Market swings should push regulators to assess computerized finance

The U.S. workforce has become more dependent on the performance of investment choices made by computers on their behalf in their retirement plans. Add to this the pervasive reliance on computers to operate and trade markets.

This has left us with the current situation of a basically financially uniformed public anxious over unexplained deep market swoons. Market professionals are equally anxious over a computerized marketplace that could be running amok.

{mosads}If this is not yet enough anxiety to stir regulatory scrutiny, add the current trend of testing computerized trading strategies run completely by artificial intelligence (AI) to the mix.

Investments were once thoughtfully chosen and managed based on fundamental performance metrics on behalf of an employer by investment managers chosen by the corporate plan sponsor. These retirement plans guaranteed workers a lifetime of retirement payments.

Investments are now chosen and assembled into portfolios on behalf of each employee by computer and periodically and automatically traded with no guarantee of a portfolio retaining its value or of periodic payments throughout a retirees’ lifetime.

It is no wonder that market anxiety and market movements are in lockstep. Markets are completely run by computers, and technology is replacing human judgment in choosing investments and in determining market prices. Regulators should be concerned that a volatile mix is being brewed for a market death spiral.

Trading of all stock orders here in the U.S. are channeled to some 50 trading venues, 13 are “lit” markets (prices observable on exchanges), and 37 others are “dark” markets (prices only observable among professional dealers and market makers).

These markets are tied together through a network of communications lines — telephones and cellular, microwave and fiber — above the earth through satellites and below the water through undersea cables. All are vulnerable to periodic failure.

Trades automatically move prices up when markets are moving higher and down when the opposite is happening. This occurs due to the nature of the markets’ price-discovery mechanism, a price-quoting system that instantaneously allows lit and dark market professionals to buy at a lower price than the selling price.

That process guarantees a profit to market professionals. The regulated profit benefits the professional dealers, market-makers and exchanges, as well as the public.

These market-making professionals (price-setters) are providing liquidity to the markets. Liquidity means always having a price available to buy or sell at so that the public can exit or enter the markets at will.

The lit and dark markets stay in reasonable proximity to each other through rules that require technology to synchronize changing prices from these multiple lit markets. These are the observable price changes that we see scrolling across our TV screens and market-watching devices.

Most of what we see, however, is way behind what the professional traders see — actually what the computers trained by theses traders see and are able to trade with.

The professional trader plays a different game, whether he or she is trading for the long term at hedge funds or mutual funds, or trading institutional portfolios for endowments and pension plans. Traders either look for what they perceive as longer-term high price points to take profits or lower price points to enter markets.

They rely on computer models that trade based on past performance, most recognizable as the statisticians that trade using price trend charts.

The traders who are speculators on their own account or who trade on behalf of speculators who expect higher returns for taking higher risk, play yet another game. They have no long-term view. They look for quick exit and entry points as market prices move up, then down and eventually up again.  

The technology infrastructure that supports price discovery and trading is quite fragile. Software embodied practices — order placement, quoting and trading algorithms are vulnerable to coding errors.

They are also vulnerable to the unintended consequences from not-yet-thought-of trading strategies entered into the software that are not accounted for in the software’s logic. Hardware-created vulnerabilities are another ever-present fragility, experiencing periodic failures of arrays of storage and processing computers.

High-speed networks, even though operating correctly, still permit cascading of thousands of trades in milliseconds, sometimes overwhelming a trading venue’s capacity to handle the volume.

Legacy payment, settlement and asset servicing systems are vulnerable to data discrepancies between trading counterparties, forcing delays in receipt and payment of funds in any one market.

{mossecondads}These funds may be needed in other markets to fund purchases or collateralize margining requirements in related futures, options and over-the-counter derivatives markets.

That computer-dependent market infrastructure is vulnerable to failures should be quite evident. What is less obvious is the long-term vulnerability of our capital markets from society’s anxiety over the effects of market swoons and market failures.

Is this anxiety warranted? Regulators may wish to find out as a generation of baby boomers are preparing to live off of their retirement portfolios’ appreciated values. They have become dependent on the values of those retirement assets.

They are sensitive to market prices falling. They would be even more desperate if market infrastructure failed them as well. Regulators would be wise to examine the effects of technology on drastic market price swings, as we have experienced recently.

Allan D. Grody is president of Financial InterGroup Advisors, a strategy, research and acquisition consultancy.