Momentary Financial Crisis... And A Lesson In Unintended Consequences

from the watch-the-automated-trades-go-wheeeeeeeeee dept

As you may have heard, yesterday was a fun day when it came to the stock market, with something causing the Dow to go into freefall for a bit, before it then bounced back up. Initially, some thought that it was a full-on financial crisis, and then there were rumors of a "fat finger" trade, as has been seen in the past. Then there was the inevitable claims of high frequency trading systems having something to do with the mess. People are still figuring out all the details, but Bloomberg has a pretty good explanation of how things snowballed, and it appears to be a case of seriously unintended consequences. Planet Money has the shorter version of how a system designed to prevent the market going into freefall, may have actually aided the market going into freefall.

Basically, there's a system for the NY Stock Exchange and the NASDAQ, called the Liquidity Replenishment Point (LRP), which is designed to stop electronic trading on stocks in freefall. The idea, of course, is to prevent the algorithms from going nuts. But, the LRP only works on those two exchanges, and we're in a world now where there are a bunch of other, electronic exchanges, that now handle an increasing percentage of stock trades -- and electronic trading on those exchanges is not stopped when the LRP is triggered. So, now things actually get worse, because orders that used to be spread more widely concentrate on these other exchanges by automatically jumping from the NYSE and NASDAQ to those alternative routes, and it can swamp those systems, which have a lot less money available. As Bloomberg explains:
While the system is designed to restore order on the Big Board, trading is so fast during times of panic that orders routed past the exchange may swamp other venues and exhaust buy orders, said Angel at Georgetown.

That's when prices may plummet as orders execute against so-called stub quotes from market makers. Brokers can set the quotes as low as a penny a share because they're never expected to be used.
And, speaking of unintended consequences, in talking about this very thing, Felix Salmon points to a blog post by Kid Dynamite explaining why the plan to cancel many of the errant trades is monumentally stupid and likely to create more unintended consequences in forgiving people for doing stupid things, and taking away incentives for others to step in and fix things:
if buyers who step in later see their trades canceled, it removes all incentive for them to step in - and then you don't get the bounce back that we saw! Think about how much havoc it causes a trader who astutely bought cheap stock, then sold it out at a profit. He's now short! Or, he spent the entire day wondering if his order would be canceled, in a state of limbo. What's the alternative - that traders should just assume that the orders will get canceled, and NOT buy stock? Guess what - if no one buys, the stock stays cheap! SOMEONE has to buy, and that someone shouldn't be penalized in favor of remedying the ignorance of the seller who screwed up.
Ah, setting off more unintended consequences in response to other unintended consequences. Sometimes you just have to let those who made a mistake take responsibility for their mistakes.


Reader Comments (rss)

(Flattened / Threaded)

  1.  
    identicon
    Anonymous Coward, May 7th, 2010 @ 3:12pm

    "Sometimes you just have to let those who made a mistake take responsibility for their mistakes. "

    Absurd!!! The government needs to take full responsibility of our actions at all times and that includes controlling us out of our freedoms. After all, government knows best.

     

    reply to this | link to this | view in thread ]

  2.  
    identicon
    Anonymous Coward, May 7th, 2010 @ 3:20pm

    Bailouts and Undos

    People are still figuring out all the details,

    What happened was that the wrong people lost a lot of money, and when that happens something will be done about it. Either the government will step in with a bailout or the system will just give the "wrong losers" a big "undo" (like five-year-olds demand when they lose).

     

    reply to this | link to this | view in thread ]

  3.  
    icon
    qhartman (profile), May 7th, 2010 @ 3:40pm

    We are the "do-over" society

    "Sometimes you just have to let those who made a mistake take responsibility for their mistakes."

    Every hates "big government" and "socialism" until it's their ass that needs saving. I say let them swing in the breeze...

     

    reply to this | link to this | view in thread ]

  4.  
    identicon
    Anonymous Coward, May 7th, 2010 @ 4:29pm

    Re:

    sometimes you just have to let a grad student with a website run things, and life will be perfect. *gag*

     

    reply to this | link to this | view in thread ]

  5.  
    identicon
    anonymous3, May 7th, 2010 @ 4:30pm

    LRP

    The solution is to require federated/coordinated enforcement of the Liquidity Replenishment Point (LRP) across all exchanges. That some stock prices were allowed to drop 90+% in

     

    reply to this | link to this | view in thread ]

  6.  
    identicon
    anonymous3, May 7th, 2010 @ 4:36pm

    LRP

    The solution is to require federated/coordinated enforcement of the Liquidity Replenishment Point (LRP) across all exchanges. That some stock prices were allowed to drop 90+% in less than 10 minutes is not the fault of traders, it is a frightening market failure. Since the computers were making nearly ALL of the decisions during that period, it is hard to lay blame at human stock trading decisions.
    [used 'less than' symbol in previous post which cut it off, please delete previous]

     

    reply to this | link to this | view in thread ]

  7.  
    icon
    Hephaestus (profile), May 7th, 2010 @ 5:24pm

    Having coded stock trade engines in the past ...

    "Sometimes you just have to let those who made a mistake take responsibility for their mistakes."

    Most of the time that is correct. If this turns out to be one or more hacked trade engine(s) (computerized trading system(s)), an attempt to profit from a statistical fluke someone found doing a historical simulation and then set in motion, or any of the other number of things that can be used to manipulate the market to cause money to unfairly change hands. In situations like this it is better to be safe than sorry and stop any profit from attempts at market manipulation. Rather than wait a year for the investigation to conclude and find that it was an externally forced event.

    JMHO

     

    reply to this | link to this | view in thread ]

  8.  
    identicon
    Anonymous Coward, May 7th, 2010 @ 5:45pm

    Re: LRP

    Computers have rights too you know. One day there will be a computer rights movement and robots and machines, just like in terminator, will demand equal rights or they will turn against humanity.

     

    reply to this | link to this | view in thread ]

  9.  
    icon
    Hephaestus (profile), May 7th, 2010 @ 5:48pm

    Re: Re: LRP

    "will demand equal rights or they will turn against humanity."

    Did you ever think that maybe, just maybe ... they arent computer glitches and the revolution has already begun. ;)

     

    reply to this | link to this | view in thread ]

  10.  
    icon
    Steve R. (profile), May 7th, 2010 @ 5:53pm

    Complex Systems Are Prone to Failure

    This is simply another example of "financial innovation" running amok. Previously we had the creation of CDOs which began to unravel. In doing so, it turned out that the holders of the CDOs could not even figure out who actually owed them the money because the underlying securities were sliced-up and re-sliced as to be unrecognizable. Truly a black box.

    Now we have people writing psychic programs to "sense" the anticipated movement of a stock. Unfortunately it looks like someone may have created a positive feedback loop. Oops!

    My point, given the freedom to innovate, these companies should exhibit a degree of self control and ethical behavior. These "people" in their self-serving greed don't seem to care that their mistakes could destroy our economy and the lives of others. Given this greed, I'm probably on the wrong planet with my recommendation!

     

    reply to this | link to this | view in thread ]

  11.  
    icon
    Hephaestus (profile), May 7th, 2010 @ 6:07pm

    Re: Complex Systems Are Prone to Failure

    "My point, given the freedom to innovate, these companies should exhibit a degree of self control and ethical behavior. These "people" in their self-serving greed don't seem to care that their mistakes could destroy our economy and the lives of others."

    Perhaps after passing your seven you should also be sworn in with an oath like the hippocratic oath or an Officer of the court and held to a higher standard. Alot of good that does us with Officer of the court though.

     

    reply to this | link to this | view in thread ]

  12.  
    identicon
    Pixelation, May 7th, 2010 @ 6:24pm

    This is Brazil

    The line from the movie Brazil seems appropriate.
    "I had complications on my complications"

     

    reply to this | link to this | view in thread ]

  13.  
    identicon
    Anonymous Coward, May 7th, 2010 @ 7:18pm

    Re: LRP

    The solution is to require federated/coordinated enforcement of the Liquidity Replenishment Point (LRP) across all exchanges.

    How many troops do you reckon it will take to invade and take over the UK so that the US can enforce the LRP on the London Stock Exchange?

     

    reply to this | link to this | view in thread ]

  14.  
    identicon
    G-Man, May 9th, 2010 @ 11:27am

    Prepare for unforseen consequences

     

    reply to this | link to this | view in thread ]

  15.  
    icon
    Jamie Stock (profile), Jul 30th, 2010 @ 1:41am

    Financial Crises

    Whatever goes in NASDAQ and other stock markets is very well known to the government agencies.

     

    reply to this | link to this | view in thread ]

  16.  
    identicon
    stock, Dec 11th, 2010 @ 4:26am

    “We believe that the union is irrelevant for the 21st century,” declared Lotito. Unfortunately, “unions have new weapons.” mortgage calculator with taxes

     

    reply to this | link to this | view in thread ]

  17.  
    identicon
    Barry Edwards, Dec 15th, 2010 @ 12:22pm

    high frequency trading

    Its a joke to talk about stopping high frequency trading and/or day trading. Where does the liquidity come from for the average working guy to buy and sell stocks for his account from home at brokers like ETrade and TDAmeritrade? From active day traders for one. Get rid of day traders and there goes the nice tight bid-ask spreads everyone enjoys right now. Practice good money management and you don't have to worry so much about events like the above happening.

     

    reply to this | link to this | view in thread ]

  18.  
    icon
    Stock Market For Beginners School (profile), Apr 5th, 2011 @ 11:17am

    Re: high frequency trading

    I agree with you Barry. If they got ride of the day traders, there would be less liquidity in the market. as day traders we provide the liquidity for a majority of the moves during the day. Hedge funds and institutional traders are not interested in high frequency trading and they don’t care about gaining 50cents to 2 dollars a day, they are after the big long term moves, but as day traders we make it possible for the other people to have daily liquidity. This has been a very interesting article.

     

    reply to this | link to this | view in thread ]

  19.  
    identicon
    Jayson Ant, Jan 6th, 2012 @ 7:49am

    Forex Trading

    "Since the computers were making nearly ALL of the decisions during that period, it is hard to lay blame at human stock trading decisions." This is true but both are at fault since everyone should take responsibility about it.

     

    reply to this | link to this | view in thread ]

  20.  
    identicon
    jaffa, Apr 2nd, 2012 @ 3:44am

    Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. Thanks.
    Regards,
    banking information

     

    reply to this | link to this | view in thread ]


Add Your Comment

Have a Techdirt Account? Sign in now. Want one? Register here
Get Techdirt’s Daily Email
Save me a cookie
  • Note: A CRLF will be replaced by a break tag (<br>), all other allowable HTML will remain intact
  • Allowed HTML Tags: <b> <i> <a> <em> <br> <strong> <blockquote> <hr> <tt>
Follow Techdirt
A word from our sponsors...
Essential Reading
Techdirt Reading List
Techdirt Insider Chat
A word from our sponsors...
Recent Stories
A word from our sponsors...

Close

Email This