“Did you hear? The stock market broke the other day. Stocks went inexplicably haywire, costing investors millions in a matter of seconds. It appears to be the result of a single market participant.”

It should frighten you to know that the quote above would have been a truthful statement roughly half a dozen times during the last 2 years. The United States capital markets have broken down. They no longer serve as an efficient system for allocating capital to companies. Our markets have become a playground for computer and data scientists who are trying to make their fortunes by writing advanced algorithmic trading strategies.

The changes in the US markets have come over several years, but the root cause is simple and obvious - high-speed, computerized trading systems. While these advanced technologies could be very beneficial if cautiously implemented and properly regulated, they have instead overcome our ability to truly understand and control them.

The owners of the largest market making firms have:

• Recklessly implemented strategies that are poorly understood and not well tested.
• Built entirely new exchanges to circumvent the restrictive regulations that tied the hands of the NYSE and Nasdaq.
• Devoted massive lobbying resources to influencing regulations so as to benefit their style of trading.

What they have failed to realize (or choose to ignore) is that orderly markets and responsible regulation are in their long-term best interests. Instead of embracing that philosophy and working to build a stable system with meaningful reforms they focus on short-term profits above all else, and subvert the rulemaking and regulatory process at every opportunity.

The result is the US stock market that stands before you today, a system so complex and fragile that individual market participants can cause extreme instability and even crash the entire market. If you have a cold, you’re not allowed near the computers running the market - a sneeze could erase a hundred billion dollars of wealth.

This should, of course, be terrifying to regulators, traders and anyone else whose livelihood depends on the efficiency and stability of the stock market. That any one individual participant currently wields the accidental power to temporarily derail an entire market is evidence that our system is woefully broken. Computer “bugs” and “glitches” make news on a regular basis. Inexplicable moves of great magnitude happen regularly on a single-stock or market-wide basis. One is left to wonder when these sorts of “mistakes” can be manufactured and manipulated for malicious purposes - or whether such foul play has already happened before our eyes.

The most recent events on Wednesday July 31 are simply the latest manifestation of a stock market that is teetering on the edge of an abyss,

• The Flash Crash in May, 2010 was set off by a single large trade estimated at $4.1 billion in the S&P 500 Futures Market. The cascade led to 20 minutes of extreme volatility, wiping out nearly1 trillion of market cap before quickly and inexplicably recovering. The economic cost of this event is completely unmeasured, but certainly huge. We were lucky it didn’t happen near the market close - had the US markets closed before they recovered, the result would have been total economic disaster as money flooded out of the stock market overnight.

• In August, 2011 the stock market swung up and down by over 4.4% on 4 consecutive days, alternating up and down days. It was wild, unprecedented volatility - only the third time in history that had happened, with the second time having been 3 years prior, during the crash of 2008. While the European crisis was becoming a more important issue at the time, this volatility was not warranted by major economic changes or historic macroeconomic events. This was computer-driven volatility.

• “Mini flash crashes” occur on a near-daily basis in individual stocks. Nanex has documented over 1,000 instances of individual irregularities in stocks since August 2011. Single-stock circuit breakers have failed to stem the tide and aim to heal a gunshot wound with gauze.

• IPO’s in Facebook and BATS (itself an Exchange) have gone horribly wrong due to technological “glitches,” souring the market for IPO’s and costing untold thousands of jobs as companies cannot raise the capital they need to expand.

• Few realize how lucky we were on Tuesday, July 30. An order to sell nearly $4.1 billion in the S&P Futures Market, the same size as what precipitated the Flash Crash, was executed 3 seconds before the market closed. There simply was not enough time for the waterfall of May 6, 2010 to repeat itself. What happens the next time when that same order is sent in a couple of minutes sooner? The SEC typically respond that their circuit breaks will save the day. Unfortunately, circuit breaks are turned-off during the last 25 minutes of trading.

• On Wednesday, July 31, Knight Capital Group - one of the largest market making firms, an official Designated Market Maker on the NYSE, had an algorithm pushed out that was not properly tested. The result? A loss for them estimated at440 million, untold economic losses for retail investors with stop-loss orders in one of the almost 140 stocks that were affected, and a further erosion in investor confidence.

It’s rather ironic: while market participants fight regulators tooth-and-nail over every proposed rule change and reform, retail investors head for the hills. Naturally, investor-flight has greatly accelerated since the Flash Crash. In fact, it has now turned negative when indexed to 1996.

As I’ve detailed in past posts, retail investors have been suffering under the current market. The economic costs of volatility, HFT algos that step in front of large institutional orders, undermined confidence, and the complete lack of a viable IPO market are dramatic. We need to take the following actions right away, and I will detail why in my next post:

• Affirmative market making obligations for any firm that would collect a rebate on any venue where securities are transacted: ATS, ECN, Dark Pool or Exchange, it shouldn’t matter where.
• Impose a 50 millisecond minimum quote life on all quotes (for reference, the blink of an eye is about 300 milliseconds).
• Eliminate pay-for-order-flow.
• Enforce price-time priority across all venues.
• Eliminate co-location and direct exchange feeds.
• Take away the self-regulatory authority of for-profit exchanges.

The beautiful visualization of fractal images belies a more terrifying reality. Fractals are a picture of a transition between two worlds - the orderly linear world and the chaotic non-linear world.

They are a picture of the “Edge of Chaos”. The US Markets are on the edge of chaos right now. We’ve been seduced by the technological beauty of these intricately interwoven systems but are now being betrayed by the chaos and non-linearity of their interactions with each other. Some would say the tipping point has already been reached, but I’m not ready to go that far. They can be fixed, but we need to act now.

In my first blog post, I discussed the skewed incentives, unfair playing field, and dangerous consequences of high-frequency trading (HFT). Is it any wonder that you could apply the same adjectives to the financial services industry in general? HFT is a destructive force in the markets: It increases the cost of trading for most people, rewards an activity that provides little to no economic value, and damages investor confidence in the fairness of equity markets. It is, however, symptomatic of much bigger and more deeply seated problems in the industry. 

Before we tackle these encompassing problems, we should consider several actions that legislators could take to help dampen or eliminate the ill effects of HFT:

• Eliminate for-profit exchanges: The experiment in for-profit exchanges has been an utter disaster. The conversion of NYSE and NASDAQ from privately held, self-regulatory organizations to publicly traded ones has not worked. It is ironic that the financial services industry should be such a great example of capitalism’s limitations. Stock exchanges should serve the general population by ensuring fair and orderly markets. Likewise, they should serve the companies that are listed or who want to list by ensuring robust price discovery and capital formation. This is the first step to instituting any reform. Our exchanges must take actions to reduce their earnings per share to ensure a more stable market and economy. That is a tradeoff most public companies are not willing to make.
• Mandate that liquidity providers fulfill obligations in order to collect rebates: If you’re willing to take the other side of a buy/sell trade (in other words, you provide liquidity, often called “market making”), you usually receive a rebate from the exchange instead of paying a fee. Electronic liquidity providers perform a critical function and should be compensated for maintaining orderly markets. They take on inventory risk and that can be costly. However, historically there have always been obligations for market makers to continue to provide liquidity even during market turbulence. This is an obligation to which HFT firms are not currently beholden. This must change. The ability to collect liquidity-providing rebates should only be available to those firms willing to stay in the market when conditions become difficult.
• Level the data access playing field:
  • Eliminate co-location: For the firm willing and able to pay for it, data center space is available for rental right next to the stock exchange. The closer you are, the faster you receive data. This, of course, only benefits HFT firms (and the earnings per share of for-profit exchanges), providing their servers information milliseconds before the rest of the market. It can be argued that this makes it non-public information. To many of these modern servers, milliseconds are an eternity. When I worked in the industry, I built models that would take 40 microseconds (40 millionths of a second) from when data hit the network card to when the trade was sent out to the market. I have no doubt there are faster systems out there now, and those reaction times will only continue to decrease.
  • Eliminate direct market data feeds: These are the feeds coming directly from the exchange providing updates every time something in the market changes. These are only useful if you have tremendous computing power to process upwards of 2 million events per second. (Unless, of course, you can do this in your head, in which case, good for you!). The Foreign Exchange (FX) markets have long worked well under a different model, and I’m not convinced that anyone would suffer from less data. If market data feeds simply sent out a snapshot of the full order book every 100 milliseconds, who would be worse off?
• Reinstate the uptick rule: For almost 70 years if you wanted to sell a stock short (i.e., wager that it would go down in value) you had to wait until that stock’s price moved up. A change to this simple rule in 2007 opened the door for many high-frequency traders. If you are a student of history, you know that cyclically the world looks very similar to the time that rule was first passed (1938). Maybe it’s time we reconsider? A long list of financial services experts (which notably does not include any HFT firms) agree with me on this one.

Unfortunately, without a substantial public uproar, I’m inclined to think the odds of any meaningful financial reform are very slim:

• It’s already 2.5 years since the SEC decided, and most of the financial services world agreed that flash orders should be banned, and they have not been.
• Regardless of how many billions of dollars JPMorgan’s prop trading desk loses, they (and others in the industry) continue to argue that institutions with federally insured deposits should still be able to “hedge” by making extremely large bets that look amazingly similar to the proprietary bets that the Volcker Rule is supposed to eliminate.
• The financial reform act negotiated by Congress was already dramatically weakened by the time it was passed, and the industry has deployed its band of lobbyists to weaken it further as the legislation is turned into actionable regulation.

Barry Ritholz gives some excellent suggestions in his most recent column on ending TBTF, while acknowledging that “[a]fter years of deregulation, it has become all but impossible to re-regulate modern banking. There was a brief window during the credit crisis, but that has passed. Today, profits trump soundness. Safety and security are secondary to risk-taking and speculation.”

I couldn’t have said it better myself. We have no shortage of great ideas for how to fix the system. We simply lack the will and the ability to push meaningful reform through our corporate-controlled, hyper-partisan government.

During my appearance on NPR’s Marketplace last week, I discussed why I left the high-frequency trading (HFT) business. When I learned that I was about to become a father, I was forced to re-examine many things in my life, not the least of which was a profession that added little value to the world. At 30 years old, I would regularly be trading positions worth millions of dollars, an extremely stressful daily undertaking. I began to fear that I was spending too much of my life’s stress budget on something that quite honestly, was helping to wreak tremendous economic havoc. Ultimately I decided to walk away from an extremely lucrative profession.

HFT is a subset of a part of the financial services industry called quantitative analysis. Researchers are often referred to as quants, and there’s a popular saying amongst quants: “It Ain’t Rocket Surgery.” This conflates “rocket science” and “brain surgery” to come up with a hybrid term that is supposed to poke fun at the fact that while what they do is very hard, it wasn’t as hard as either of those.

Lately, I’ve thought about this saying in a different way. The most successful quants make huge amounts of money — annual bonuses in the millions of dollars. Quants who have proven themselves successful (or who just sound really smart and interview really well) can command base salaries very similar to top neurosurgeons, and without the 15 to 20 years it takes to advance in said profession. While working at one of the largest hedge funds in the world, I heard the story of a quant manager who was so offended by his meager $85 million bonus that he left the company. I’m not sure there’s an aerospace engineer or neurosurgeon or even a Major League Baseball player in the world that wouldn’t happily take this bonus.

I wouldn’t argue that compensation in HFT is dramatically different than in the rest of financial services, but it is certainly among the most extreme in the industry.

This would all be well and good if high-frequency traders contributed some value to society at large. Examining the value proposition (or lack thereof) of HFT would take many blog posts, or an entire book (which was just published, Broken Markets by Sal Arnuk and Joe Saluzzi). There is a case to be made that rather than providing liquidity and increasing market efficiency, HFT is doing the opposite (Nanex has produced some excellent research on this topic).

I have personally seen how HFT is increasing market volatility, creating events such as the Flash Crash of May 2010. I was on the trading floor when the market disappeared that day, and stopped functioning. While the standard explanation of the flash crash is an order that was too big for the market to handle, it had seemed inevitable that Chaos Theory and the nonlinear implications of sensitive dependence on initial conditions would lead to a destructive positive feedback loop. In other words, a butterfly flapped its wings somewhere in Delaware, and the entire U.S. equity market fell apart for a few minutes. Nothing has changed since then, and individual securities demonstrate this behavior on a daily basis.

There is no doubt that the fallout of the Flash Crash is that retail investor confidence has been undermined, and small investors have been fleeing equity markets even as the economy flattens out and the market rises. According to the Wall St Journal, “$370 billion has been withdrawn from U.S. stock funds by small investors” since this event. Some argue that equity outflows are a result of the worst financial crisis since the Great Depression. However, the stock market has risen by almost 19 percent in the two years following the Flash Crash (though there was a month — from July to August 2010 — during which the market dropped more than 16 percent). With this kind of volatility, is it any wonder that retail investors are fleeing from a market that they no longer understand?

There are much graver implications to our economy from increased market volatility and decreased investor confidence. Higher volatility creates a negative wealth effect. Retail investors tend to time the market poorly, buying when stocks are too high and selling when they are too low. In addition, higher correlation amongst stocks means that traditionally unrelated companies and sectors move in a more concerted fashion. This eliminates the benefits of diversification, an idea that has been championed to retail investors for decades. As retail investors pull out of the market, the bedrock of the greatest capital formation and price discovery mechanism ever created is disappearing, leaving behind statistically-driven trading systems trying to game each other to shave pennies here and there. This is destroying the U.S. economy’s ability to support and grow new businesses.

I entered the world of finance for many reasons. I grew up during the dot-com bubble, so I thought I knew how to pick stocks. The compensation was extremely high. There’s also huge appeal to “the game,” the relentless judgment passed by the market on a daily basis demonstrating how right or wrong you are. But at my core, I have philosophically been a capitalist my entire life. As I witnessed the destruction of capital markets, driven by crony capitalism and the ambition of a small wealthy population to become yet wealthier, I could no longer sit idly by and watch it happen. Something must be done to dramatically shake up the financial services industry, and while regulations are being written and manipulated by lobbyists, that will not happen. In my next post, I’ll talk about some possible solutions to this problem, and why we have little hope of seeing them passed without several more crashes, flash or otherwise.

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