Financial Regulatory Reform: Ask Basic Questions About Computerized Trading

One of the principal reasons for the financial crisis of 2007-08 was the failure--of Wall Street executives, lenders, investors and regulators--to ask basic questions about the computer modeling that was used to construct the now infamous derivatives contracts whose flaws triggered our lengthy, ongoing recession. While these models covered, more or less, 99% of the potential market scenarios that could arise, they didn't cover the possibility that the real estate market might, on a national level, fall. Such a phenomenon had not occurred in a very long time. And because of that, the big players in the derivatives markets presumed it wouldn't occur. That was a mistake. We are still paying the price.

High speed computerized trading has recently been in the news. Outsized profits at Goldman Sachs, followed by outsized bonuses, were partly the result of electronic trading at speeds measured in the millionths of seconds. The alleged theft of some of Goldman's ultra-fast trading software by a former IT employee added tabloid sensationalism to the story. Complaints about flash trading, where some firms with superfast computers can see and trade ahead of other large orders, have led the SEC to consider banning the practice. "Naked access," which is about money, not sex (remember, this is Wall Street), involves a favored customer of a brokerage firm using the broker's identity to trade directly on an exchange. This would presumably heighten the speed of its trade executions. The high speed firm would, to the rest of the market, appear to be an exchange member. But it wouldn't necessarily behave like an exchange member and might destabilize the market. A third kind of high speed trading involves the arbitrage of prices in more than one market, an established trading strategy now conducted at exponentially faster speeds.

Computerized trading is now reported to be more than half the total trading volume in the stock markets. This represents a fundamental change. Back in the days when landing a human being on the Moon was still a dream, the stock markets consisted of the interactions of human judgments. Human interactions can be strange and even destructive. The history of financial booms, bubbles and busts demonstrates that. But at least people more or less understand each other most of the time. Family bonds, society and commerce wouldn't be possible if that weren't true.

But computer models are another thing. They don't always work as intended, because of imperfections in design by their human financial engineers. Yet, the image of computers as more reliable and thorough than humans leads to the notion that they are less prone to errors. That, as we know from the recent mortgage-backed mess, is demonstrably untrue. We need to know if computerized trading could have unintended consequences at a time when we really don't need more unintended consequences.

It's important to consider basic questions. Flash trading could create a two-tiered market, with better prices for well-computerized big players and crumbs for everyone else. This ultra-short term profiteering isn't in keeping with the baseline purpose of the stock markets--to provide capital for long term investment. Flash trading doesn't offer much in the way of societal benefits. Yes, there are arguments that it increases liquidity. But let's remember that not all liquidity is the same. There is the liquidity provided by exchange specialists and market makers, which is "counter-cyclical." This means that they sell when investors want to buy and buy when investors want to sell. Counter-cyclical liquidity is good for markets because it keeps things flowing. But wouldn't flash trading liquidity more likely be "pro-cyclical," meaning it would be used to buy ahead of a market surge and sell ahead of a market drop? This would destabilize markets.

It's also important to look at the collective interaction of these high speed trading strategies. When more than half the trading volume in the markets is computerized, it's fair to conclude that machines are observing and interacting with other machines a lot of the time. Perhaps flash trading or naked access could create price anomalies that a multi-market arbitrage system would believe to be the beginning of a profit opportunity. But, without the human element that made historic trading patterns what they were, the markets might move in unexpected directions. The hyper vigilance that a computer can provide might result in large wolfpacks of high speed traders pouncing on pricing anomalies with ultrafast trades, pushing prices far into the opposite direction and producing asymmetries never before seen. That might be bad.

And there's also the problem of inputs. Remember what they say about computers: garbage in, garbage out. Interest rates, for example, have historic relationships with the values of other assets. The Federal Reserve has pushed interest rates down to extraordinarily low levels. It's possible that the computers are misinterpreting what the human action by the Fed means. Perhaps these extremely low interest rates make the computers think that stocks are more valuable than they really are. The humans pretty much know that the Fed can't keep interest rates down with the flounders forever. But who knows when the humans at the Fed will begin the process of draining the vast oceans of liquidity they have dumped into the economy, how fast they will do it, and what mechanisms they will use. The computers may have contributed heavily to the upside delirium we have recently seen in the markets, where there is no such thing as bad news and all news makes the market rise. Interest rates--especially short term rates--are the product of government policy, and today we have government policies and intervention never before seen. Might the computers, programmed to react to historical patterns, misinterpret what's going on? If the computers exaggerate the upward momentum, might they draw in humans who--thinking they're seeing, not computers, but other humans buying--invest when they would otherwise be worried about jumping in at the top of an asset bubble?

There are surely many other questions that could be asked, especially if one can get a detailed understanding of how these computerized trading strategies work. The regulators can get that information, and should. It won't be easy to evaluate this stuff. A lot of it involves technical complexity and serious math, things that the liberal arts majors who heavily populate the legal staffs of regulatory agencies don't hanker for. But you can't regulate an industry if you don't understand it, and it's time to get a thorough understanding of what high-speed trading is all about, before unintended consequences once again wreak havoc in the markets.