Features May 20, 2010, 5:00PM EST

The Machines That Ate the Market

(page 5 of 5)

Seemingly minor advances had profound consequences. The switch in 2001 to decimal share pricing, from sixteenths of a dollar, gave investors greater flexibility. Any firm willing to sell for a penny less than the best available offer price could step in and make the trade. A traditional Nasdaq market maker that had bought at $10 and sold at $10.0625 found itself in a lower-margin business. This favored the new electronic communications networks and the ever-speedier high-volume traders seeking microscopic profits across a multitude of transactions.

Market making moved from exchange floors to computers. On its Web site, Wolverine in Chicago says its servers receive direct data feeds from more than 15 exchanges and execute more than 1.5 million orders a day. The culture of the industry changed, too. Membership on a college sports team no longer constitutes a ticket to an entry-level job. In the past, Wall Street traders "were taller, bigger, more aggressive," says Kahn, who oversees market making at Wolverine. Today's HFT firms, by contrast, look for "more of a quant-computer-type person," says Kahn, who has a finance degree from the Wharton School.

The quants use a range of strategies. One is simultaneously posting bids and offers for ever-changing amounts of a single stock. Prices tend to vary by minuscule amounts on different electronic exchanges, so a stock can be bought at a lower price on one, then sold instantly at a higher price on another. The profit could be as little as a hundredth of a cent per share, which, multiplied by millions of shares a day, adds up to real money.

One thing that apparently happened on May 6 is that when HFT firms reacted to the market's sudden moves by slowing their computers or switching them off, buy orders that had been in place only seconds earlier disappeared, causing disequilibrium. HFT behavior, to be sure, wasn't the only factor that turned a down day in the markets into an abrupt collapse. Conflicting rules among exchanges also played a role.

RGM's Gorelick says his HFT firm, founded in 2001, continued to trade during the market turmoil. Its software developers and IT support people crowded onto the trading floor in Austin and quietly stared at the computer screens. Gorelick says, however, that high-frequency buying and selling wasn't so much the problem. He blames "old-fashioned human panic," worsened by inconsistent policies among exchanges.

Kahn disagrees. "The system broke down" on May 6, he says. "There should be and will be structural changes in the future." New regulation is coming, he adds. "We just don't know what it will be."

Schapiro has said she hasn't assessed any blame yet. HFT firms that pulled back may have acted appropriately, given that they had no legal obligation to do otherwise, she told Congress. In addition to its circuit-breaker proposal, the SEC is expected to consider requiring high-frequency traders to continue to make markets, even during a major selloff.

Some would resist such a mandate. "No one should be forced to provide liquidity when CNBC is showing riots in Greece in the morning and there are worries the bailout of Greece and Portugal will fall apart and they'll default on their debt," says Pipeline's Federspiel.

On another front, some lawmakers have proposed enacting a tiny tax on each equity trade. Such a levy would likely discourage some high-frequency trading, slow the market's pace overall, and raise billions in revenue for the federal government. Some of the tax proceeds could be used to bolster SEC monitoring.

After the frenzy of May 6, Clarence Woods of Baltimore says he ended up more or less where he started. He's moving ahead with plans for his new hedge fund and counts on the SEC to reassess the market: "We'll sit back, see what works and what doesn't." Manuel Henriquez, the Palo Alto venture capitalist, acknowledges "a visceral reaction to pull all the computers out." He doesn't think that's feasible, though. "We need to continue to embrace technology, but understand that technology can bite both ways."

Matt Andresen helped launch Island ECN in 1996 and later oversaw market making at Citadel Investment Group, which he left in March 2009. "The impact of the high-frequency tool has been, I believe, very democratizing," he says. Brokers serving individual investors can execute orders more quickly and less expensively—at least on most days. Then there was May 6. "Whatever the cause of it," Andresen says, "the failure mode was unacceptable."

With Jeff Kearns, Whitney Kisling, and Peter Coy

Mehta is a reporter for Bloomberg News. Thomasson is a reporter for Bloomberg News. Barrett is an assistant managing editor at Bloomberg Businessweek.

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