Rise of the Machines
Take a moment to ponder the distinguished looking gentleman in the photo above. He’s a trader on the floor of the New York Stock Exchange. We’ve all seen pictures like this. Every other news story about the stock market seems to have some variation of the generic theme: stock photos of stock traders waving their hands in the air in a frantic scrum of buying and selling. This guy just looks a bit more elegant than usual. And this picture was taken a half century ago. The vibe is a bit quaint and genteel.
The truth is that this fellow’s modern counterparts, with their blue jackets and lanyards, frantically shouting out quotes on the trading floor are just as archaic as he is. Floor traders have about as much relevance to market trading today as the costumed inhabitants of Colonial Williamsburg. Actual flesh-and-blood humans handle only a tiny fraction of all the trades made every day around the world. Like everything else, the securities business has become automated. (Even Ferraris, so beloved of stock brokers, are now assembled by robots.) Where traders used to bellow and elbow each other on the stock market floor, banks of computers now duel with each other, buying and selling stocks at lightning speed, executing enormous instantaneous trades based on proprietary algorithms, and moving billions of dollars in mere fractions of a second.
The life blood of modern markets is now pumped by automated systems executing trades at ever increasing speeds. Some of the finest mathematical minds in the world devote their energies to devising software with which to squeeze profits out of the tiniest increments of time. Market advantage is now measured in milliseconds, and the lag between matching and executing orders is being relentlessly whittled away. High frequency trading accounts for 90 percent of all exchange-traded derivatives, which Warren Buffet so famously described as “financial instruments of mass destruction.”
No doubt, modern electronic trading is efficient. But what social value does the inexorable race to shave nanoseconds off trading time provide? And how do we prevent the sudden, precipitous market crashes that can occur when machines furiously bet against each other? What happens when Allen Greenspan’s “irrational exuberance” arises out of robotic tenacity rather than extraordinary popular delusions and the madness of crowds? What threats do these autonomous trading systems pose to market stability and society at large? Are the markets being controlled by SkyNet?
Regulators have been struggling to come to grips with the technological arms race underway between traders. In September, the Commodity Futures Trading Commission published a Concept Release on Risk Controls and System Safeguards for Automated Trading Environments.
Prompted by the 2010 “flash crash”, the $440 million “errant trading” glitch at Knight Capital Group, and the recent Nasdaq breakdown, the Commission is trying to wrap its institutional brain around automatic trading systems in general and high speed trading in particular. As the commission notes, traditional risk controls and safeguards that relied on human judgment and speeds, and which were appropriate to manual and/or floor-based trading environments, must be reevaluated in light of new market structures. The genie won’t go back in the bottle. In the CFTC’s words, the evolution from manual trading in open-outcry pits to electronic trading platforms is substantially complete. Now the Commission wants help from the public in finding a way forward to a new regulatory environment.
The CFTC’s release is no run of the mill-of-the-mill request for comment – it is seeking public input on a total of 124 questions. The questions the Commission is posing fall largely into four groups: risks related to high frequency trading; latency-related risk; the risks posed by interconnected markets; and the continuing importance of manual controls and safeguards. The Commission is particularly interested in better understanding high frequency trading and determining whether it should receive different regulatory attention than automatic trading systems in general.
The complexity of the task facing the CFTC was underscored this last week by the Securities and Exchange Commission with the release of its much-anticipated MIDAS (Market Information Data Analytics System) website.
MIDAS collects and processes data from the various exchanges as well as from the separate proprietary feeds made individually available by each equity exchange. According to the SEC, these individual exchange feeds are typically used by only the most sophisticated of market participants such as market makers and high-frequency traders. The SEC tells us that most institutional investors, retail investors, and academics, generally do not consume this data – it is extremely voluminous, challenging to process correctly, and requires specialized data expertise. Hence, the introduction of MIDAS.
The SEC has done a terrific job of taking an immense amount of data and lassoing it into a number of eye-catching interactive graphs. (There’s also the obligatory Excel charts for the old schoolers out there.) Two things became immediately apparent when I started playing around with the MIDAS tools. The first is how much high speed trading is going on out there. The second is just how tiny the time parameters are. The MIDAS tools let you zoom in to see orders and cancellations executed in the merest fractions of a second. Mary Jo White describes MIDAS as a game changer, and says that it should spur innovation by unlocking the power of data and research to unlock a wealth of ideas from investors, market participants, and academics. White might not be engaging in hyperbole. MIDAS could prove to be a very powerful tool.
While ordinary market participants might not find themselves spending hours on end pushing and pulling the MIDAS charts like teenagers lost in World of Warcraft, I suspect analysts at the CFTC will.
The CFTC faces a daunting challenge, even with the SEC’s lovely new toy to play with. If you want to offer your thoughts on their 124 questions, you have until December 11, 2013 to pass them on.