Michael Santoli

Trade Glitches Test Investors’ Fragile Faith in Market

Michael Santoli

This has been another week in which the market machines have displeased their human masters - or should that be human slaves?

From the "Twitter flash crash" to a forced shutdown of Charles Schwab Corp's (SCHW) brokerage network to a nearly day-long system outage at the CBOE Holdings Inc.'s (CBOE) Chicago Board Options Exchange, the past few days have served as an uneasy reminder that U.S. markets are a twitchy assemblage of computer networks arranged for maximum speed and eye-blink competition for order flow. This includes little human mediation from manned trading desks or central exchange floors.

First was Tuesday's momentary "#HashCrash," when headline-scanning trading computers helped drop stock indexes more than 1% after a bogus Tweet from the hacked Twitter account of the Associated Press "reported" that a White House explosion had injured President Obama. Stocks fleetingly lost and recovered hundreds of billions of market value before most investors had even ingested the fake news. This reinforced the already entrenched belief among the public that the bloodless trading 'bots control the flow of real-time capital through the financial economy's vessels.

Tuesday's trading halt at Schwab, the country's largest discount broker, was attributed to malicious cyberattacks; it was more nuisance than market mover. The CBOE snafu Thursday, due to an internal system problem, didn't have much market-wide impact, though certain popular, CBOE-exclusive index-option products were unavailable for trading.

Structural vulnerabilities

Still, correctly or not, these structural vulnerabilities give abidingly wary retail investors one more excuse to mistrust the light-speed circuitry of today's markets.

While not exactly Everyman, the mega-rich technology entrepreneur and Dallas Mavericks owner Mark Cuban Thursday spoke for plenty of ordinary market spectators when he said in a CNBC interview that he rarely bought stocks any more, feeling the opportunities for gain can't overcome the sense that the game is rigged.

"I think that's a reflection of the lack of trust, the fact that we don't know what business the markets are in, and there's so much algorithmic trading and technology-driven trading it's created downstream problems," Cuban said.

While this is probably a fair reflection of many would-be investors' anxieties about how today's markets operate, the ironies pile high against this view. For one thing, stock trading and investing has never been cheaper, more efficient or more easily accessible to the small investor. And essentially all the structural changes in the past decade and a half came as a result of regulatory edicts aimed at protecting small investors through open competition for orders, narrower trading spreads between buy and sell prices, and equal treatment of retail trades.

The superstructure

Sure, it's now a high-tech Rube Goldberg superstructure, with some 60 separate electronic trading venues, 2,000 order types largely conveyed by cat-and-mouse computer algorithms and more than 10% of volume executed in "dark" pools of institutional liquidity and featuring opaque fee-and-rebate arrangements for opportunistic players.

Yet when the retiree clicks Buy to acquire 100 shares of Citigroup Inc. (C) through his online-brokerage account, the trade is done with zero friction, completed before his finger is off the mouse, at a trivial cost below $10.

The clash of perception and reality could be heard through the debate Thursday at the annual conference of the Security Traders Association of New York, a group representing brokers and exchange personnel.

On one side, electronic-trading executives said the Twitter crash didn't expose any flaws in the system but rather showed the market performed rationally, as engineered and intended.

Bryan Harkins, chief operating officer of electronic-exchange firm Direct Edge, said the Twitter flutter was an understandably titillating story given its encapsulation of so many raw-nerve issues. It involved "a Tweet, information security, high-frequency trading, 'algos gone wild'" he pointed out. Yet the market dipped "only 1%" and "worked as designed" as correct information hit the tape.

Harish Devarajan, chief executive of an algorithmic-trading firm catering to brokers, exchanges and investment funds, pointed out at the STANY event that the preloaded, Twitter-scanning trading strategies reacted the way any rational trader would have, only faster.

If the hacked AP headline had been true, markets would no doubt have fallen hard, so the automated reflex to sell and pull bids for stocks made sense. Once the tweet was debunked, the "risk-off" impulse was reversed -- no doubt in part as other algorithms detected an outlier, low-probability move and taking the other side.

This notion drew animated and angry objection by Kenny Polcari, a longtime exchange broker and director of NYSE floor operations for O'Neil Securities. He insisted such sudden air pockets in stocks and indexes, even if just a steep narrow spike on the daily chart, show how the complex system lacks the buffer of designated, real-money intermediaries with an incentive and responsibility to provide liquidity and smooth price moves in jumpy markets.

A lack of faith

To Polcari and others suspicious of the market's machinations today, such jagged, unnerving moves are contributing to a general lack of faith by the public, with small investors on the whole not broadly participating in a market that has more than doubled in four years.

Of course it's true that, even in the heyday of NYSE floor dominance, some savvy traders operated at the "highest frequency," whatever it was at the time. Rumors have also forever influenced prices; it just used to happen more slowly and less visibly. Back then investing was more expensive for virtually everyone, with wide trading spreads and lush commissions applied as a sort of private tax on retail investors, pension funds and everyone else.

Meantime, high-frequency trading operators (never as profitable as the sheltered specialists and market makers of old) are earning much less today, and are far less dominant as a source of orders, than they were just a few years ago, as their volatility-sniffing techniques became too popular and the "vig" arbitraged away.

It's overwhelmingly likely that the small investor has never had it so good, based on cost and access to a fair price for shares, while it's large institutions that suffer most from a fragmented market that makes it hard for them to execute trades in the large chunks they need.

But tell that to the financial-TV viewer who heard the Dow executed a 150-point yo-yo within the span of a commercial break Tuesday afternoon, all because some text-scraping software detected an ersatz, malicious headline likely sent by self-styled revolutionaries half a world away.

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