Culture Shock: Computerized Trading's Technological and Human Limitations

The need for speed. It's been a feature of human development ever since the first humans attempted to catch - or avoid being caught by - their prey.

In the digital era, this imperative has overwhelmed any number of industries where quickness and convenience combine to offer a competitive advantage. The impact has been perhaps most dramatic in finance, where the institution of computerized and, now, high frequency or algorithmic trading has changed not just the expected outcomes but has revolutionalized the very process by which information is transformed into profits.

This tectonic shift has produced its share of problems. Any change of such magnitude might be expected to do so, but the impact has been particularly noticeable in an industry previously dominated by human beings, mostly guys, who often came from similar backgrounds and even knew each other, to machines which could care less about who or what is on the other side of a trade.

The velocity at which this activity takes place and the ability of humans to process the implications continues to bedevil the institutions that dominate the business. Technological glitches are bound to happen, but at this speed, the affect can be significant. At the same time, the humans programming and interpreting the results face their own limitations in managing the flow. The changes are probably permanent, or at least, accepted, until some as-yet-unforeseen crisis mandates adjustment. But the larger challenge may lie in acknowledging, as the financial crisis of five years ago taught, that the unrecognized threat from the imperfect melding of human and technological interaction may be the biggest one the system faces. JL

William Alden reports in DealBook:

“You’ve gone from the jock culture that used to dominate the trading pits to more of a geek culture,” said Manoj Narang, the chief executive of Tradeworx, a high-frequency trading firm in New Jersey. “It’s entirely different individuals, and there’s a lot of sour grapes as a result of that.”
After a technological breakdown froze the Nasdaq stock market for three hours last month, investors across Wall Street wrung their hands.
But Thomas H. Shafer allowed himself a bitter laugh. After all, he had forged a career as a stock exchange specialist — buying and selling shares to help the market function properly — only to have his profession sharply diminished by technology.
Now that technology was proving yet again to be a source of error. With the rise of computer-driven trading, a number of problems — including the “flash crash” of 2010 and the crippling computer error at the Knight Capital Group last year — have led investors and regulators to demand tighter safeguards. Last week, the Securities and Exchange Commission asked the nation’s stock exchanges to introduce “kill switches” and other technological changes.
“There were times when the you-know-what hit the fan, and I feel we did a real good job with the human element,” Mr. Shafer, 48, said. “That’s what we were supposed to do — slow the process down so calmer heads can prevail.” Mr. Shafer’s current vantage point on the markets is a world away from Van der Moolen, the specialist firm he left at the end of 2007. Having fled a dying business, he now works to reclaim a dead forest — running a start-up company in Maine that makes flooring out of century-old logs collected from the bottom of the Penobscot River.
Even though he works in the remote town of Millinocket, Me., Mr. Shafer still feels compelled to check the market every day. “I’m the only guy in Maine that has a BlackBerry,” he joked.
The move to computers, of course, had benefits for investors large and small, making stock trading cheaper, faster and more efficient. But each technological malfunction provides fuel for critics who argue that today’s market structure can allow digital errors to become disasters.
In the past, such accidents would not make headlines, said Charles P. Dolan, a former specialist who was a colleague of Mr. Shafer.
“I will tell you that 99 percent of those orders, we gave them the opportunity to cancel,” said Mr. Dolan, 49, who is the chief operating officer of AFScott Technology Integrators, an information technology services company in New Jersey and a member of the New Jersey State Investment Council. “That saved them millions of dollars.”
Through the 1990s, a group of firms with now largely forgotten names like Spear, Leeds & Kellogg and LaBranche & Company enjoyed a central position at the New York Stock Exchange. In times of stress, it was up to specialists to lean against the wind, acting as buyers and sellers of last resort.
The profits from this line of work could be bountiful. Specialists at the Big Board oversaw all trading in particular stocks, and they collected spreads of as much as 12.5 cents a share, represented as one-eighth of a dollar. Such princely rewards raised eyebrows.
New regulations, combined with the increased automation of the market, ushered in the extinction of the specialists.
Spreads — the price differences that fed specialists’ profits — shrank significantly after the Securities and Exchange Commission in 2001 required all stock prices to be quoted in decimals rather than fractions. The smallest possible price increment collapsed to a penny from one-sixteenth of a dollar.
At the same time, competition was increasing. Under pressure from regulators, the Big Board in December 1999 voted to eliminate a rule that prevented certain stocks listed on the exchange from trading elsewhere. And by 2007, the S.E.C. required stock orders to go to whatever exchange offered the lowest price.
Today, only about 20 percent of stocks listed on the New York Stock Exchange actually trade there, compared with around 80 percent in 2004, according to data from the Tabb Group, a research and advisory firm.
In place of specialists, so-called designated market makers are now in charge of smoothing volatility at the Big Board, with technology that lets them handle 10 times as many stocks as the specialists once did.
A little more than 100 of these market makers work on the exchange floor, according to a person briefed on the matter who spoke on condition of anonymity. That compares with about 440 specialists a decade ago.
The dominant force in the market is now high-frequency trading. Such firms accounted for more than half of the shares traded in the United States last year, compared with about a fourth in 2006, according to the Tabb Group.
Even former specialists acknowledge that change was probably inevitable. William J. Nelson Jr., a former specialist with Bear Wagner Specialists, described the process as “Paul Bunyan versus the chain saw.”
“We were no longer making markets. We were really just moving the mouse around to run the programs making the markets,” said Mr. Nelson, who co-founded Valuation Metrics, a San Francisco-based firm that helps companies find investors, after leaving Bear Wagner in 2009.
Mr. Nelson, 47, was able to harness advanced technology in his second career, buying the rights to software that his company uses to analyze investment portfolios.
For many, the emotions are still raw. John J. Conklin III, who had the unpleasant task of cutting jobs when he was president of Bank of America’s specialist unit, wrote a barb-filled essay for TheStreet.com in the wake of the flash crash in 2010, saying lawmakers and regulators had “sold their souls” in pursuit of faster trading.
And yet, the beneficiaries of the new system extol its virtues.
Mr. Shafer now pursues a different life. He has traded his Audi luxury sedan for a Ford pickup truck. Instead of a suit, he now wears an industrial uniform supplied by UniFirst.
Late last month, on a trip to New York, Mr. Shafer returned to his old haunts. He stopped by Bobby Van’s Steakhouse near the stock exchange, exchanging a warm greeting with the manager and occasionally glancing out the window at familiar faces.
A New Jersey native who started on Wall Street as a clerk in 1989, Mr. Shafer rose to become a governor on the stock exchange floor. The sale of his longtime firm, Lyden Dolan Nick & Company, to Van der Moolen in 2002 turned out to be well timed, Mr. Shafer said, as the business went into decline.
After taking an exit package, Mr. Shafer sat on the sidelines of Wall Street as the financial crisis caused job opportunities to dry up. By 2009 — the year Van der Moolen went bankrupt — Mr. Shafer was on an island in Maine, helping build a cabin on his family’s property there, when he met his current business partner.
His company, Maine Heritage Timber, is not yet profitable, but Mr. Shafer said he recently secured a large order for tables, wall paneling and bar tops from a restaurant in Florida. Though he finds the work more fulfilling than his previous career, it is also more stressful — he is now trying to build something that lasts.
“When you traded, it was like playing a basketball game. You threw the ball up, and when the bell rang it was the end of the game,” he said. “This is never over.”