"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 two 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 U.S. 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.
- 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 U.S. 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 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 U.S. markets closed before they recovered, the result would have been total economic disaster as money flooded out of the stock market overnight.
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.
- 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 U.S. 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.