crashes as a result of actions made by rational agents. We argue that the advancement of information technology, which has long been associated with competitive advantages, may cause ambiguities with respect to the game form that give rise to a Hypergame. We employ Hypergame Theory to demonstrate that a market crash constitutes an equilibrium state if players misperceive the true game. Once the ambiguity is resolved, prices readjust to the appropriate level, creating the characteristic flash crash effect. By analyzing the interaction with herd behavior, we find that flash crashes may be unavoidable and a systemic problem of modern financial markets. Furthermore, we outline that flash-crash-like effects are also relevant in other applications that rely on increasing automation, such as the automated management of energy demand.