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Kill Robo-Trading in the Stock Market Before it Kills Us

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In the 19th century, investors who employed agents and carrier pigeons to bring information to them first made great fortunes. Today, money is being made by those who employ armies of quants (physicists and mathematicians), who build microwave towers and lay fiber-optic cables beneath oceans in order to get information and trade in less than the blink of an eye.

The quants and their computers now represent half of all trading in the United States. This is replacing long term value investments, based on fundamentals, with automated micro trading bets lasting milliseconds. Unlike other actions, these high-frequency trades are not regulated and have begun to destroy the market itself.

The most recent glimpse into a frightening future occurred on August 1 when a computer glitch at Knight Capital Group Inc. in New Jersey, that handled 11 per cent of all U.S. stock trading, was obliterated by an unproven algorithm. In less than an hour, the firm's new "program" bid for 150 stocks incorrectly then ended up holding $7 billion worth at one point. Immediately, rival computers traded against the bids and, by the end of the day, Knight had lost $440 million and had to be rescued.

"To me, the most frightening element of the Knight Capital situation was the speed in which the company lost nearly a half-billion dollars, raising the question as to whether the pursuit of profits in technology (whether it is in market-making or high-frequency trading) is leading us uncontrollably down the road to ruin," wrote market guru Doug Kass on a website called thestreet.com.

The most halting fact about the Knight Capital fiasco is that its computer glitch bypassed safeguards that had been put into place by the U.S. Securities and Exchange Commission after the infamous Flash Crash on May 6, 2010. That Crash followed a single $4.1 billion trade in the S&P 500 Futures Market, sparked a cascade of selling and wiped out $1 trillion of market cap before mysteriously recovering. If the U.S. markets had closed that day before they recovered, the result would have been total economic disaster as money flooded out of the stock market overnight.

The Securities and Exchange Commission since claimed they had installed circuit breakers, but that's a complete joke. On July 30, another Flash Crash nearly took place after an identical order of $4.1 billion was placed three seconds before the market closed. Fortunately, there wasn't enough time for a gigantic sell-off but a few minutes earlier would have been a meltdown. This is because the circuit breakers are turned off in the last 25 minutes of trading.

Clearly, the regulators must smarten up and impose Draconian measures to end this hyper trading-for-trading's-sake abuse of markets and investors.

Last year, CNBC's stock expert Jim Cramer did not mince words about the quants and their investment bank employers or clients: "High frequency trades have a speed edge and weapons that are like machine guns in World War I and individual investors are foot soldiers, mowed down by a new technology they can't understand. The individual investor is fodder in the face of these fields of fire."

A Chicago Booth/Kellogg School Financial Trust Index in July found 15 per cent of respondents trusted stock markets. Since the Flash Crash, investors have pulled out $127 billion from mutual funds and their participation has been steadily shrinking since 1996.

The solutions include speed limits (such as a five-second delay to stop the split-second in and out trading) and, most importantly, the removal of self-regulation from stock markets. The markets are the culprits by allowing artificially generated trades to generate fees.

By the way, these high-frequency troops never contribute to wealth formation because they buy or short stocks for split seconds to bet for or against market momentum and other correlations. They earn fractions of a cent on millions of tiny transactions.

Former software engineer, Ellen Ullman, wrote in the New York Times this week that algorithmic traders should be held liable for damages and, like credit companies, should have to police their own actions by putting in place artificial intelligence systems to catch faulty or fraudulent or weird algorithms. Just as credit card companies routinely call users if they detect unusual purchases, these companies should have internal systems to catch their own unusual trades.

"The SEC and other regulatory bodies should independently deploy their own [artificial intelligence] systems," she added. "Credit card issuers get stuck with the bill. If Knight Capital and other firms were forced to pay back everyone -- everyone -- who got caught in their downdraft, just imagine what brilliant systems the companies would devise."

Whatever happens, the system's integrity must be restored. Without that, ordinary investors, or their money managers, cannot get information on a timely basis or have an opportunity to back achievement and good ideas. Doug Kass was more indelicate this week: "I say kill the quants and their technology before they kill us."