How the Machines Took Over Wall Street


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On May 6th, 2010, in the space of one-half hour, the Dow Jones Industrial Average (DJIA) dropped almost 1000 points. Two DJIA component stocks, Procter & Gamble and 3M, lost over 30% of their value in 15 minutes, while shares of Accenture went from $40 to a penny before recovering. What happened? Several theories were promulgated, from the “fat finger” trader error to “multiple erroneous trades.” The common denominator? Advanced technology: computerized, high-frequency trading (HFT) that allows for the buying and selling of millions of shares in a matter of milliseconds. Completely automated trades made by super-computers, absent human interaction.

Computerized trading has been around for forty years. In 1971, NASDAQ became the first electronic stock market, allowing dealers to offer price quotes for securities. In 1976, the New York Stock Exchange (NYSE) initiated the use of its ”designated order turnaround” system (DOT), which facilitated the routing of buy and sell orders previously handled by buyers and sellers standing next to each other on the exchange floor. In the 1980s, markets become fully electronic, and a new strategy called “program trading” was instituted. Program trading is defined as “any trade involving fifteen or more stocks with an aggregate value in excess of $1 million,” and many people are convinced that it was the principal culprit or a substantial contributor to the October 1987 crash, where the market lost 22.6 percent of its value in one day.

In the ’90s, electronic communications networks (ECNs) emerged, allowing traders to conduct business outside the boundaries of traditional exchanges and traditional business hours. This was made possible when the Securities and Exchange Commission (SEC) approved a regulatory framework for “alternative trading systems” due to the “important role of technology, and the increasing competition, in today’s securities markets.” ECNs spawned the growth of computer systems which use algorithms to facilitate trading.

In 2001, algorithm trading was further buttressed when markets began quoting stock prices in decimals instead of fractions. Thus the minimum size of a stock price went from 6.25 cents (one sixteenth of a dollar) to a penny, leading to increased liquidity. Finally in 2005, the SEC enacted a series of rules called the “Regulation National Market System,” which facilitated the emergence of high frequency trading. High frequency trading may now account for as much as 60-70 percent of the volume on major U.S. stock exchanges. Some speculate it may be even higher than that.

“This is where all the money is getting made,” said former chairman and chief executive of the New York Stock Exchange William H. Donaldson back in 2009. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.” Joseph M. Mecane of NYSE Euronext offered a vivid assessment of reality. “It’s become a technological arms race, and what separates winners and losers is how fast they can move,” he said.

Speed is indeed the name of the game. A two-tenths of a second advantage can be the difference between success and failure, allowing traders to buy or sell millions of shares, milliseconds ahead of the pack. The profit or loss on each trade may amount to tenths of pennies, but when those trades number in the millions over the course of a single trading day, tens of million of dollars can be won or lost.

Speed is so critical that a 40,000 sq.ft. facility in Mahwah, New Jersey — a location chosen due to its proximity to Wall Street, but away from nuclear power plants, geological fault lines and flight paths — was constructed so trading firms could “co-locate” their super-computers next to those of the trading exchanges in order to gain microseconds worth of speed over their competitors. ”We’re getting down to, you know, ‘How fast can the electrons travel at this point?’” said Larry Leibowitz, chief operating officer of the New York Stock Exchange, who has spent time promoting Mahwah to NYSE clients. And then there’s the advancement of computer technology itself. Vendors such as Hardcore Computer and Supermicro® UK, sell “submersion cooling technology,” which enables them to “over-clock CPUs,” allowing those processors to run faster, cooler and longer.

HFT has its proponents and detractors. Proponents believe HFT adds liquidity to the market and lowers the spread between the bid and ask prices. “High frequency trading has introduced a massive amount of competition, and competition is the only mechanism that can and will keep it honest,” contends Eric Falkenstein, former portfolio manager and author of Finding Alpha (2009). “All it takes is ten smart people competing with each other to whittle profits almost down to nothing, all the while increasing the depth and lowering the spread to retail investors.”

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  • kwg1

    GATA has been talking and trying to do something about this since before the year 2000. http://WWW.GATA.ORG

    • Amused

      Gee , that's only TEN YEARS , think they'll do something ?

      • kwg1

        How much have you done? This is a private group of individuals fighting the government and the CFTC. I guess you think the government is a responsive and responsible organization huh? From your remark you must be following this situation very closely, to have such great insight!

  • Amused

    Ahhh, for once ,somebody here " Gets It " !! This maybe news around here , but it's been going on for several years .All you "Regulation Haters " , take note .Wall Street IS and Has Been out of control , human that is ….in a sense .In that moguls have been spending , not millions , but HUNDREDS of Millions on these Super Computers ,which have made investing in America ,a Casino with marked cards and loaded dice ..These people literally suck every penny out of the market on such a scale that Main Street investors are left with crumbs and empty pockets . If anyone here dares call this "capitalism " , then they need their heads examined . This is nothing more than hi-tech thievery , and it can destroy the economy in literally a matter of minutes .

  • Amused

    This is why there is regulation ….to nprevent people from running amuck .

    • kwg1

      You do not get it, the government regulations are allowing it, they are the problem not the solution. The government in order to keep currency stable (so they can remain in power) manipulate the gold amd silver and allow others to trade and slam the markets. It is beginning to unravel, as more and more people see the problem. It is not the average Joe and Jane, but the regulators and the politicians.

  • Amused

    This is one of the reasons WHY , small investors are merely getting crumbs , and losing confidence in the market . And that's what it's all about in Wall Street investing …."confidence " . Ain't it ?

    • kwg1

      Yes!

  • Amused

    Both Parties are GUILTY of allowing this . Wall Street has become a CASINO Game with loaded dice and marked cards .And every time they wreck the economy , they come back with a new trick . This ain't capitalism people .

  • Amused

    Anyone here want to call this "capitalism " ?

  • Amused

    "provides liquidity " ? does anyone really believe that ?

  • Ben

    The human inclination to the identical behaviour combined with the minimizing information about the deal objects may lead to instabilities of the kind that described by the chaos theory

  • Amused

    Yea Ben , wanna bet your 401 on CHAOS THEORY ?

  • Amused

    AS FOR YOUR REMARKS , kwg1 , yes I've known about this for several years , that's why I've lost absolutely NOTHING [that's what I've done ] in the market downturns since B4 the 2000 dot com bust ….the signs were there , I 'm not an MBA in finance or anything close to it , but as the saying goes "you dont need a weatherman to know which way the wind blows " . And There is NO regulation regarding this "super-trading " . In fact Wall Street should be complaining more than I …..but they're making the money aren't they ? Havent seen any traders going to the poor house , now matter how much a bath the average investors take .

  • Amused

    BTW kg1 , I tried making a post addressing the several issues that I subseuently had to scatter , because the Admin here, saw fit to disalow the whole post , for reasons known only to them . And I did not say or imply that the problem rested on the average Joe , I clearly stated that it was a lack of regulation ,and that due to the politicians sans the lobbies . Yet it persists and gets worse , as the politicians try to "preach " confidence in the stock market ,while doing absolutely nothing to shut this down ,as IT SHOULD BE SHUT DOWN . It's got NOTHING to do with any sort of "liquidity " but everthing bto do with cheating and fiduciary MISCONDUCT .

  • maturin20

    Amused makes many fair points.

  • Delicia Mott

    Having read this article, I must say I’m rather confused. While the example of the tripadvisor widget might be likened to advertising your competitors hotel on your own site, some of the principles and reasons seem dated to me.

  • http://www.stocktrading.net/ codysoules

    Things like this happen when there are simply too many variables to keep track of and the effect of multiple computers seeing the same platform but not being in contact with one another. Situations like the one mentioned where culprit computers dropped stocks to the value of a penny and back can't be avoided – but what you can do is create a system that spots the errors in other methods and have it ready to pounce on mispricings like that!