Image by AFP/Getty Images via Daylife
Yesterday, the stock market suffered the equivalent of a run-on-the-bank. Liquidity disappeared and prices nosedived, with the Dow spiraling down nearly 1000 points. Today the Dow faces another 3-digit-loss. Economist Paul Kedrosky explains in his blog today just how and why the markets are particularly vulnerable to bone-rattling volatility. As you doubtless already suspect, computer-driven trading is the chief culprit. But Kedrosky carves out a nuanced explanation on the ways algorithm-based trading has changed the market essence. Here’s Kedrosky in his own words:
There are fewer traders prepared to make a market for the sake of market health. This is partly because they can, but mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers, but in the course of normal business generally accepted as a price that gets paid to the market’s battle bots.
But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn’t just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, “No thanks. You battle bots take it”. And, they don’t.
Wall Street Social 
I seem to recall a certain inexplicable crash in 1987 when the stock market took a bizarre dive and all the automated trading took the bad situation and made it much much worse.
Certain “circuit breakers” were supposed to be installed in the stock market back then. What became of them?
Portfolio insurance was one of the culprits in the 1987 crash. Wall Street had sold sell programs to major institutions worried about protecting their gains. When prices started falling in ’87, the programs started kicking in — all at once. Too many people were elbowing their way to exit. The stampede that ensued wasn’t very pretty. Today, the computers that are engaged in trading are much more complex, powerful, and dominant. As much as 2/3 of daily trading on the NYSE is computer driven. That’s why everyone points fingers at the computers. But, of course, it’s not that simple. People actually created the computers and didn’t take into account how such powerful creatures could overwhelm the few humans left on the trading floor.
As for circuit breakers, they too were overwhelmed. Almost by definition, the solutions to the past problems are rarely effectual for long. Wall Street keeps inventing something more and more ingenious to make everyone richer for a while until mayhem ensues. You know, it seems like we’re in a perpetual Tom and Jerry cartoon. Every time Tom is about to capture the Jerry — KERPOW! – Tom gets clobbered. Well, every time the regulators or Wall Street think they’ve conquered risk in the marketplace — BOOM! — things go haywire.
Ms. Miller,
Every time the market behaves in uncomfortable ways, everyone blames the computers. It is a “glitch” they say, an unfortunate convergence of programing. Nothing could be further from the truth. It is well known that computers are very stupid, they do exactly what they are told (i.e. programmed) to do. Traders program computers to trade in exactly the same way that they do, just faster and more consistently. They do not pause, or flinch, or think, they trade – just as a human trader would. They look for exactly the same market signals that humans look for.
So what happened was what was we expect the market to do, reflect how profitable the overall investment / speculation market is. Well, with chaos in Greece and Europe trembling, Dubai collapsing, and China’s domestic housing bubble ready to burst, it does not look good. Computer of human, the logic is the same, investing in stocks tied to these huge investment markets is a bad idea. Since there are few good investments to shift investments to, prices fall.
This is not a glitch, it is not a mistake, is the market being a market.
I think an alternate title could be “How computers are the stock market”.
Watching the shouting matches yesterday, I saw basically this:
You have a fault in the computer algorithm!
You didn’t trust the computer algorithm enough!
Like any on-line game that allows bots, if you don’t have one, you can’t play competitively. Unlike games, the stock market doesn’t have a “casual gamer” niche, unless you consider it to be the “individual investor”. In the games they call them, “noobs” they are looked down upon and used as prey.