High-Frequency Trading and Crash Risks

Reuters' Goldstein and an NYT op-ed raise questions about a potential feedback loop

We’ve been keeping an eye on the high-frequency trading story since Matthew Goldstein of Reuters broke the story of a computer programmer at Goldman Sachs stealing a chunk of its automated-trading software code.

One of the most intriguing and worrisome parts of the high-frequency trading debate is the idea that the algorithms behind the automated trading will somehow converge, latching onto the same trend and crashing the market in a kind of feedback loop. It’s not an unreasonable question when automated trading accounts for the majority of all stock trades.

Goldstein hits on this point in a column yesterday and further legitimizes by talking to a source who oughta know: Michael Durbin, the guy who set up a high-frequency trading desk for Citadel Investment Group to trade stock options. Citadel is a mega hedge fund, and Goldstein reports its options HFT desk is the industry’s biggest. Durbin is now director of HFT research for a smaller firm. Here’s what he says:

Durbin says it’s reasonable to wonder whether Wall Street’s unfettered embrace of algorithmic automated trading could be setting the stage for a future meltdown.

“You have multiple HFT trading firms and sometimes their agendas are complementary and sometimes they’re not,” explains Durbin, director of HFT research with Blue Capital Group, a small Chicago-based options trading firm.

“There could be a time where these HFT programs unintentionally collaborate and you have a two- or three-minute period where the markets are going crazy. Then other traders respond to it and it simply gets out of control.”

Something similar happened in the great crash of 1987, as Paul Wilmott pointed out in an excellent New York Times op-ed the other day:

It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms…

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday.

Goldstein has the correct impulse here:

It’s high time for the Securities and Exchange Commission, the Commodity Futures Trading Commission and overseas securities regulators to start working together now to assess the potential systemic risks posed by high frequency trading before a problem occurs.

Indeed. I’d be shocked if the SEC knew diddly squat about what’s really going on here. The problem is that this stuff is a black box, there’s little accountability, and it’s something that could have devastating effects for us all.

Goldstein writes that this potential risk may be all for nought, despite high-frequency traders’ claims that it provides liquidity to markets, making them more efficient. Well, all for nought for us, anyway. It does enrich the traders:

In 1999, some 445 million stock option contracts were traded, according to The Options Clearing Corp. A year later, when the International Securities Exchange opened for business, annual trading volume jumped to 672 million contracts.

But stock options trading really began to surge after Citadel, Interactive Brokers and a handful of other brokerages and hedge funds jumped head-first into high frequency trading in 2003. So by 2004, a little more than 1 billion contracts were traded. And in 2008, some 3.28 billion contracts were traded, according to the OCC.

That big increase in trading came from a rather exclusive club.

The focus on potential feedback loop is not to mention the other serious questions raised about whether high-frequency trading programs are allowing firms to manipulate the markets and “front run” via flash orders.

We’ve called for more drumbeat reporting from the press, which too often has a great story that’s just a one-off and moves on to the next topic—something Audit Chieftain Dean Starkman has compared to “corks bobbing on a news Niagara.”

So it’s great to see someone in the mainstream press (The blog Zero Hedge has been critical in furthering the story) like Goldstein sink his teeth into this story and give it a vigorous shaking.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.