The financial markets in the U.S. are the most sophisticated in the world, yet they can unaccountably spin out of control at a moment’s notice. The latest case involves Knight Capital Group (KCG), a securities-trading company laid low by one of its inadequately tested computer-trading programs. In less than an hour on Aug. 1, the program entered incorrect bids for about 150 stocks into the interconnected electronic marketplace. Computer programs at other firms sniffed out the errors and traded against Knight. By the end of the day, the company was out $440 million, forcing it to seek outside financing to survive.
By now, it’s pretty clear that computer-driven trading is a major source of volatility. In the so-called flash crash of May 2010, the Dow Jones industrial average shed almost 1,000 points in less than an hour, only to bounce back just as fast.
In March of this year, Bats Global Markets had to withdraw its initial public offering after its system froze, forcing a halt in shares of Apple (AAPL). Two months later, Facebook (FB) couldn’t trade on time in its first day as a public company because of hang-ups in a Nasdaq computer.
The pursuit of speed is an obsession among trading firms. They can profit by taking advantage of minuscule discrepancies in prices that might exist for a few microseconds or by getting a sneak peek at orders before they are executed. Markets now believe that “if something is faster, then by definition it’s better,” says Duncan Niederauer, chief executive officer of NYSE Euronext (NYX), which owns the New York Stock Exchange. “We are understanding that speed is not always better.” Amen.
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 the industry insisted trading data not be available until the next day, which might not help regulators who are called upon the instant a market blows up. 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. One idea the SEC might consider is applying circuit breakers to specific firms that issue an excessive number of trade orders.
Market apologists have said Knight’s errant trades caused no harm to anyone other than Knight and its shareholders, who saw the value of their investment shrink by about $600 million in a few hours. Yet who can be so certain the next bug-infested program won’t inflict much more damage?