A costly computer trading glitch involving market maker Knight Capital has intensified the debate over the effects and value of high-frequency algorithmic trading. The holding period for most of these strategies is measured in milliseconds. Specially designed computer algorithms blast out millions of orders a second. Most of these orders are merely probes, designed to gauge market interest. The vast majority are canceled almost instantly before they become actual trades. High-frequency traders are also adept at pocketing the rebates or fees that stock exchanges pay traders to route orders on their platforms.
Critics say these probes clog the system, crowding out legitimate orders. By making it more difficult to get execution of limit orders, for example, algorithmic trading disproportionately harms retail investors. And that’s when everything works the way it is designed! In 2010, the Dow dropped roughly 1,000 points in a couple of minutes due to a computerized trading error. The cause of the so-called “flash crash” still remains largely a mystery.
What can be done? After the “flash crash,” exchanges around the world installed additional circuit breakers to slow down wild swings. Many have suggested placing some sort of transaction tax on high frequency trading, and the S.E.C. is studying the risks these traders pose to the stability of financial markets. Like many proposed Wall Street reforms, however, these are incomplete solutions that fail to address the deepest roots of the problem.
In our forthcoming book, “God and Man on Wall Street: The Conscience of Capitalism,” Mark Hendrickson and I argue that Wall Street reform also requires nongovernmental regulatory solutions—additional self-restraint inculcated through culture-shaping institutions such as familial, civic, social, educational and faith communities. Along with an updated regulatory framework, these powerful influences make redemption possible.
Yes, technology promotes liquidity in markets. However, hubris is Wall Street’s Achilles’ heel, as participants frequently disregard man’s limitations for measuring and predicting future risks. It’s becoming clear that the existing technology infrastructure, i.e., the plumbing of Wall Street, can’t fully support the complexity of high-frequency trading.
While the “algos” have a right to push the envelope of innovation, they should not be permitted to hide behind complexity. Financial professionals should be required to provide a clear roadmap for how to monitor and disarm any innovations that could go rogue under extreme conditions. Shooting a rocket into space is only half the mission. It must also be equipped to safely return to earth.
Don’t get me wrong, I am an ardent believer in the benefits of financial innovation. Today, we take for granted many of these powerful innovations, like ATM’s, certificates of deposit and index funds. Many of today’s investors are also unaware of Wall Street’s so-called “Paperwork Crisis” of the 1960s, when increased trading volumes overwhelmed the industry’s paper-based, back-office record-keeping. Only more sophisticated computer and administrative systems resolved the settlement crisis.
The dominant belief on Wall Street today, however, is that added complexity enhances competitive advantage. Everyone assumes that complexity will serve as a barrier to competitors while superior intellect and resources will always enable one’s own firm to prevail. Within this worldview, culture and values are thus rarely seen as important sources of competitive advantage. “Smartness” often crowds out other important human virtues like empathy and compassion.
This attitude isn’t confined to Wall Street’s small band of sophisticated high-frequency traders. Dangerous complexity marked MF Global. One of its regulators conceded in Congressional testimony that the firm’s books were simply too complicated. That complexity outstripped MF Global’s inadequate risk controls. Some financial institutions have become so large and opaque that it’s difficult for any CEO to adequately oversee them—particularly during extreme financial shocks.
Monetary authorities around the world have also demonstrated the same hubris. Under this thinking, no interventionist strategy appears too novel or risky. In fact, throwing things at the wall to find out what sticks can seem downright proactive. This assumes, however, that the process of perpetual tinkering is both costless and harmless. There are boundaries to endless experimentation—a clear distinction between Dr. Salk and Dr. Frankenstein.
In many cases, regulators simply can’t keep up with the innovation arms race. Both non-banking lending and mortgage derivatives, for example, developed faster than regulators could police or even evaluate. Financial engineering is like blood doping in professional cycling: the innovators are always one step ahead of techniques for detection.
Because of this inherent gap, it is essential that we discuss character and values within the financial system. The risks to the broader economy place these issues within the realm of public trust. Some have said that the recent breakdowns demonstrate that trading no longer pits man versus the machines but rather machines versus machines. I would argue that, at its core, it’s still a battle of man versus himself.
Editor’s note: A version of this article first appeared at RealClearMarkets.com.
Dr. Craig Columbus is a fellow for entrepreneurship and innovation with The Center for Vision & Values. He is also the executive director of The Center for Entrepreneurship & Innovation and chair of the Department of Entrepreneurship at Grove City College.
© 2012 by The Center for Vision & Values at Grove City College. The views & opinions expressed herein may, but do not necessarily, reflect the views of Grove City College. Used with permission.