So much for the biggest, safest, most liquid securities market in the world.
Of course we’re talking about the U.S. equities market, which used to be described in those glowing terms. But now, after Thursday’s trading debacle, the market looks more like a casino — and not just any casino, but one of those smelly joints with sawdust on the floor, ripped felt on the blackjack tables and loaded dice.
I’ve been inside casinos like that. I wouldn’t think of laying a 10-cent bet with the dealer. So why would I buy stock on an exchange emitting the same odor of rancid beer?
The market’s friends, including executives of the various exchanges and some traders with access to turbocharged equipment, would like us to think that the system worked Thursday. This is based on the idea that things could have been a lot worse.
But let’s not sugarcoat the event. When you have the Dow Jones industrial average falling nearly 1,000 points before recovering, including a nausea-inducing collapse of more than 700 points in a matter of minutes; when you have legitimate stocks like Accenture quoted at a penny a share, or about zero percent of their real value; and when therefore you have millions of investors trapped by insane prices, by any rational standard of market performance that’s a sin.
Here’s another sin: As of the close of business Friday — 24 hours after the event — the markets’ overseers were still not sure what happened.
Yet the New York Stock Exchange shockingly insisted that its systems worked perfectly well Thursday because it was able to “slow things down and allow common sense to be inserted into the process,” as NYSE Executive Vice President Louis Pastina told Reuters.
I’m not sure where Mr. Pastina detected common sense at work that day. But his observation reminded me vividly of the claim uttered by Richard Whitney, the president of the Big Board, that “the Exchange is a perfect institution.” That was in 1933, four years after it had laid its biggest egg of all time, and a few months before Congress, wisely ignoring Whitney’s words, created the Securities and Exchange Commission to make the exchange even more perfect.
Although it still isn’t clear what caused Thursday’s bedlam, we can identify generally where to look. The most obvious place is in the explosive growth of “high-frequency trading,” in which traders use computer algorithms to pump billions of dollars in orders onto exchanges in milliseconds. If there are glitches or manipulative aspects to any of those trades, they may be nothing but a puff of electronic smoke before anyone catches them.
High-frequency trading has mushroomed to 70% from 30% of U.S. equity markets over the last few years, Sen. Ted Kaufman (D-Del.), who has been warning about the phenomenon for a year, told me last week.
Much of that trading occurs beyond the reach of market surveillance, so nobody knows the size and shape of the orders, who’s placing them and to what end. But even when the trading can be monitored and analyzed, the markets’ monitoring systems are hopelessly outgunned in terms of electronic sophistication.
“The problem may not be too much computerization, but too little,” says James Angel, an expert in market regulation at Georgetown University and an outside board member of DirectEdge, a new electronic exchange. “We don’t have the kind of computerized monitoring that can track this activity in real time.”
When a suspect trade shows up on regulators’ screens for analysis by a human monitor, Angel observes, “the process can take several minutes. But you can have a high-frequency trading glitch in milliseconds.”
Plainly, when computers can outrun human beings by such an enormous margin, the only options for reintroducing sanity to the process is to slow down the computers or speed up the humans. Since the latter must accommodate certain natural limits, the exchanges have tried the former. The NYSE expressed inordinate pride last week in its procedure for shutting down electronic trading in certain stocks so that humans could step in.
One flaw in that process is that only the Big Board imposes such circuit breakers on individual stocks, and there are a dozen or more other exchanges or exchange-like electronic markets that could accept some of the orders backed off by the NYSE. On a day like Thursday, therefore, the equities market can blow at any seam.
That points to another flaw — the regulatory system. The Securities and Exchange Commission, which has the authority to standardize trading rules across all U.S. markets, has heard warnings for more than a year that the growth of electronic trading had made many of its rules obsolete.
But the SEC doesn’t operate at human speed — it operates at regulatory speed, which can make even the schlubbiest human look like Secretariat. Over the last year it has held round tables on these trading issues, ordered staff reports and prepared to solicit comments from experts, investors and traders on any rules it might consider.
“We would, of course, study all comments very seriously,” SEC Chairwoman Mary Schapiro told Kaufman in September, sounding much like a priest delivering the last rites to a terminal patient.
“This hasn’t been a high priority for them, compared to day-to-day stuff like catching the next Bernie Madoff,” Angel, who participated in one of those round tables, told me.
No one would claim that the SEC should plunge into regulation of electronic trading without study. When it shoots first and asks questions later, as it did in its short-sale restrictions during the financial meltdown in 2008, the result can be self-defeating, useless or at best transitory.
But the issue should have been on the front burner long ago.
“Last year, I felt a little lonely raising these concerns,” Kaufman said on the Senate floor recently. “But this year, I’m starting to have plenty of company.”
That was back in March. I bet he’s got a lot more company today.