Sunday, March 25, 2012

The BATS IPO and the Stupidity of Computers

BATS's aborted IPO on Friday, March 23, 2012, is an excellent example of the stupid side of computerized trading. While the precise course of events isn't entirely clear, BATS (short for Better Alternative Trading System) tried to initiate trading in its own stock around 10:45 a.m., at a price of $15.25 per share, or $0.75 per share below the IPO price of $16. Not a good sign when an IPO begins trading below the offering price. But that wasn't the really bad news. Rather, trading in BATS stock stopped moments later for technical reasons.

Around 10:48 a.m., BATS announced it was looking into "system issues" concerning stocks having symbols between A and BFZZZ. Nine minutes later (10:57 a.m.) Apple stock, which was trading in the high 590's, suddenly traded on BATS at $542.80 a share for a single 100 share transaction. This was a 9% drop from the previous price, even though there was no intervening news or other public event. Trading in Apple stock was halted. Five minutes later, it resumed back in the high 590's.

Around 11:07 a.m., BATS informed other exchanges that it was having problems and they need not send orders to it. Since competition for order flow is the essential dynamic between exchanges, this instruction was like making an unexpected pit stop in a NASCAR race.

At 11:14 a.m., BATS resumed trading in its own stock with a large trade at $15.25 per share. Within seconds, BATS shares were trading for pennies per share. Trading in BATS stock was halted again, and didn't resume. Near the end of the day, BATS announced that it was withdrawing its IPO.

In essence, we had flash crashes in Apple (which rebounded within minutes) and BATS (which cratered in the most embarrassing way on its IPO day). These morasses were apparently the result of computer glitches. Both were plain stupid, perfect examples of stupid is as stupid does. It's inconceivable that a human trader would have sold 100 shares of Apple at $542 on no news when the market was in the high 590's. There's no way a human trader would have sold BATS stock for pennies seconds after BATS traded at $15.25. That these trades happened is because a computer has no way to tell when it's doing something stupid. It can only follow the instructions in its program coding. And if the coding is deficient, the computer will blithely plunge forward however stupid the result.

Of course, human traders are eminently capable of stupidity, and are stupid more often than not. But humans trade much slower than computers. And few humans control as much order flow as computers at the large high-speed trading firms. So when a computer does something stupid, it can do it really fast and perhaps in really large quantities. No human is fast enough to stop the computerized stupidity before it happens. And no computer has been programmed to have the judgment and common sense to realize that it's about to do something really stupid.

Friday's morass didn't affect the larger market, which ended the day up. But it serves as a reminder that the baseline problem in computerized trading--how to prevent it from having unexpected and undesired consequences--is hardly any closer to solution than before the Flash Crash on May 6, 2010. Unless high speed trading firms can find a way to prevent stupid trades, their animal spirits will likely be curbed. And it's hard to argue against constraining them when they produce results as ridiculous as last Friday's.

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