Automation boosts market volatility, analysts say

High-frequency trading can lead to fear and panic among investors

Over the past month, stock market indices have looked like a lot like a Six Flags roller coaster, with 500 point swings either way -- often on a daily basis.

The Dow Jones Industrial Average finished at 12,747 on July 21, fell to 10,719 on Aug. 10, rebounded to 11,529 on Wednesday before dropping to 10,953 on Thursday. The Nasdaq stock index has experienced a similarly erratic ride.

Some observers say automated computer systems can be blamed for at least part of the accelerated unpredictability of the markets

"[The recent] volatility is absolutely crazy," said IDC analyst Sean O'Dowd. "I don't know a better way to put it. We've seen record lows to record highs in a span of days, not months or years," O'Dowd said. "That's what electronic markets have done."

Up to 70% of trading volume is now consummated by computerized high-frequency trading systems, according to O'Dowd.

DJI
Dow Jones Industrial Index over the past three weeks

David Furlonger, an analyst at Gartner, said proprietary algorithms developed by hedge fund and other Wall Street firms are making decisions without human input. "That doesn't necessarily allow for more analytical, reasoned judgment by a human," he said.

Hedge-fund management firms, like Renaissance Technologies, Getco, and Millennium-Traders are big users of automated trading systems, observers say.

Such firms generally build their own computer infrastructures and design proprietary algorithms that consider the timing, price, and quantity of a trade order, and then initiate the stock buy or sale, all without human intervention.

A little history

In 2003, analysts projected that the financial services industry would spend some $6 billion over two years replacing manual workflows with a new scheme dubbed straight-through processing (STP) of trades.

In simple terms, STP is the replacement of manual processes with an unbroken electronic stream of information that travels from the broker/dealer systems to the clearinghouse. STP uses messaging standards, translation middleware and networks that link investment managers, broker/dealers, custodian banks and clearinghouses.

In 2005, the New York Stock Exchange (NYSE) moved into the electronic exchange marketplace by merging with Archipelago Holdings,a pioneer electronic trader. The Nasdaq Stock Market followed suit by purchasing Instinet Group, the other leading U.S. electronic trading company at the time.

Automatic problems

Fears that automated trading could cause problems have been fulfilled at times, such as last October when a so-called "flash crash" saw the Dow plunge by almost 1,000 points in a half hour, wreaking havoc on the financial markets.

An investigation by the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) determined that automated trade execution caused the "flash crash." An SEC report said automated trade execution system had flooded the Chicago Mercantile Exchange's Globex electronic trading platform with a large sell order causing a panic among investors.

The Financial Industry Regulatory Authority (FINRA), the enforcement arm of the U.S. Securities and Exchange Commission (SEC), responded by enacting rules requiring a pause in the trading of individual stocks when the price moves 10% or more either way in a five-minute period.

Congress has not investigated automated trading systems, according to O'Dowd and Furlonger.

Lucas Mearian covers storage, disaster recovery and business continuity, financial services infrastructure and health care IT for Computerworld. Follow Lucas on Twitter at @lucasmearian, or subscribe to Lucas's RSS feed . His e-mail address is lmearian@computerworld.com.

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