Understanding Risk Management and Compliance, What Is Different After Monday, April 27, 2015

You have probably heard that as a result of the increasing use of algorithms in trading, trading banks of the future will simply consist of a computer, a man and a dog. The computer will be there to handle the transactions and the dog to stop the man from interfering with its trading programs. The man’s job will be to feed the dog.

But we have a problem! As Commissioner Kara M. Stein told us, Algorithms “don’t quite get jokes”.

A recent example that demonstrates some of the potential pitfalls of overreliance on technical and algorithmic trading occurred on April Fools’ Day this year. A Tesla press release jokingly announced a new “W” model for a watch.

It was clearly intended as a joke. However, it was taken all too seriously by computers dutifully executing their algorithms in response to the press release.

The algorithms didn’t quite get the joke, trading hundreds of thousands of shares and spiking the stock price within one minute of the issuance of the release.

So, a computer, a man and a dog are never going to replace all other employees of a future bank. I love jokes.

Commissioner Kara M. Stein is really good at explaining our reliance on algorithms.

“For hundreds of years, securities transactions were dominated by human hands.

Traders stood face to face and looked each other in the eye.

Some of the New Yorkers in the audience may know that the Buttonwood Agreement established the New York Stock Exchange in 1792.

Twenty-four brokers signed the agreement to become the NYSE’s first members.

The agreement created a closed club whose members agreed to trade only with each other.

The location of the exchange was originally under a tree – a buttonwood tree - at 68 Wall Street.

Face-to-face trading in securities and in-person communication were everything.

It was a clubby exchange where everyone knew each other and deals were done in person and with a handshake.

Over 200 years later, today’s securities markets would be unrecognizable to those who signed the Buttonwood Agreement.

Forget about conducting business under a tree – the central nexus of securities trading activity for decades, the trading floor, has also rapidly become a relic of the past.

The close-knit atmosphere of the Buttonwood days – which persisted to some extent on trading floors – is gone.

Human dealers and specialists have largely been phased out.

Today, nearly all trades occur on electronic venues, with more than one third of orders executed off-exchange.

The early 1970s brought fundamental change to the actual process of transacting in securities.

A confluence of regulatory changes, technological advancements, and changes in communication drove the market to automate securities transactions.

As a result, our securities market is, for better or for worse, less human.

Gone are the trader’s gestures and shouts.

Artificial intelligence is replacing human intelligence.

Human considerations are being replaced with mathematical models and algorithms.

And, the need for speed is unquenchable.

Wires are being replaced with fiber optics, microwaves, and laser beams.

The human blink of an eye is too slow for today’s market.

Trading volume is scattered among venues with no one exchange having an overall market share of twenty percent.

Increasingly, more and more volume is executed off- exchange.

Computer “matching engines” match electronic limit orders with electronic market orders.

High-speed trading dominates, representing over 55 % of US equity markets and 40% of European markets volume.

Liquidity provision has largely shifted from traditional market-makers to computerized systems that trade at light speed and across different exchanges and securities.

In addition, computers, not research analysts, cull through vast quantities of data ...