The Dark Knight of High Frequency Trading

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Traders work at the Knight Capital kiosk on the floor of the New York Stock Exchange. Knight Capital Group Inc said on 1 August, 2012, that a “technology issue” in its market-making unit had affected the routing of shares of around 150 stocks to the New York Stock Exchange, where abnormal volatility roiled the markets in early trading. Photo – Reuters

The technological glitch at Knight Capital Group was not the first time that technology had reared its ugly head in trading and led to massive fluctuations in different stocks. Before that it was the flash crash of May when billions were erased from the Dow Jones index that was corrected in a matter of seconds. The case of Knight, however, was the first time that a private market maker had gone through the wrath of technology and even though it was able to survive the situation, the debacle pushed it close to bankruptcy and seek a helping hand to cover its losses and stay afloat.

The anger and disgust over this situation was two pronged. On one hand, the critics of high frequency trading (HFT) were displeased over the fact that scientific and mathematical algorithms written in the back of an office somewhere were becoming more involved with trading which was once a more human activity. The thought processes used by a trader and his experience and judgement was now being copied by software and the existence of the day old trader was being lost. Trade had moved from trading floors to computer terminals and the art of trading was further losing ground against its technological nemesis.

The glitch led to more people calling for a limitation to be put in place. The other side wanted to protect the investors who were losing their hard earned savings and investments in a matter of seconds based on the methods used by the computers. People on both sides said that if humans were used in the trading or even if human supervision was used, these situations could be avoided in the future. On the other side, the proponents of HFT say that human beings are slow to react and cannot respond quickly to market movements. The time it takes a human to decide on trade, or even to execute it, the opportunity might be gone.

If a computer was in its place, the execution and decision making would be seamless and the trade would have gone through by the time a human being or a computer operator would have been able to even think about it in the first place. The situation seems like a classic case of what if. What if there were no computers and everyone was on the same playing field. In that case, any unfair advantage gained by use of technology would have been blocked from even coming in. Now, however, technology has been embraced and whoever does not have it is a step behind the market.

There still is a need for some sort of checks and balances in place to control the situation and that’s where the next move should be. SEC has launched a formal investigation into the fiasco that took place at Knight and would find what the problem actually was. Based on the findings of the investigation, the SEC should try to get ahead of the problem and place limits and locks into place which are triggered in case of extraordinary moves. It would be better to have a human being interacting with the machine in case of huge fluctuations and might even trigger a shut down if the price ranges go haywire.

The human override would make sure that even if there are huge losses, they are suffered primarily by the brokerage house itself and not the investors who stand to lose their investments even though they are not at fault. This can act as a deterrent to many houses from using HFT if it’s not willing to bear the losses and would make them self-regulate themselves by having more efficient and smooth running systems at their disposal.

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