Joe Nocera: Frankenstein Takes Over the Market

August 3rd, 2012

The New York Times
By Joe Nocera
August 3, 2012

This week, yet another Wall Street firm most people have never heard of, relying on a computerized trading program that they can’t possibly understand, shook investors’ faith in the market. This is happening a little too frequently, don’t you think?

The company, of course, was Knight Capital, a major market maker that generated an astonishing 11 percent of all the trades in the first half of this year, according to the Tabb Group. It caters to sophisticated Wall Street traders as well as small investors, whose brokers often used Knight to fulfill their trades.

Trying to stay a step ahead of its competitors, Knight rolled out some new trading software. The software wasn’t ready. Instead of fulfilling customers’ orders, Knight’s computers went on an out-of-control spree of rapid-fire buying and selling. As trading volumes swelled, the Wall Street guys jumped in. (Sophisticated traders, relying on their own rapid-fire computers, often love volatility because it leads to trading anomalies they can take advantage of.) Many retail customers, having no idea what was going on, wound up losing money. I know: shocker.

The mishap also cost Knight so much money that its future is in jeopardy. Even putting aside the havoc wreaked on customers, you’d think that self-preservation would have been enough for Knight to want to ensure that its software worked. But apparently not. Wall Street is now as blindly reliant on computers, on algorithms, on high-frequency trading, as it was once blindly reliant on the risk models that allowed “toxic bonds” to be rated Triple A. Wall Street has created its own Frankenstein. The machines are now in charge.

On the upside, as my colleague Floyd Norris noted on Friday, are lower trading costs and more liquid markets. But computerized trading, especially rapid-fire trading, which has caused its own share of market mayhem, has other consequences as well. Most rapid-fire trading has nothing to do with the core idea that drew people to the market in the first place — that if you picked good companies, and did your homework, you could make money. High-frequency trading is about buying and selling in seconds — for a trader relying on an algorithm, the “long term” is an hour. Maybe.

A second consequence, flowing from the first, is that the market feels less and less hospitable to individual investors, while becoming, increasingly, a playground for the big boys, the way it was before the creation of the Securities and Exchange Commission in the 1930s. Yes, if you can shut out the white noise — à la Warren Buffett — rapid-fire trading shouldn’t matter over the long haul. But very few of us have Buffett-like blinders.

The third consequence is that the software too often goes awry, which then reinforces the idea that the small investor’s only role in the market is to be fleeced.

Take, for instance, that other recent disaster, Facebook’s initial public offering. Yes, human beings probably priced the shares too aggressively. But it also turned out that a number of institutional investors had been given word that the company’s growth was slowing. And then Nasdaq’s computers broke down, failing to confirm orders, which led to chaos — and losses by the small investor. I don’t have that much sympathy for Facebook investors; they thought they were being handed free money. Then again, that is exactly how Wall Street views I.P.O.s. Somehow, though, with small investors participating in the I.P.O., everything went wrong.

The primary way the government has tried to restore faith in the stock market is by prosecuting a series of high-profile insider-trading cases. That’s fine, but it doesn’t do a thing about the public, sudden events that have shaken investor confidence, like computerized trading glitches. As Jason Zweig pointed out recently in The Wall Street Journal, over the last 13 months, $136 billion has been withdrawn by investors from stock mutual funds. No doubt part of the reason for the withdrawals is that investors are unhappy with their returns. But I suspect that an even more important reason is that between the glitches and the scandals, people have simply had it with the market.

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