The U.S. stock market conjures an image of adrenaline-fueled traders, yelling. That image is a memory. Now computers do most of the trading, silently. American equities change hands on more than 50 mostly automated markets that exist in data centers in New Jersey and elsewhere. Microsecond reaction times have lowered investors’ costs and bestowed an advantage on trading firms that are primed for speed, while increasing the risk of errors that paralyze trading and shake investor confidence.
Nasdaq’s system for distributing prices for the U.S. stocks it lists malfunctioned on Aug. 22, 2013, preventing trading for three hours in shares of thousands of companies, including Apple, Google and Microsoft. Responding to the breakdown, the U.S. Securities and Exchange Commission ordered exchanges to collaborate on improving their infrastructure and to prevent single points of failure from bringing down the whole market. The Nasdaq suspension was the latest in a series of failures beginning with the flash crash of May 2010, when a chain of events erased more than $800 billion from the value of U.S. stocks in a few minutes. Three malfunctions made headlines in 2012: Bats Global Markets canceled its own initial public offering after errors on its own computers prevented its stock from trading; Nasdaq mishandled Facebook’s IPO; Knight Capital Group almost went bankrupt after barraging markets with errant orders. Regulators and prosecutors in the U.S. and Europe are now looking at the effects high-speed trading has on market stability and whether it gives some investors an unfair advantage. New York Attorney General Eric Schneiderman has called for changes in the way markets work with speed traders, and the Federal Bureau of Investigation opened an inquiry to determine whether they improperly use information not available to other investors.
Stock markets have never been problem-free. The NYSE ruled in 1927, for instance, that orders completed at wrong prices due to “mechanical error” would stand despite the mistake, the New York Times wrote at the time. In the late 1960s and early 1970s, a deluge of paperwork amid surging volume routinely prompted full-day closings and shortened hours, and several computer glitches halted trading. Although computers entered the scene in the 1960s, the modernization of trading really began in 1975, when the U.S. Congress mandated the creation of a “national market system” linking venues around the country. The advent of the Internet and lower-cost computer hardware fueled the emergence in the 1990s of upstart all-electronic trading platforms with names like Island and Archipelago, which offered better technology than the incumbents at a lower price. NYSE ultimately bought Archipelago and Nasdaq bought Island. The 2001 shift to pricing stocks in one-cent increments eroded profits for human traders, with speedy automated trading firms stepping in to fill their traditional role. The final major shift came in 2007 with Regulation NMS, which requires that a stock be traded on whatever market has the best price at any given time.
Critics of modern markets, including Warren Buffett, argue that they are too fast and too beholden to cutting-edge technology. The critics say the dangers of disruptive breakdowns has grown to dangerous levels; that speed traders, with their focus on short-term returns, hurt investors with a stake in the long-term success of companies; and that the worst abusers may be guilty of illegal manipulation. Despite their gripes, it’s unlikely that the role of computers will diminish or that trading will noticeably slow down. That doesn’t mean there won’t be changes: In recent public appearances, regulators and stock exchange executives have voiced a desire to improve the reliability of systems and establish back-ups to minimize disruptions when they do happen. It may be that, as with any other machinery, the best to hope for is fewer failures and little damage when malfunctions occur.
The Reference Shelf
- The Securities and Exchange Commission’s Concept Release on Equity Market Structure.
- Bloomberg Businessweek article on high-frequency trading and electronic markets.
- The SEC’s dedicated Market Structure mini-site.
- Senate Banking Committee page has transcripts and webcasts of testimony at a December 2012 hearing on electronic markets.
- Michael Lewis’s 2014 book, “Flash Boys,” argues that speed trading hurts ordinary investors.