November 24, 2014

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Electronic Bulls, Bears and Pigs: Predicting the Next "Flash Crash"

Without robust reform, high speed financial markets are heading for global collapse.

Hazelhenderson

By Hazel Henderson

Remember the old Wall Street adage, “Bulls make money; bears make money; pigs go broke!”? Today, not so much.

Pigs often win, particularly those armed with computers and algorithms. Speed and complexity are the tools of those seeking alpha, hiring quants to create ever more complex derivatives and optimize mathematical paths to trading and gaming markets. Another adage was that of “shearing the sheep,” (i.e., small investors).

Fleecing Small Investors

Computers arrived on Wall Street in the 1960s with early electronic markets like Instinet (now owned by Nomura) and AutEx (the first offering for block traders, now owned by Thomson-Reuters).

I remember discussions around my dinner table in New York with Instinet’s founders envisioning they would make a tender offer for ATT. For full disclosure, I would later partner with Alan F. Kay, the Harvard inventor-mathematician who founded AutEx.

In 2012, Kay wrote how appalled he had become by high-frequency trading (HFT), co-location, latency, maker-taker electronic exchanges and up to 70 percent Pig investingof all trading on Wall Street being taken over by computerized algorithms. The May 6, 2010, flash crash was a wake-up call for millions of small investors. Stocks in their 401Ks, usually reliable blue chips, fell to pennies in minutes.

While these mostly bounced back, many mini-flash crashes have occurred since. Reforms, including Dodd-Frank, have been weakened by lobbyists and the flood of political money opened by the U.S. Supreme Court since 2010.

Darwinism Perverted

Those “pigs,” the old adage warned, were greedy – simply trying to make money out of money, trading competitively with speed, driven by the hormone testosterone. These young, mostly male traders do have elevated testosterone, as illustrated by the research of biochemist John Coates in The Hour Between Dog and Wolf (2012). They exalt in what they see as the “Darwinian” struggle and the “survival of the fittest.”

Never mind that Charles Darwin did not coin this phrase but quoted it from Herbert Spencer, a writer for The Economist, which later in 2005 apologized! Recent research by David Loye reveals that Darwin actually held that humanity’s success was due to our genius for bonding, sharing and cooperation and our potential for evolving our altruistic behavior.

Another Crash in the Making?

Other warnings appeared in 2012 about how computers’ high-speed algorithmic trading had morphed into electronic front-running, abetted by the over 80 proliferating electronic exchanges, including those of NYSE, NASDAQ, BATS and Direct Edge. Those exchanges bid for order flow by offering co-locationFlash Boys near their big computer servers and “rebates” to brokers.

Sal Arnuk and Joe Saluzzi went public on 60 Minutes and wrote Broken Markets (2012) after their many pleas to the SEC to investigate were ignored. Scott Patterson, in Dark Pools (2012), traced the history of computers’ takeover of Wall Street in appalling details, forecasting that the next flash crash will be global. Michael Lewis’ story-telling prowess made his Flash Boys (2014) an instant bestseller – prodding the U.S. Department of Justice and New York D.A. Eric Schneiderman’s current investigations.

Regulate Derivatives as Gaming, Not Investing

So what can be done to restore trust in Wall Street?

Regulation fails due to lobbying and corruption as well as “cognitive capture” of SEC regulators whose computers cannot compete in the technological “arms race” with HFT. Similarly, the CFTC, whose crusading head Brooksley Born was ousted in 1991 by the Rubin-Greenspan-Summers troika, also is kept short of funds, its current efforts to regulate derivatives over-ruled by the DC district federal court.

These derivatives now stand at a notional over $1 quadrillion (11.5 times larger than global GDP of $87 trillion). These bets are largely between four big banks: Bank of America, JPMorgan Chase, Citi and Morgan Stanley, and might actually all net out to zero. They are just bets and as such have nothing to do with investing and should be regulated by state gaming commissions.

The World Future Council has identified laws on gaming in Germany, Switzerland and Austria that make gaming winnings uncollectable and unenforceable.

Market-Based Reforms

Market-based reforms are taking hold.

Alan Kay and I have promoted financial transactions taxes (FTT) of below 1% since 1995. They are now approved by the European Union’s 28 members and already operate in many countries. Originally, they were proposed by James Tobin in the 1970s and by Larry Summers in 1989 to “throw some sand in the gears” of HFT.

Technological reforms now underpin the IEX, documented in Flash Boys, which opened in October 2013, and has already overtakenhigh frequency trading the volume on AMEX. Brad Katsuyama, the young Canadian hero of Flash Boys, also included many ethical reforms into IEX: transparency and service only to investors with electronic barriers to HFT predators and three simple order types, clarifying rules for “best execution.”

The SEC’s National Market System (NMS) unfortunately led to today’s digitized “best execution” based only on price, which encouraged HFT. The original report, Electronic Bulls and Bears (1990), was produced after two in-depth studies in 1981 and 1982 by the late lamented U.S. Congress Office of Technology Assessment (OTA) on which I served from 1974-1980.

The Republicans shut down the OTA in 1996.

But the question remains: how can trust be restored to securities markets and avert the next crash? No market can operate without trust.

Stay tuned!

The opinions, beliefs and viewpoints expressed by CSRwire contributors do not necessarily reflect the opinions, beliefs and viewpoints of CSRwire.

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