Reining things in
Technology apologists and the high-frequency traders who profit big time from bots like to remind us that we all benefit from greater use of technology in the markets. We have faster and cheaper trades, better data and the convenience of being able to trade from almost anywhere.
That is all true, and no one but a Luddite would want to ban bots altogether and go back to the old trading systems. But we still need reforms. Several tweaks can improve the safety of the markets significantly, say market experts. Here's a list:
- Create a better kill switch. New circuit breakers on stocks were introduced after the flash crash. But they're turned off at the open and close of trading, and they need to be expanded to the entire day. We also need kill switches that can shut down bots when it looks as if they are out of control.
- Make market data available equally, to all. Many of the stock exchanges are now publicly traded companies looking for ways to boost profits. One way is to create special data feeds that send out information more quickly to those willing to pay for it, like the HFT shops. This isn't fair. "It creates an unlevel playing field," says Brooks. "You shouldn't be able to pay extra to get data first." The Securities and Exchange Commission recently fined NYSE Euronext (NYX), the parent of the New York Stock Exchange, as part of a settlement of allegations that the exchange delivered some data faster to customers paying extra. This would be against the rules, but it is not clear exactly what happened and the NYSE neither admitted nor denied wrongdoing as part of its settlement.
- Make traders stand by their quotes. Since HFT shops use fleeting quotes to sniff out big orders and take advantage of the system, making them honor their quotes for a minimum time would help clean things up. It wouldn't take much. Saluzzi says making HFT shops honor quotes for just 50 milliseconds -- less than a blink of an eye -- would do it.
Harvey Pitt, a former SEC commissioner who is now the CEO of Kalorama Partners, a securities industry consulting firm, agrees that market rules should make it clearer that traders must place orders in good faith. He also favors taxes that encourage investors to hold stocks longer. "There have to be strong disincentives for those who want to be in and out of the stock in nanoseconds," he says.
- Get the SEC up to speed on technology. The SEC is staffed mainly with lawyers. This makes little sense now that technology is so prevalent in the stock market, says James Angel, an associate professor of finance at Georgetown University's McDonough School of Business. The SEC needs to hire more software engineers and former market participants with expertise in the technology used to create trading systems. "We need to change the culture of the SEC. It has too many lawyers," says Angel.
- Build a better order trail. All traders and HFT systems should be given identification numbers that are entered along with quotes. This would help identify traders behind unusual activity so that they can be contacted to see if their bot has gone wild, and it would remove the "cloak of anonymity" to deter predatory behavior such as quote stuffing, says Lauer. After a meltdown, this would also help regulators figure out what caused it.
- Require better computer system testing. The Facebook IPO fiasco and the Knight Capital blowup might have been avoided with better testing, which should be required. But there are limits here. "Automated trading systems make trades with other systems doing the same thing, based on what they see in the market," explains Jordan Dea-Mattson a software expert who has worked for Apple (AAPL). This creates unpredictable feedback loops, because that market is so complex. "You can't replicate the whole market. So there's no way to completely test a system."
At the time of publication, Michael Brush owned or controlled shares of the following company or fund mentioned in this column: T. Rowe Price mutual funds.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
