Scott Eells/Bloomberg News
The New York Mercantile Exchange last month. Computers that make high-frequency trades - like the ones that started the mishap Thursday on Wall Street - started in stock markets but have since spread to commodities exchanges.
Financial markets have greatly improved over the past quarter-century. Trading costs, whether for small individual investors or large institutional investors, have declined sharply. The cuts going to middlemen are smaller, and many markets are deeper and more liquid than ever.
Most of the time.
Unfortunately, the improved markets also are more prone to disaster. The same computerization and increased competition that provided the benefits also weeded out people who had the obligation to step up in times of stress, and virtually eliminated the ability of people and institutions to slow or halt markets when something goes badly wrong.
And with technological innovation continuing apace, the risks may have increased. Regulators can require changes that will prevent an exact repeat of any given disaster, as they did after the flash crash of May 6, 2010, but there appears to be no way to guess what will be the immediate cause of the next problem. And that problem may be huge. On Wednesday, computers at , a firm that executes millions of stock trades every day, went haywire.
Unintended orders spewed forth and some stocks gyrated wildly. It took the firm the better part of an hour to turn off its computers, and on Thursday it estimated its losses at $440 million.
Knight, one of the biggest players in the stock market, said it was exploring strategic alternatives. That is a polite way of saying it is desperately searching for a buyer.
It may be worthwhile to consider what would have happened a few decades ago had a computer somehow done the same thing.
The orders would have flooded into specialists at the - people who had a duty to make markets - or to the market makers in Nasdaq stocks who had a similar responsibility. Some of the stupid orders might have been executed, but trading in the affected stocks would have come to a halt within minutes while people tried to figure out what was going on. There would have been red faces at the firm responsible, but much less red ink.
Those market makers are largely gone now. Their sources of profit - the spreads between what they sold stocks for and what they would pay for them - have vanished with competition and rule changes that allow share prices to move by one cent or less, rather than the one-eighth of a dollar, or 12.5 cents, that used to be the minimum change.
Market makers have been largely replaced by high-frequency traders who use computers that can react to orders in nanoseconds. They send in orders - and cancel them - far faster than any human could hope to do.
Exchanges, knowing that they need market makers who will take the other side of customer orders, offer rebates to high-frequency traders who manage to fill a lot of orders. In normal times, the result is markets that are highly liquid and very fast.
Decades ago, the size of an order that could be executed was limited by the capital available to the stock exchange specialist, and it was necessary for Wall Street firms like Goldman Sachs and Salomon Brothers to fill the role for large institutional orders. There are enough high-frequency firms that big orders can now be filled quickly and at lower costs.
However, those high-frequency traders have no obligation to hang around and continue to make markets when things get dicey. There was plenty of criticism of the specialists and market makers in the old days. We are approaching the 25th anniversary of the 1987 crash, when many Nasdaq market makers panicked and decided that the safer course was to not answer their phones.
But the market makers generally met their responsibilities. If they were unwilling to do so, perhaps because of a flood of orders to sell a particular stock, the market in that stock would simply shut down for a time. That pause would give others time to see what was happening, and anyone who thought the market move was unreasonable could step in and offer to buy the stock.
Now, many of the high-frequency traders - who have no power to halt trading, even if their computers somehow concluded that was wise - have simply programmed their computers to get out of a market if it is going crazy. The result is that markets may have far less liquidity when that liquidity is needed most.
To get the advantages that come with being listed as market makers, high-frequency firms were required to usually have offers posted to buy and sell the stocks in which they made markets. That rule led to the stub bid. If things were going crazy, the firm would put in a bid of $1 a share for a $40 stock. It met the requirement, but obviously no one would be stupid enough to sell at that price.
Unless that someone were a computer.
