After every debacle, one can identify a point at which it should have been obvious to all that things were getting crazy. We are at such a point with high-frequency trading in financial markets.
In the 1630s, when one tulip bulb sold for more than the price of 10 tons of butter, the Dutch should have known that bulb trading was getting out of hand.
In 2007, when investment banks were setting up Structured Investment Vehicles, independent companies headquartered in the Cayman Islands whose only purpose was to hold bonds that consisted of fragments of other bonds that consisted of fragments of other bonds that were backed by packages of mortgages, we should have known that the mortgage-backed securities game was about over.
In 2012, as we read that trading firms are fighting to get office space in Lower Manhattan close to the New York Stock Exchange because the length of copper wire between trader’s computers and those of the exchange is a factor in which firm’s high-frequency trading program has an edge in speed over the others, we should realize that what we are seeing is crazy and unsustainable.
On August 1, Knight Capital ran a new version of its trading software with an error in it. Though not particularly well known by the general public, Knight handled about 18 percent of the volume on the NYSE and NASDAQ and was a “market maker” or specialist for more than a fifth of all stocks traded on the NYSE, and will resume its role as a designated market maker Aug. 13. (Knight also had owned Deephaven Capital Management, the Minnetonka-based hedge fund group that sold off its assets after the crash of 2008.)
In the 40 minutes or so before it was shut down, the defective software managed to lose the firm $440 million. Knight’s own share value collapsed and it has since been bailed out in a $400 billion deal by other Wall Street companies that are taking a 73 percent share in the firm. Anyone who held stock in the company on July 31 has lost nearly all their investment.
Is there anything bad about this? On its face, this is how market economies are supposed to work. A private firm makes a bad mistake and its owners suffer. That demonstrates to other firms in the same business that they should be very sure to not make similar mistakes. It tells potential investors that stock in innovative financial firms is riskier than they may have thought. This is all to the good. Milton Friedman and Alan Greenspan would be pleased.
Moreover, there is little evidence that any third parties were hurt. Yes, there were some anomalous upward blips in the prices of certain shares that morning. The $400 million loss by Knight means that some group of stock owners got $400 million more for shares they were selling than they might have gotten otherwise. Such winners probably were other Wall Street firms also engaged in “high-frequency trading,” but there is nothing to show any widows or orphans lost a dime.
There is a broader question, however — that of whether the computer-driven high-frequency trading that led to this kerfuffle really benefits society as a whole as opposed to the handful of firms that excel at it.
These firms are quick to use the well-established argument that having speculators in a market adds to liquidity and makes market movements smaller. Investors, especially small ones, are more willing to put their money into a market if they know that there will be a willing buyer whenever they want to get out.
This is true. But it is also true that as higher and higher fractions of total trading on stock markets is now made up of a few companies trying to beat each other out by a few millionths of a second, many small investors are deciding that this is a game in which they will always be at a disadvantage. The more bread-and butter savers see stock markets as rigged against them, the less efficient the allocation of capital. That is bad for the country as a whole.
Moreover, the fact that an increasing fraction of total trading is taking place off organized exchanges like the NYSE or NASDAQ means that the reported prices and trading volumes from those exchanges are increasingly suspect. Do they really represent underlying trends for share prices as a whole or just those for the “tip of the iceberg” that is visible to the general public?
Much of this evolution in financial markets is driven by technology. High-frequency trading exists because of computing power and data transmission speed. Off-exchange trading in “dark pools” exists because of the capability of matching buyers and sellers through proprietary computer-based systems.
The technological genie is out of the bottle and it would not be easy for regulators to wave a wand and put it back in. Moreover, Wall Street maintains enormous, and probably growing, power in Washington. It can always wave the bloody shirt of “if you regulate us, all the business will move to London or Shanghai.”
That said, there are all kinds of warning signs that we are getting into an unsustainable situation that will blow up in our faces eventually.