Technology is both problem and solution for modern financial markets, but 'financial system 2.0', which will see technology used in a more responsible and rational way, will learn from lessons past.
The electronic glitch that cost global financial services firm Knight Capital Group $440m in August 2012 is emblematic of a new form of risk in the digital economy: technological risk. As one of the largest and most technologically advanced firms in the US, Knight is responsible for $20bn of trades on the New York Stock Exchange each day, about one-sixth of the exchange’s total daily trading volume. Much of Knight’s trading is handled entirely electronically, and its success and growth as a broker-dealer is a direct consequence of Moore’s Law – the continuing trend of cheaper, faster and more powerful computers.
But the financial industry differs from the semiconductor industry in at least one important respect: human behaviour plays a more significant role in finance. As the great physicist Richard Feynman once said: “Imagine how much harder physics would be if electrons had feelings.” While financial technology undoubtedly benefits from Moore’s Law, it must also contend with Murphy’s Law, that “whatever can go wrong will go wrong”, as well as its technology-specific corollary, “whatever can go wrong will go wrong faster and bigger when computers are involved”.
If Knight were an isolated incident, it would be unremarkable. Software errors occur all the time in every industry – remember Y2K? – but no one would have guessed that as technologically sophisticated a firm as Knight would be the one to get hit with a major software failure. Over the past few years, the number of technology-related problems in the financial industry seems to have grown in frequency and severity. More worrisome is the fact that these glitches are affecting parts of the industry that previously had little to do with technology, such as initial public offerings. IPOs have been a staple of capitalism since the launch of the Dutch East India Company in 1602, and there is evidence of publicly traded firms going back to the Roman republic in the second century BC. How could software errors possibly affect such a basic and well-understood financial transaction?
Facebook and friends
On Friday, May 18, 2012, social networking pioneer Facebook had the most highly anticipated IPO in recent financial history. With more than $18bn in projected sales, Facebook could easily have listed on the New York Stock Exchange along with the 'big boys' such as Exxon and General Electric, so its choice to list on Nasdaq instead was quite a coup for the newer market. The combination of Facebook’s computing prowess and Nasdaq’s technology focus seemed tailor-made for each other, a financial fashion statement in keeping with Facebook CEO Mark Zuckerberg’s hoodie hacker persona.
Facebook’s debut was less impressive than most investors had hoped, but its lacklustre price performance was overshadowed by a more disquieting technological problem with its opening. An unforeseen glitch in Nasdaq’s IPO system interacted unexpectedly with trading behaviour to delay Facebook’s opening by 30 minutes, an eternity in today’s high-frequency environment. As the hottest IPO of the past 10 years, Facebook’s opening attracted extraordinary interest from investors, but Nasdaq prided itself on its ability to handle high volumes of trades. Nasdaq’s IPO Cross software was reportedly able to compute an opening price from a stock’s initial bids and offers in less than 40 microseconds (a human eye blink lasts 8000 times as long).
However, on the morning of May 18, interest in Facebook was so heavy that it took Nasdaq’s computers up to five milliseconds to calculate its opening trade, 100 times longer than usual. During this calculation, Nasdaq’s order system allowed investors to change their orders up to the print of the opening trade on the tape. But these few extra milliseconds before the print were more than enough for new orders and cancellations to enter Nasdaq’s auction book. These new changes caused Nasdaq's IPO software to recalculate the opening trade, during which time even more orders and cancellations entered its book, compounding the problem in an endless circle.
This glitch created something software engineers call a 'race condition', in this case a race between new orders and the print of the opening trade, an infinite loop that required manual intervention to exit, something that hundreds of hours of testing had missed. By the time the system was reset, Nasdaq’s programs were running 19 minutes behind real time. Seventy-five million shares changed hands during Facebook’s opening auction, a staggering number, but orders totalling an additional 30 million shares took place during this 19-minute limbo. This incredible gaffe, which some estimates say cost traders $100m, eclipsed Nasdaq’s considerable technical achievements in handling Facebook’s IPO.
BATS out of hell
Less than two months before, another IPO suffered an even more shocking fate. BATS Global Markets, founded in 2005 as a 'better alternative trading system' to Nasdaq and the New York Stock Exchange, held its IPO on March 23, 2012. BATS operates the third largest stock exchange in the US; its two electronic markets account for 11% to 12% of all US equity trading volume each day. BATS was to stock exchanges what Knight Capital was to broker/dealers: among the most technologically advanced firms in its peer group and the envy of the industry.
Quite naturally, BATS decided to list its IPO on its own exchange. If an organisation ever had sufficient 'skin in the game' to get it right, it was BATS, and if there were ever a time when getting it right really mattered, it was on March 23. So when BATS launched its own IPO at an opening price of $15.25, no one expected its price to plunge to less than one-tenth of a penny in a second and a half due to a software bug affecting stocks whose ticker symbols began with the letters A and B. (Apple was also affected, but only lost 9.4% over a five-minute interval.) The ensuing confusion was so great that BATS suspended trading in its own stock, and ultimately cancelled its IPO altogether.
While technology has advanced tremendously over the past century, human cognitive abilities have been largely unchanged over the course of the past several millennia. Therefore, technologies that leverage human abilities often magnify both positive and negative outcomes. Automated trading systems provide enormous economies of scale and scope in managing large dynamic portfolios, but trading errors can now multiply at the speed of light before they are discovered and corrected by human oversight.
A solution?
The paradox of modern financial markets is that technology is both the problem and, ultimately, the solution. The current financial system has reached a level of complexity that only 'power users' – highly trained experts with domain-specific knowledge – are qualified to manage. But because technological advances have come so quickly and are often adopted so broadly, there are not enough power users to go around. Also, the growing interconnectedness of financial markets and institutions has created a new form of accident: a systemic event, where the 'system' now extends beyond any single organisation.
The 'flash crash' of May 6, 2010 is a case in point, where a game of 'hot potato' among high-frequency traders, hedging activity by slower-paced mutual funds, and a loophole allowing traders to post bid/offer quotes that were merely placeholders, all conspired to create a breathtaking 20-minute interval from 2:40pm to 3:00pm when the Dow Jones Industrial Average dropped nearly 1000 points, and the stock price of the world’s largest management consulting firm, Accenture, fell to a penny a share.
These events occurred not because of any single organisation’s failure, but rather as a result of seemingly unrelated and innocuous activities across different parts of the system that generated the perfect financial storm when they occurred simultaneously.
The solution, of course, is not to foreswear financial technology – the competitive advantages of automated trading and electronic markets are simply too great for any firm to forgo. Instead, the answer is to develop more advanced technology; technology so advanced it becomes fool-proof and invisible to the human operator. Every successful technology has gone through such a process of maturation, and financial technology is no different – we need version 2.0 of the financial system.
Managing the system
The starting point is the recognition that the financial system is, in fact, a system and must be managed like one. Financial institutions can no longer take the financial landscape as given when making decisions, but must now weigh the ripple effects of their actions on the system and be prepared to respond to its responses. Regulators can no longer operate in isolated agencies defined by institutional types or markets, but must now acknowledge the flexibility created by financial innovation and regulate adaptively according to function rather than form. And individuals can no longer take it for granted that a fixed proportion of stocks and bonds will generate an attractive return at an acceptable level of risk for their retirement assets, but must now manage risk more actively and seek diversification more aggressively across a broader set of asset classes, strategies and countries.
But perhaps the most significant innovation of the financial system 2.0 will be to create a financial system that is not predicated on the purely rational actions of Homo economicus, but one that recognises the frailties and foibles of Homo sapiens by addressing Murphy’s Law as successfully as it exploits Moore’s Law. As disruptive and disastrous as the recent series of crises have been, they have provided us with a wealth of critical information about the most important weaknesses in our existing financial infrastructure. The tendency for financial institutions to become too big to fail, the tendency for politicians to issue government guarantees because the reckoning is beyond their term in office, and the tendency for regulators to look the other way when business is booming and no one is complaining are just a few examples of 'bugs' that need to be fixed in version 2.0. We know how to do it. We just need to want to do it.
Technology is the reason the human race is the dominant species on the planet. But technology is often accompanied by unintended consequences: pollution, global warming, pandemics and financial crises. Financial technology can facilitate tremendous growth, but history shows that when used irresponsibly, it can lead to great devastation. Let’s hope that the financial system 2.0 will be more Moore than Murphy.
Andrew W Lo is the Charles E and Susan T Harris professor of finance at the MIT Sloan School of Management.
