Fixing Wall Street’s Autopilot

New York Times Op-Ed
May 7, 2010

ON Thursday afternoon, the Dow plunged 1,000 points within a few minutes, followed by an equally sudden recovery. We don’t know all the details about the drop, but it was almost certainly the result of computer or human error in a high-speed trading program.

Among the many arcane corners of the financial world highlighted by the Wall Street crisis, high-frequency trading — in which computers scan billions of bits of market data for trading opportunities that may exist for mere fractions of a second — has generated a surprising amount of discussion. Alongside the risk of expensive errors like what happened Thursday, critics say, these programs facilitate insider trading and overwhelm regulators’ access to critical information.

These are fair criticisms. Fortunately, they can also be easily addressed without undermining the positive role that high-frequency trading plays in the market.

Let’s start with the insider trading charge. Often, when an exchange operator receives an investor order and finds that another exchange has a better price, it will “flash” the order to a few select traders in its exchange a split second before sending it to market, giving those traders an opportunity to improve their price, too. When used properly, flashing ensures that investors trade at the best available prices.

But that hair’s breadth of time also gives high-frequency traders an opportunity to make a tidy profit off what amounts to insider information. How? Rather than improve their price, the recipient of a flash can go to the other exchange, buy up all the assets at better prices, and force the original investor to trade with them at an inferior price.

We don’t allow trading based on private knowledge of pending business deals or court rulings, and we shouldn’t allow it in high-frequency trading, either. But that doesn’t mean we should ban flashing all together. Instead, to deter abuse, anyone who gets a preview of a trade, whether by phone or flash, should be required to register with an exchange and keep records of every negotiation.

A trickier problem lies with the software that handles the trades. Heavy use of any software will magnify even the smallest flaw — and when it comes to high-frequency trading, a tiny flaw can put millions of dollars at risk before anyone notices.

One plausible explanation for Thursday’s 16-minute crash and recovery, for example, is that computers programmed to sell when prices hit a certain level did so en masse, prompting yet other computers to do the same, until the prices of some stocks were pushed down to nearly zero. Then other computers, recognizing these as extraordinarily unreasonable prices, began buying them up with equal relish.

Indeed, the rapid development of automated-trading software and the maddening complexity of even the most simple systems make the introduction of technological errors inevitable. While it’s true that electronic exchanges require trading software to be certified before it is used, there is no market-wide standard for testing the software and nothing to effectively stop a firm from trading with uncertified software.
Financial regulators should take a page from the Federal Aviation Administration and the National Transportation Safety Board and develop quality standards for trading software, as well as investigatory procedures that would allow the industry to learn from episodes like Thursday’s.

Finally, the Securities and Exchange Commission needs better access to the fire hose of data hitting the market each day. Because a great number of trades go through middlemen, regulators have no easy way of even knowing who the high-frequency traders are. With millions of trades made every day, this administrative hurdle means traders are essentially anonymous to regulators.

This opacity allows firms to reap benefits intended for nonprofessional investors. Many exchanges, for example, have rules that require them to fill orders from retail investors before those from pros. Anonymity allows professionals to masquerade as amateur investors and thus get their trades in faster.

But there’s an easy solution here as well: the Securities and Exchange Commission should require that everyone who originates a trade be identified. The commission is reported to be working on just such a rule, and it can’t come soon enough. Otherwise, it’s akin to asking someone to officiate a football game wearing a blindfold.

Like the autopilots that control most airplanes nowadays, high-frequency trading is more beneficial than harmful. It automates the routine elements of a complicated and high-risk mission, reducing the likelihood of human error. But costly errors will still happen, and some traders will bend the rules beyond the breaking point. We need reforms that actually address the risks of high-frequency trading and facilitate the restoration of public confidence in the markets.