By JIM MCTAGUE
Last year’s Flash Crash was a hair-raising experience for stock and commodities investors—comparable to the sudden descent of a large airliner from 38,000 feet to tree-top level, followed by an equally sudden and steep ascent.
A trillion dollars in equity vanished in minutes, as stock futures, exchange-traded funds and equities plunged. I’ve recently heard from a computer-trading expert warning of the very real possibility of a more widespread and catastrophic “splash crash,” a dislocation by high-speed trading computers that could simultaneously splash across many more asset classes and markets. Imagine our metaphorical jet buried in the earth up to its tail.
The possibility of a splash-crash nightmare springs from John Bates, the affable chief technology officer of Progress Software (ticker: PRGS), a $1.89 billion company whose worldwide headquarters is in Bedford, Mass. Bates has an impressive résumé, including a doctorate in computer science from Cambridge University. He’s also a member of a panel of technology experts that advises the Commodities Futures Trading Commission.
“I think there is an extreme risk of seeing this because we’re not serious about putting measures in place to police against it,” says Bates, who freely acknowledges that his company has computer programs that it would like to sell to securities and commodities regulators to address this very issue.
HIGH-SPEED COMPUTERS TRADING millions of times a day on multiple exchanges around the globe have in effect linked once-disparate markets into an unstable, volatile whole. The nimble robotic brains are instructed by their masters to buy and sell stocks at the speed of light without human intervention. Packed full of pattern-recognition software and other advanced programs, these artificial-intelligence systems base their trading decisions on factors such as market volume, momentum and direction, and the historic pricing relationships between various stocks and asset classes.
Some of the programs even react to breaking news stories, translated for their consumption into algorithms by companies including Dow Jones, the parent of Barron’s, and Reuters. Each second, these talented robots monitor dozens of pricing relationships for multiple securities and commodities on many exchanges and buy or sell whenever an arbitrage opportunity arises. Many of the machines are plugged right into the exchanges’ computers to give them an extra speed advantage. They need it. Some of these opportunities are so fleeting—we’re talking milliseconds—that they are invisible to us mere mortals.
The machines typically hold the stocks from two to seven seconds, realize a portion-of-a-penny profit, and repeat the process, over and over. The pennies accumulate into astronomically large heaps. Estimates of the unregulated, secretive industry’s profits for 2009 ranged from $2 billion to $5.6 billion.
Oversight of robotic trading is so slight that regulators have little idea of itsimpact. Progress Software’s Bates frets that, absent more oversight, terrorists wielding the smart machines could attack the markets in an attempt to cripple our economy. Regulators counter that it would be much more difficult for hackers to infiltrate a stock exchange than, say, a company like Sony (SNE), the recent victim of a crippling criminal cyber attack. But it isn’t impossible. Imagine an agent working for a foreign government infiltrating a firm that owns robots and infecting one or more of the machines with a malicious virus.
“You almost need something like a Norad [the joint U.S.-Canadian North American Aerospace Defense Command]… for the markets,” Bates says. Because some 15% of the U.S. economy is based on financial services and the markets, they should be protected on the basis of national security, he asserts. This is arguable. Other experts opine that the Securities and Exchange Commission is more lacking in manpower than technology and that it could stay fairly on top of the market with a hundred more mathematicians, as opposed to a billion-dollar supercomputer.
Often, the robots or their handlers blunder and, consequently, individual stock prices go haywire. Regulators have tried to dampen the effect with “circuit breakers” on the most popular stocks and ETFs—a trigger that halts trading when a stock’s price swings up or down by 10% within any five-minute period. Even so, there are several bizarre trading events every week. For example, last Wednesday, May 18, the Class C preferred shares of Strategic Hotels & Resorts (BEEPRC) rose to $2,600 from $28.32 in just 11 seconds, according to Eric Hunsader of Nanex, a market-data provider from Winnetka, Ill. Then, they reverted to their previous price.
There’s also circumstantial evidence that some of the robots are mechanized Ivan Boeskys, attempting to manipulate prices. “Everybody knows it,” says Bates. “The regulators know it. So do the exchanges. They should begin actively policing trading.”
This might not be easy. Some of the “crimes” might be the result of simple operator error or the unintended consequences of technological complexity. Regulators and the Justice Department are employing pattern-recognition software in an attempt to differentiate deliberate acts from innocent mistakes.
“POLICING REQUIRES YOU TO ACTUALLY sit within the stream of data as it is being generated,” Bates adds. “That way the regulators can catch the malicious machines in the act and stop them before they can impact the markets.” The SEC, in conjunction with the Justice Department, is conducting a more traditional investigation, poring over historical market data to detect patterns of criminal behavior.
Bates isn’t a lone voice. Other market experts agree that a bigger flash crash is possible. Joe Saluzzi of Themis Trading in Chatham, N.J., warns that fixes like the circuit breakers are Band-Aids: “Even if regulators had their 10% limit-up/limit-down circuit breakers in place for all stocks, the market could still drop 10% in a matter of seconds or minutes. This will shatter already-fragile investor confidence.”
I’m shattered already.
If you are thinking of dipping your toe into the markets the above article should be a warning to you
It is a very stressful type of job (as can been seen on video clip below) and often brings you to the brink, especially when the market turns and you are not prepared for it as almost 90 % of traders get caught out every time !
I was wondering most articles seem to concentrate on a possible market meltdown I am curious what are the chances of a market explosion to the up side. It must be just as plausible! Do the market regulators have a trip switch in place for such an eventuality?