Robots vs. Regulators: How We Lost Control of the Market

What's wrong with this picture?

Source: Nanex.

That depends on whom you ask. My Foolish colleague Matt Koppenheffer pointed out last week that it shows only the increased presence of high-frequency trading, or HFT, on more tickers across various markets over the past five years. No cause for alarm, right? But many commentators chose to look at it differently. Most wanted to use big, ominous, downright apocalyptic words like "warzone" and "overwhelmed" and "terrifying."

The precise impact of HFT on the markets is still hotly debated, but that just highlights the bigger problem -- virtually no one can say with any certainty what that impact is. The algorithms in HFT code are so zealously guarded that Goldman Sachs (NYSE: GS  ) filed criminal charges against a former employee to keep its "special sauce" secret.

Even if some other financial firm got a hold of Goldman's code, they'd still be a step behind unless they also happened to have their trading machinery parked right in a major exchange's data center for maximum speed. The higher spikes you see as the graphic above creeps closer to the present are one result of this special hosting service, called co-location, that NYSE Euronext (NYSE: NYX  ) markets as "a competitive edge... [that] provides unsurpassed value." That premium positioning gives HFT computers a few extra milliseconds to place a bid before any competing orders can sneak in. Talk about being in the right place at the right time.

Is any of this terrifying? Well, we fleshy investors have had a long and complicated relationship with machines, thanks in no small part to their wildly varied portrayal in mass media. For every R2-D2 there's a Dalek, and for every helpful giant Autobot in Transformers there's an equally evil giant Decepticon. Most people don't understand technology well enough to feel comfortable when it malfunctions in high-profile ways. When the market gyrates wildly and fingers point to computerized trading, as happened not too long ago with Knight Capital (NYSE: KCG  ) , explaining it as "robots make mistakes, too" isn't particularly reassuring.

Now, what can we do about it? At the moment, not much, but the answer shouldn't be to throw our hands up and wait for another glitch. The rise of the HFT machines is one symptom of a larger problem: a spreading opacity across the public market that makes it harder for ordinary investors to trust the numbers they find.

Now, what's wrong with this picture?

Sources: Morningstar, Goldman Sachs, and SEC annual reports.

Multiply that big orange wave a few dozen times and you might get a better sense of what regulators are up against. Every year, the resources the SEC wields to keep the financial sector on the straight and narrow are dwarfed by the money Goldman Sachs spends on its annual operations. And that's just one major financial firm that happens to have some HFT running on the side. In the past year alone we've seen multiple instances of financial-industry ethical failures, both in and out of Washington.

  • The SEC dropped its investigation of Goldman Sachs after failing to find enough evidence of duplicity in Goldman's sale of a subprime mortgage investment package. Goldman itself has been spinning its actions as "puffery" to evade responsibility for misleading investors.
  • Multiple major banks have been implicated in the manipulation of LIBOR rates, which are used to set interest rates for trillions of dollars of debt instruments.
  • The STOCK Act, passed earlier this year, has a nice big gaping hole that allows the family members of elected representatives to trade in insider information. That renders moot any hope of trading transparency from Congress, as long as its members can simply pass knowledge on to their favorite uncle or sister-in-law.
  • The JOBS Act, a real abomination of "reform" legislation, has already led to such laughable situations as a globally popular 134-year-old British soccer club going public as an "emerging high-growth" company.

And then there are other problems simmering under the surface, like "dark pools" of secondary markets that may make up nearly half of all trading, without ever being visible to you and me. Many HFT actions take place in these dark pools, where they may never be tallied or tracked. That has a real impact on ordinary investors, who don't get to see what happens behind the curtain or understand why.

You might have gotten a glimpse of this growing opacity during Facebook's (Nasdaq: FB  ) disastrous IPO, when a perfect storm of backroom downgrades, technology glitches, and dueling underwriter priorities led a lot of underinformed retail down a rabbit hole of losses that's yet to abate. Maybe it blindsided you in March, when the HFT-friendly BATS Global Markets exchange performed such a comedy of errors during its IPO that it managed to drag down most stocks with A and B tickers, including everyone's favorite iPhone maker. Technological fumbles are not isolated mistakes, but little can be done to control them when the agency in charge of market regulation is so hopelessly outmatched.

High-frequency trading is not the greatest threat to your portfolio, but it is one of many potential threats that we barely understand. Without real reform, and without some effort to drag these shadowy algorithms into a public light, another technological failure will happen in the near future. You can be sure of it.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.

The Motley Fool owns shares of Facebook. Motley Fool newsletter services have recommended buying shares of NYSE Euronext, Facebook, and Goldman Sachs. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (9) | Recommend This Article (22)

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  • Report this Comment On August 20, 2012, at 1:05 PM, JohnCLeven wrote:

    So, you're saying that computers may be increasing the number of violent gyrations in the market? That's great! I hope you're right! That means even more oppurtunities to take advantage of!

  • Report this Comment On August 20, 2012, at 2:27 PM, TrojanFan wrote:

    When capital gets allocated inefficiently on a massive systematic scale, even for mere miliseconds we all pay the price.

    The bigger issue is that these computers are playing on an unfair playing field. They have the ability to see your orders (even your limit orders) before they hit the market and step in front of you with a 50/50 bet where they make $100 if they're right and only lose $1 if they're wrong.

    That's blantantly out of line and every mutual fund and pension fund is getting ripped off and clipped every day by these trading bots as they skim off of legitimate investment transactions and regulators don't do anything about it. It's like an added transaction tax that no one agreed to.

    It's such easy money which is the other ridiculous thing. The only thing these firms have done to earn this return is move their machines and switches closer to the exchange then the other guy and the exchanges are complicit in allowing them to do this.

    This is rent seeking behavior at its ugliest and it should be brought to a halt.

    The other side will likely argue that they bring much needed liquidity to the market especially during periods of market turmoil, but somehow the market managed to clear before they participated in it.

    The ideological issue here is that if one creates no value then they deserve no compensation and it is highly questionable that these trading algorithims create any value at all.

    It should make even long term investors uncomfortable that these guys can see your order coming and step in front of it and mark the price up to you before you get filled.

  • Report this Comment On August 20, 2012, at 2:37 PM, Melaschasm wrote:

    The problem with HFT is when regulators bailout the institutions using HFT. If a formula or computer messes up and GS losses millions, they should not have the transactions reversed.

  • Report this Comment On August 20, 2012, at 3:29 PM, kkrramer wrote:

    Read Broken Markets for a comprehensive look at this whole issue and how we got to where we are.

    As the book points out, no one should get to see the results of a horse race before anyone else...period..

  • Report this Comment On August 20, 2012, at 4:45 PM, eibe wrote:

    Apart from all the "it's just unfair" part there is a way deeper problem with those high speed traders.

    They want to make their trades in mikroseconds ... light in void space travels roughly 300m (or 3000 ft.). You cannot transmit information faster.

    So they spare on everything else that slows them down like avoiding any firewalls ... guess what a black hat hacker could do once he gets into such a system.

    I am pretty sure some countries which are not on a friendly base with US are actively researching such options,

  • Report this Comment On August 20, 2012, at 5:13 PM, eibe wrote:

    Actually it is even worse. 1 mikrosecond on a 2.6 Ghz core are only 2600 cycles. Way to few to do any work even with multiple cores. So the HST (High speed "junkies") need very specialized Hardware. FGPA's for example, taylor made for their use and many boards that are connected via some proprietary protocol (TCP/IP is just to slow).

    Well, any newly written proprietary software is full of bugs and full of security holes. That is just a law of IT.

  • Report this Comment On August 20, 2012, at 10:51 PM, NOTvuffett wrote:
  • Report this Comment On August 24, 2012, at 5:40 PM, whyaduck1128 wrote:

    Skynet is active.

  • Report this Comment On August 25, 2012, at 7:47 AM, babeshamal wrote:

    A) The "manipulation" of interest rates IS WHAT BANKS ARE FOR !! Otherwise we should have to each, individually, negotiate our own interest rates; and CHAOS would ensue.

    B) If "insiders" are not allowed to trade, how are the rest of us to know where to put our money? BUT they should be compelled to announce their trades, publicly, and at once.

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