Politicians and regulators realize there's an issue, but by the time Washington gets a handle on the situation, some experts fear, the damage may already be done. "We're always fighting the last fire," says Dave Lauer, a market technology expert who has worked for high-speed trading firms.
If it's a fire the SEC needs to fight, the agency is working with equipment that's more reminiscent of bucket brigades. The New York Times has called regulators' tech "rudimentary." David Leinweber, the director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory, has slammed the SEC and the CFTC for running an "IT museum"—and taking nearly five months to analyze the flash crash, which was essentially over in five minutes.
One mysterious algorithm was described as running "like a bat out of hell on crystal meth with a red bull chaser."
To enhance its market-monitoring capacity, the SEC has had to turn to industry—specifically, a firm called Tradeworx that specializes in very-high-speed trades—for a new computer program to analyze trading data. That program, called Midas, was scheduled to go online at the end of 2012. But even Midas won't give the SEC a comprehensive picture of the markets. It offers no data on so-called "dark pools," private markets where buyers and sellers can trade anonymously, and it won't tell the SEC who is responsible for a given trade. To fill those gaps, the SEC plans to ask market participants to submit comprehensive information about every trade in the US markets—creating what is called a consolidated audit trail. But the SEC won't receive this information in real time. Instead, the audit information will be due by 8 a.m. the next day.
"When that data does come in, since we have every single step, we will be able to reconstruct it exactly as it happens," says Gregg Berman, an ex-physicist and SEC adviser who led the agency's inquiry into the flash crash. "The only thing we miss is the opportunity to do something the same day. But given that a robust and defensible analysis of even a small portion of the trading day can itself take many days, we don't give up much by waiting until the next day to receive a complete record of the day's events." Studying this market data will help the agency develop rules to address problems in the market—but only after they occur.
Meanwhile, the financial world is getting even more fast-paced, opaque, and downright mysterious. The same week Schapiro spoke at the SEC roundtable, an algorithm consumed 10 percent of the bandwidth of the US stock market. It "ran like a bat out of hell on crystal meth with a red bull chaser, to mix a few metaphors," Leinweber wrote on his Forbes blog. "It generated 4% of U.S. stock market quote activity," but the program "didn't make a SINGLE TRADE, cancelling every order. That is pretty darn weird." Leinweber suspects that the culprit was a new algorithm being tested, but that's just a guess—no one knows for sure, least of all the SEC. It used up "10% of the communications capacity of our overly wired market," Leinweber noted. "Ten of these guys could use the whole market...Scary stuff."
So far, the problems caused by algorithms appear to be mostly accidental. But what if someone designed a program intended to wreak havoc? John Bates, a computer scientist who, in the early 2000s, designed software behind complicated trading algorithms, worries that the kind of tools he's created could end up in the wrong hands. "Fears of algorithmic terrorism, where a well-funded criminal or terrorist organization could find a way to cause a major market crisis, are not unfounded," he wrote in 2011. "This type of scenario could cause chaos for civilization and profit for the bad guys and must constitute a matter of national security."
Ask the Wall Street lobbyists about things like cascade failures or algorithmic terrorism and they'll tell you not to worry. They'll note that transaction costs have never been lower and that the average investor can execute trades faster and cheaper than ever before. In their view, the fact that Knight lost $440 million and didn't take the rest of the financial sector down with it suggests that the market isn't nearly as fragile as detractors claim.
Thanks to these arguments, and the nearly $200 million Wall Street spent lobbying Congress around the Dodd-Frank financial reform bill in 2010, that law did almost nothing to regulate high-speed trading. In the absence of actual rules, the most widely discussed safeguards are now the "kill switches" or "circuit breakers" that kick in when a certain threshold is breached. After Black Monday in 1987, when the Dow Jones dropped by nearly a quarter in one day, the New York Stock Exchange instituted circuit breakers that halt trading temporarily when the market falls by 10 percent and shut it down entirely when it falls by 30 percent. Neither of these fail-safes, though, was triggered by the flash crash—the market fell in a blink, but it fell less than 10 percent.
After the flash crash, the SEC implemented new circuit breakers that kick in when an individual stock experiences rapid, unusual price swings. But those didn't prevent the Knight debacle—it was mostly trading volume, not unusual prices, that cost the company hundreds of millions. New SEC rules slated to take effect in February will halt trading for five minutes if prices of individual stocks move outside of a set range for more than 15 seconds. But those are "a Band-Aid," complains Lauer, the technology expert. "You're treating the symptom, not the cause."
Lawmakers have proposed a financial-transactions tax to limit high-speed trading churn, and raise revenue.
Most participants at the SEC's October market tech roundtable endorsed the idea of installing more kill switches at various levels—for individual firms, individual stocks, and perhaps for the market as a whole. But there's a problem: If a kill switch or circuit breaker is automatic, it does nothing to reintroduce human judgment. Conversely, if a person has to pull a kill switch, he or she has to take responsibility for doing so—which creates its own problems. "No one wants to be the guy who cried wolf and got you onto the front page of the Wall Street Journal," Black says. "The word that's going to be used is that [you] panicked."
So, if kill switches and circuit breakers don't prevent future problems (and they haven't before), how do you avoid the algorithmic apocalypse? Reformers are advocating what amount to speed limits. One of their proposals involves implementing what could be viewed as a temporary "no backsies" rule, requiring trading firms to honor the prices they quote for a minimum amount of time unless they execute the trade or make a better offer. Even a minimum quote life of just 50 milliseconds "would have eliminated the flash crash," says Eric Hunsader, the CEO of Nanex, a company that makes software for high-speed traders.
In a more far-reaching proposal, Rep. Peter DeFazio (D-Ore.) and Sen. Tom Harkin (D-Iowa) have proposed levying a financial-transactions tax—they suggest 0.03 percent—on each trade, as a way of discouraging churn and raising revenue. (The United States had such a tax until 1966.) Economists, activists, and even some finance big shots—Warren Buffett among them—have endorsed the idea. "Even at the modest level we've proposed, [the tax] would raise $35 billion a year, which would either be used to defray the deficit or be used for job-creating investments by the government," DeFazio told me. Eleven European Union countries (though not the United Kingdom) are pressing ahead with the idea—and they've talked about a tax as high as 0.1 percent. Wall Street lobbyists have pushed back against both speed limits and bringing back the transaction tax. But in the wake of the Knight episode, some industry experts are expressing doubts about the status quo.
"I believe this latest event was handled better than the flash crash, but the larger question is whether our markets are adequate to deal with the technology that is out there," Arthur Levitt Jr., a former chairman of the SEC and a dean of the financial establishment, told the New York Times in August. "I don't think they are." That view is becoming more widely accepted, even among corporate CEOs, traders, and the algorithm builders themselves.
The chief executives of publicly traded companies—who are hired and fired based on stock prices—increasingly worry that their shares could be sent into a free fall by an algorithmic feeding frenzy. The current markets have created a "somewhat disjointed world between what a company does and what its stock does," the CEO of one billion-dollar, NYSE-traded company told Mother Jones.
According to Ben Willis, a longtime NYSE trader, "When you have the heads of the Fortune 500 companies say, 'Hey, wait a minute, guys: Our stocks look like hell and...no one can tell me with any certainty who is doing what to my stock and why,'" the critics might gain political momentum. Then again, the financial sector has a pretty solid track record of stymieing reform. And, given the extent to which the international financial markets are intertwined, would slowing down Wall Street make a difference if similar measures weren't taken in London and Hong Kong?
As market-shaking episodes pile up, even some of the tech geniuses who helped usher in Wall Street 2.0 now worry about their innovations running amok. Wall Street Journal reporter Scott Patterson's book on high-speed trading, Dark Pools, recounts the story of Spencer Greenberg, a young math genius who built a hugely successful trading algorithm named Star but later came to have reservations about what he had unleashed on the world. "In the hands of people who don't know what they're doing," Greenberg warned a gathering of algorithmic traders in 2011, "machine learning can be disastrous."