Computers Are Taking Over Wall Street

The New York Times – Frankenstein Takes Over the Market
This week, yet another Wall Street firm most people have never heard of, relying on a computerized trading program that they can’t possibly understand, shook investors’ faith in the market. This is happening a little too frequently, don’t you think? The company, of course, was Knight Capital, a major market maker that generated an astonishing 11 percent of all the trades in the first half of this year, according to the Tabb Group. It caters to sophisticated Wall Street traders as well as small investors, whose brokers often used Knight to fulfill their trades. Trying to stay a step ahead of its competitors, Knight rolled out some new trading software. The software wasn’t ready. Instead of fulfilling customers’ orders, Knight’s computers went on an out-of-control spree of rapid-fire buying and selling. As trading volumes swelled, the Wall Street guys jumped in. (Sophisticated traders, relying on their own rapid-fire computers, often love volatility because it leads to trading anomalies they can take advantage of.) Many retail customers, having no idea what was going on, wound up losing money. I know: shocker.

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The Wall Street Journal – Don’t Overreact to This Knightmare
Our trading activities expose us to the risk of significant losses.” This formulaic line in Knight Capital Group’s annual regulatory filing is filled with foreboding. The securities broker, like many firms before it, didn’t expect that a ritual warning in its yearly paperwork would turn into a real-life drama—a crazy half-hour during which erroneous trades from Knight’s balky computers flooded the stock market and caused a $440 million loss…The difference between, say, Morgan Stanley and Knight is that the latter’s failure wouldn’t have threatened the financial system. Which is why there was no question of granting Knight a bailout, or even the access to emergency federal funding Morgan Stanley and Goldman received in 2008. If anything, the Knight episode should silence the recent talk of forcing a split between the securities and consumer units of the big banks by showing how fragile the former can be when standing alone. Knight’s problems have, however, ignited a policy debate on two related topics: the structure of capital markets and the regulation of broker-dealers.

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Bloomberg.com – Knight Blowup Shows How High-Speed Traders Outrace Rules
The pursuit of speed is an obsession among Wall Street trading firms. They can profit by taking advantage of minuscule discrepancies in prices that might exist for no more than a few microseconds or by getting a sneak peek at orders before they are executed. The risks of this are becoming more obvious, even to some market leaders. Markets now believe that “if something is faster, then by definition it’s better,” says Duncan Niederauer, chief executive officer of NYSE Euronext, which owns the New York Stock Exchange. “We are understanding that speed is not always better.” Amen. It is also true that making markets more resilient doesn’t mean a return to telephone orders, paper order tickets or stock exchanges with only human traders bellowing out bids and offers. What we can do, at a minimum, is ensure that monitoring systems keep up with the traders’ algorithms. The Securities and Exchange Commission last month took a half-step by requiring markets to build a $4.1 billion system that can generate audit trails of all transactions. The trouble with this system is that trading data won’t be generated until the next day, a feature the industry insisted on. Day-old data might not help regulators much when they are called upon the instant a market blows up. (It took five months to confirm the cause of the flash crash.) Nor is it clear that the system will be able to pinpoint the identity of every party in a transaction. The SEC might need to consider whether more work is needed on market circuit breakers, a device introduced after the 1987 market crash that temporarily stops trading when an individual stock or an entire market behaves erratically. New rules, scheduled to take full effect next August, set lower thresholds for triggering a trading halt.

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For more information on this institutional research, please contact:

Max Konzelman
max.konzelman@arborresearch.com
800-606-1872