Bond Trading - Could another flash crash reset US debt?

On May 6^th, 2010 US the DJIA and other stock indices dropped about 9% in a matter of minutes and then recovered equally quickly.  Someone who had standing buy orders, or was quick on the trigger, could have made a lot of money very quickly.    It’s well-known that computer trading programs are instructed to follow the herd.  If everyone else is selling, they too sell, lest they be left holding stocks or commodities worth vastly less at the end of the day.   Here are the elements of a short-story based on the flash crash and how it could be engineered to happen again.

Computer Trading

The US government could quietly steal a copy of the code that another deep pocket uses.  This other deep pocket is the Chinese government trading desk which owns around one trillion dollars of T-bonds.   The Chinese don’t really expect the US or anyone else to steal computer code so it’s not protected as closely as say nuclear secrets, missile capabilities or even diplomatic cables.  A small team (think the Watergate Plumbers) could break into the trading offices, copy the hard drives,  and create a diversion by sloppily forcing open some file cabinets to steal papers on some other secrets such as what individuals are being investigated for taxes. 

Code Breaking

The encrypted hard drives are brought back to the US and turned over the super-computers of the NSA who spends weeks with their Crays crack the codes.   It might help speed up the decryption if the US had performed a bit of social engineering by picking up some old passwords and similar information from a mole or paid spy inside the Chinese trading offices. 

Market Simulation

The decrypted hard drives are sent to top-secret labs to have the trading programs inserted into large simulation.  They would be poked and prodded to find out how they would respond to various market movements.   The US would develop a trading routine and set of inputs (i.e. dumping T-bonds on the market to cause a spike downward) that optimally took advantage of the Chinese program, inducing it to sell huge volumes and then not buy back too quickly when the US jumped in and rebought the bonds just sold minutes earlier. 

E-Day 

The US Fed unleashes their program on the markets, first driving down prices and inducing the Chinese to follow suit, then buying back in quickly at a much cheaper price.  Of course this will be tricky to pull off and might take several waves up and down in order to sell and buy back hundreds of billions of dollars of Treasuries.  

Aftermath

Even without knowing the Chinese computer trading programs the US could likely induce a flash-crash in T-bonds and skin the Chinese by jumping in and buying back the bonds at vastly cheaper prices.  Stealing the trading programs merely allows the process to be optimized so that the US could win the largest possible prize.  It would be hard for the Chinese to complain without looking foolish.  “We have had these big movements before.  Didn’t you learn anything from 5/6/10?  You shouldn’t have programmed your trading operations to dump Treasuries at such cheap prices.  Lol  No we don’t know who was on the other side of all those trades.”    This is merely plausible deniability. 

Of course the Chinese would know that only the US Fed would have a few hundred billion dollars to throw around and pull off this ruse, but they wouldn’t have a leg to stand on in order to get an investigation into this obvious market manipulation.  The US could even accuse the Chinese of causing the crash, muddying the waters.   Furthermore the Chinese wouldn’t want to admit to having been outsmarted, so the issue would quietly die.  The Chinese government would be a bit smarter, a bit more careful and considerably poorer after the greatest Sting in history.