Last Updated May 7, 2010 3:38 PM EDT
High frequency trading uses computers to execute millions of buy and sell orders in milliseconds. Many of these trades are set to occur automatically if stocks reach a certain price. A dip in the market can trigger millions of automatic sales, which like dominoes, trigger millions more in just seconds. Before humans even realize what's happening, a panic has begun.
The growth of this kind of trading is staggering. HFT accounted for just 30% of all trades in 2006. Now that number is estimated to be closer to 75%. During the same 2005-2009 period, the volume of total HFT trades on the NYSE grew by a factor of 10, while the average speed of execution fell by 93 percent. Check out page 6 of this SEC report for more details.
Compounding the problem is the intense competition between the big financial firms. "It's become a technological arms race, and what separates winners and losers is how fast they can move," Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange, told the NYT last year. Firms want faster computers, better algorithms and closer access.
This culminates in what is know as "naked access", where HFT firms move their machines directly onto the exchange floor, a proximity that provides a nanosecond advantage over their peers. The NYT reports that 38% of all trades originate from firms with naked access to exchanges, up from just 9% five years ago.
The problem is that these trades aren't screened for errors. Back in January, the SEC proposed a ban on naked access, and gave a spot-on prediction of the kind of problem the market saw yesterday, "We are concerned that order entry errors in this setting could suddenly and significantly make a broker dealer or other market participants financially vulnerable within mere minutes or seconds," said SEC chairwomen Mary Shapiro.
As the folks at Ars Technica recently pointed out, the SEC is stumped insofar as what else to do about all this. The practice of high speed trading is so ingrained in the market at this point that banning it outright would be impossible. Taxing these transaction might slow their growth, but as yesterday's 1000 point drop indicates, we've already crossed the threshold into dangerous territory.
Warren Buffett famously quipped of investors, "You only find out who is swimming naked when the tide goes out." HFT and "naked access" has created an new environment in which the tide changes so quickly, and violently, it's liable to strip unwitting investors bare.
Image from Flickr user Aussiegal