Sunday, October 18, 2009

Computerized Stock Trading: A Grave New World?

The nature of the stock markets is changing. More than half today's trading volume comes from computer-directed transactions. This mostly consists of ultra-fast trades of vast quantities of stocks. Prices can be quoted and transactions completed in milliseconds, before the human eye can begin to comprehend the quote. There are, in essence, two different markets--one taking place on a superfast scale between computers, and the horse-drawn buggy market for those slow-poke humans. In such a scenario, the market pros that own the computers are likely to get the best prices, and mom and pop investors trying to put aside 100K or 200K for their modest retirements may be left with table scraps.

Many of the computerized trading firms are financed with ultra cheap credit provided courtesy of the Federal Reserve. The Fed's zero interest rate policy provides an incentive to speculate, making risk taking appear more attractive. Indeed, current Fed rumblings about withdrawing accommodation may only increase stock speculation. If you know the Fed might take the bargain basement credit away at any moment, you wouldn't invest long term, or even medium term, in something so mundane as, say, America's manufacturing capacity. Lose your cheap financing and the deal that looked so good a few months ago may turn out to be junk. Instead, it's better to jump in and out of stocks on a minute by minute or even second by second basis, laying off your risk before the Fed has a chance to mess up your profit potential. It may be that, in their innermost thoughts, the Fed's governors want an exuberant stock market, since it takes a lot of political pressure off of them. But lasting recoveries won't come from stock bubbles.

Then, there is the possibility that the computers are distorting prices. Back in the days when Leave It to Beaver was broadcast on prime time TV and human beings determined stock prices through their collective desires to buy and sell, there was no limit on the factors that might influence prices. While the fortunes of each company issuing stock most directly affected the price of its stock, politics, war, weather, currency fluctuations, interest rate changes, government policies and a host of other factors affected stock prices. No computer program, however many variables are incorporated into the algorithm on which it is based, can completely replicate the infinitude and variation of factors that humans would consider relevant to a stock's price. Recall the vaunted risk management systems used by Wall Street earlier this decade to evaluate the chances of a downturn in the real estate markets. By all indications, virtually none of these systems got it right. The possibility of downside real estate risk on a national level seems to have been programmed out of the computers. This would have been a human programming error, but computers cannot self-correct for programming errors.

With the flood of computerized trading now hitting the market, we must wonder whether we'll have deja vu all over again. It may be possible for one computerized trading system to miscomprehend prices and send out a torrent of orders that appears to another computer system to be anomalies that provide trading opportunities. The second system then sends out its own torrent of orders to take advantage of the perceived "anomalies," which in turn may appear to other computerized trading systems as "mispricing" that should be hit with buy, sell and short sell orders in the next two nanoseconds before the pot of gold disappears into the maw of another firm's computers. In this mosh pit of computer vs. computer, prices may drift away from fundamentals, and eventually that would turn out to be a bad and painful thing.

There's a chance the SEC will clamp down on some of the most unfair aspects of computerized trading. But it would have a hard time, legally and philosophically, prohibiting high speed, computerized trading. Abstractly speaking, people should be able to innovate through the use of computers. But the large-scale, hyper fast trading that we have today runs the risk of making smaller, long term investors feel like they are simply grist for the big boys' mills. That would only fuel the populist streak in today's efforts at regulatory reform. Wall Street's current short term trading profits could lead to long term increased regulation. We know that many on the Street take the view that while the music is playing, you have to get up and dance. But the last time Wall Street did a collective hokey pokey with mortgage backed securities, things ended badly.

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