Wall Street meets The Matrix

July 30, 2009

Michael Durbin is no Wall Street rebel. But Durbin, who has been on the front lines of
high-frequency trading (HFT) since its early days, isn’t afraid to buck the industry line that lightning-fast trading of stock, options and commodities poses little or no risk to the stability of the markets.

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.”

What Durbin’s talking about is the dreaded contagion effect, in which a bad trade or a rogue algorithm misfires — sparking copycat sell orders at other high frequency desks.

It’s the kind of machine-driven crash that sounds like the plot line for “Wall Street” meets “The Matrix”.

High frequency trading programs are designed to scour the markets to decipher trends in trading patterns and place buy and sell orders a millisecond ahead of the pack. It all happens at warp speed, and except for developing the algorithmic programs, the human element is all but gone from the equation.

And with high frequency trading desks accounting for the majority of daily trading activity in stocks, options and commodities, Wall Street has become a place where machines are often trading with machines. The potential for something going awry is real, if one of those machines malfunctions and the humans minding the store aren’t quick enough to pull the plug.

Can anyone say “I, Robot”?

Durbin certainly has the bona fides to speak to the potential risk. Before joining Blue Capital, he worked for two years at Citadel Investment Group, constructing the hedge fund’s high frequency trading desk for stock options — the largest in the business.

Durbin published a popular layman’s guide to derivatives in 2005 called “All About Derivatives” and has taught several finance classes at Duke University. Paul Wilmott, a leading expert in quantitative finance and a founder of a hedge fund that specialized in algorithmic trading strategies, recently wrote in The New York Times that “the problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market.”

That’s enough for me. 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.

Now, the proponents of high frequency trading naturally dismiss all this doomsday talk as utter nonsense.

Big players in the field like Goldman Sachs, Citadel Investment Group, Getco and Interactive Brokers claim they’re mainly providing liquidity — making it easier for other traders, institutions and investors to get in and out of positions. The vast majority of high frequency traders would have you believe they are nothing more than service providers.

Yet it’s fair to question the necessity of the service that high frequency traders say they are providing. Much of the liquidity high frequency traders are adding to the mix is simply to match trades created by other high frequency traders.

Want proof? Look at what’s happened with stock options trading in the United States over the past decade.

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.

Again, it’s premature for anyone to suggest that regulators either prohibit or severely restrict high frequency trading. But let’s be clear what we’re talking about here — this is mainly trading for trading’s sake. High frequency trading is simply another way for Wall Street firms and hedge fund to make money.

There’s nothing inherently wrong with profit-driven trading. But if high frequency trading isn’t critical to keeping the markets humming, there should be nothing stopping regulators from putting a review of this strategy at the top of their agendas.


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