The Modern Stock Market: Man vs Machine Means We All Lose
The finger pointing that's followed last Thursday's stock market panic seems borrowed from a science fiction film. Backers of the high speed computers that have come to dominate day trading blamed the human beings who called a temporary halt to collect their thoughts. The humble mortals retorted that haywire machines were the driving force behind the 1000 point drop.
The truth is that the explosive growth of new electronic exchanges and high frequency trading has created a fragmented and volatile system that neither regulators no market participants fully understand, or control.
The record setting plunge caused billions of dollars in losses, hitting big names like Google (GOOG), Procter & Gamble (PG) and Accenture (ACN), whose shares went from $40 to just 1 cent. Investigators are looking at an early incident on the Chicago Mercantile Exchange (CME), where a futures contract pegged to the S&P 500 (SPX) index took a sudden tumble on Thursday. This may have triggered a wave of automated selling by computerized HFT firms across a broad range of stocks.
The spark that started the fire, however, is really a red herring. The problem is not a trader's fat finger, or a random computer glitch. The issue is how the market responded, and what that says about the larger mechanisms that now dominate day trading.
Here's a quick breakdown of how the perfect storm developed. Something set off a wave of automated selling by high speed computers. As prices plummeted, the NYSE called a temporary halt to try and figure out what was going on and find buyers to match with the sudden wave of sales. As NYSE CEO Larry Leibowitz put it, the system is, "Designed to allow human intelligence to supplement artificial intelligence when trading appears irrational." But unlike a decade ago, the NYSE no longer has the clout to call a meaningful time out.
As Terry Savage, Director of the CME Group wrote today in the Sun Times:
When the cascade started, the NYSE floor immediately declared a 'pause' of about 90 seconds to assess whether these trades were 'for real.' During those few seconds, orders were automatically directed to smaller electronic stock exchanges, which were still posting bids. The sales pushed prices downward, hitting the stops (automatically triggered sales) in these thinly traded markets.According to NASDAQ CEO Robert Greifeld this "mini circuit breaker" drove prices down by eliminating buyers and added fuel to the fear that something was wrong with the markets. Well, duh. Something was wrong, and the human traders on the floor were trying to make sense of it. But as the electronic exchanges continued to pour in sell orders, the NYSE move compounded the problem.
The big argument for high-frequency trading, or HFT, which many market analysts and participants see as dangerous and unethical, is that it adds liquidity to the market. As my colleague Alain Sherter points out, there have been academic studies that back this up, at least in theory. HFT firms have claimed that the huge volume of high speed trading they provide helped the 2008 crisis from being worse than it was. But as Alan Abelson points out in Barron's:
It sorrows us to report that the bare bones of what happened on Thursday is that when the going got rough, the high-frequency crowd stampeded for the exits and their vaunted pools of liquidity vanished with them.In the end, humans didn't trust their machines to sort through the mess. As the WSJ notes, a number of big computerized trading firms yanked their systems offline when the going got rough, deepening the confusion and panic in the markets.
At the Congressional hearing today regulators and major exchanges are expected to lay out new "circuit breakers" that would allow the market to better coordinate its response to these sudden panics, as well a more comprehensive auditing system to track the initial source of the problem. But they will also have to address the deeper systematic issue of a cyborg stock market that has grown beyond the control of its masters.