The Machines That Ate the Markethttp://www.businessweek.com/magazine/content/10_22/b4180048321511.htm?campaign_id=rss_null
Bloomberg Businessweek May 20, 2010
â⦠Hysterical Thursday did no apparent long-term harm. Some venerable stocks dropped to a penny apiece before bouncing back. Overall, the Standard & Poor's 500-stock index declined 6.2 percent, from 1,136.16 to 1,065.79, in a 20-minute spanâan $862 billion paper lossâbefore recovering to finish down 3.2 percent.
Still, the brief crash threw up a flare that illuminated a financial topography that was unfamiliar even to many experienced investors. A Bloomberg Businessweek investigation into those harrowing minutes revealed the extent to which the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries. Instead, these former mathematicians and computer scientists see securities as a cascade of abstract data. They direct their mainframes to sift the information flows for minute discrepancies, such as when futures contracts fall out of sync with related underlying stocks.
High-frequency traders (HFTs), as they're known, set an astonishing pace. On May 6, 19 billion shares were bought and sold; as recently as 1998, 3 billion shares constituted a very busy day.
The HFT wizards argue that all that extra buying and selling provide the liquidity that makes the market more efficient. As long as the machines are humming, electronic bids and offers abound. On May 6, however, we saw what happens when digital networks follow conflicting protocols and some of the mighty computers temporarily power down. Liquidity evaporates. Panic combined with automation leads to much faster panic.
The decline began midmorning as skittishness intensified over the Greek economic debacle spreading elsewhere in Europe. A closely watched gauge of volatility calculated by the Chicago Board Options Exchange hit a high point for the year at 2:08 p.m. The volatility index, or VIX, is derived from options on the S&P 500, and it measures investor perceptions of market risk. When the VIX surged again, in its biggest gain in three years, some high-frequency programs may have automatically slowed their normal pace to limit losses, according to a May 15 research note by Nomura Securities.
Sell orders piled up much faster than buys, an imbalance that worsened over the next hour. During the period of heaviest selling, starting around 2:30 p.m., the NYSE paused electronic trading in certain stocks and switched to computerized auctions conducted by human traders. This caused electronic sell orders to be rerouted to other trading venues, where there were few, if any, buy orders to absorb them. As Mary L. Schapiro, chairman of the Securities & Exchange Commission, put it in congressional testimony five days later, some high-frequency firms "withdrew their liquidity after prices declined rapidly."
During the next few hours of confusion, exchanges began canceling trades in hundreds of stocks. NYSE Arca, an electronic platform operated by the Big Board, erased transactions in 295 companies. A surge in trades rejected by exchanges constitutes another trigger that automatically causes some high-frequency firms to slow down, says Ethan Kahn, a principal at Wolverine Trading, an electronic market-making outfit in Chicago: "You disable. You shut down." Wolverine pared back activity in equity futures because of concerns about the accuracy of data it was receiving, he adds.
In Washington, the staff at the SEC began reviewing up to 10 terabytes of market data to figure out what happened. Twelve days later, on May 18, the agency conceded that it still couldn't offer a firm answer. That uncertainty in itself suggests the disquieting complexity the stock market now presents.
The SEC and the Commodity Futures Trading Commission issued a preliminary report in which they outlined six hypotheses that could explain the scare. "We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges," Schapiro said upon the report's release. As one response, the SEC proposed that exchanges halt trading in individual stocks that swing more than 10 percent during a five-minute period. The new "circuit breaker" rules are subject to commission approval after 10 days of public comment.
While temporarily slowing trading during periods of investor high anxiety makes sense to regulators, at least some high-frequency traders disagree. "I don't think that's the right solution," Wolverine's Kahn told Bloomberg News after the SEC announcement. "It could cause a lot of complications. On a busy day where the market is making major moves, you'd have a handful of [stock] names where it's circuit breaker-on/circuit breaker-off all day.ââ¦"
