10.25.12 6:44 PM ET
When Machines Rule the World
Stock markets are supposed to be efficient. Rational actors continually process data in a methodical way and spit out the appropriate price. But today, the market is increasingly peopled by machines–algorithms, programs, trading bots, and high-frequency traders swapping large and small bits of stock at an insanely rapid pace. High-frequency trading accounts for about half the volume on U.S. stock exchanges. And in recent years, we’ve learned that dispassionate machines and software can act in ways that seem highly irrational.
One move in the market triggers a reaction, which pushes a machine to issue a trade, which triggers a host of other trades, and so on. That’s how the Flash Crash came to pass. On May 6, 2010, the Dow Jones industrial average lost about 1,000 points in 20 minutes as computers ran amok. All it takes is one misplaced or mistimed trade, one small bit of misinformation or incorrect data, to set off a chain reaction.
We got a view of that on Wednesday, when the stock of IAC/Interactive Corp., The Daily Beast’s parent company, gyrated wildly in the mid-morning. The culprit was a single piece of information that turned out to be incorrect. The mistake was corrected, but not before several hundred millions dollars of shareholder value had disappeared.
Here’s what happened. On Tuesday, IAC’s stock closed at $52.46. In the morning, IAC released its third-quarter earnings, which were generally better than analysts had expected. In trading before the stock market formally opened, shares rose. At 10:30 a.m., IAC submitted the required filing to the Securities and Exchange Commission. This filing contained additional information about expected 2013 results for specific units, including the “Media” unit and a unit labeled “Other.” The filing included some complicated accounting language but basically said those two units were expected to report a loss for 2013. After opening higher than its Tuesday close, the stock began to drift downward. Again, nothing abnormal.
At 11 a.m. IAC started a conference call during which executives discussed the results with analysts and investors. (You can check out the call here. Then, at 11:28, StreetAccount, a unit of financial-data provider FactSet, incorrectly entered data suggesting that IAC had reported that it expected the whole company would report an operating loss in 2013—not just the “Media” and “Other” units.
Within seconds, as the chart shows, the stock began to plunge. Of course, markets are supposed to process new information that might affect a stock price. And some investors may have dumped the shares based on FactSet’s new piece of information, which turned out to be incorrect. But it’s also highly likely that electronic traders picked up on the action in the stock, thus triggering their own sales—which in turn triggered more trading systems to hit sell. And so a decline quickly became a rout. The stock, which stood at about $50.50 at about 11 a.m., plunged to $45.57 by 11:34—a decline of nearly 10 percent. At 11:34, NASDAQ, the exchange on which IAC is traded, halted trading in IAC’s stock—that’s what it does every time a particular stock falls rapidly in such a short period of time.
Informed of the activity, IAC’s management told investors on the conference call, which was still happening, that incorrect information had been disseminated. Trading resumed at 11:39 a.m., and by noon, the stock had regained much of the ground it gained in its mini-crash. The stock closed the day at about $48. By the middle of the day on Thursday, IAC’s stock had rallied back to almost precisely where it was before the mini-crash.
No harm, right?
In the end, the system worked as it was supposed to. The stock exchange halted trading to prevent things from getting really out of control. The market, being somewhat efficient, ultimately tossed out the incorrect data. IAC’s mini-crash will look like a blip on the long-term charts. On the other hand, episodes like this can be damaging, says Scott Patterson, a Wall Street Journal veteran and author of Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System. Patterson notes that “mini flash crashes seem to be happening on a daily basis.” Last week, when Google’s earnings were released prematurely, the stock fell 10 percent in a matter of minutes.
Individuals will always make mistakes, and the markets will always react to them. The difference now is in the speed, magnitude, and severity of the reaction. “There’s no doubt that the stock market shoots first and asks questions later now,” says Joe Saluzzi, co-head of equity trading, at Themis Trading, and a high-frequency trading critic. “Machine-readable news has accelerated this process even more.” Computers ‘read’ the news flow and react accordingly, often without human intervention. And when many traders—human or machine—react to negative news at the same time, market-makers pull out. “This creates a price vacuum that is further exacerbated by short sellers jumping on the momentum,” says Saluzzi. With his partner, Sal Themis, Saluzzi is co-author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio.
On Wednesday, IAC lost well over $400 million in market value in a matter of minutes. And it’s likely that unsuspecting individual or institutional investors who wanted to buy and sell IAC shares based on a long-term investment thesis found that the system played havoc with their orders. Wading into gyrating markets is like trying to swim laps in a pool that can turn into a boiling, shark-filled, highly powerful whirlpool at any time. After a scary experience, you may decide to stay out of the water. “What happens when issuers feel they can no longer trust that their stocks will be treated fairly by today’s Formula One stock market, and at the same time investors don’t trust their own cash with it?” Patterson wonders. “We won’t have a stock market anymore.”