Tuesday, July 19, 2011

Making markets (appear) safe -- through more vigorous lobbying

It's as predictable as the Sun rising not long after it sets -- financial firms rightly criticized for creating dangerous systemic risks will do what is natural to protect their turf. No, not by looking deeply at their practices and asking if they actually do create greater risk, but by hiring a slew of lobbyists and image consultants to change the debate and stop any potential regulation in its tracks. As this article in the New York Times describes, now it's the turn of the high-frequency traders to follow this time-honored path (thanks to Alex Bentley at the University of Durham, UK for pointing me to this).

I learned last year that writing about finance isn't like writing about science, which I've been doing for 15 years. Scientists get touchy if you criticize their work, but generally respond with reasons and try to convince you you're wrong. Financial firms respond with threats of lawsuits. I found this out last year when I wrote this article for Wired UK on high-frequency trading and its potential systemic perils. I sent an early draft to the then PR person for GETCO, one big HFT firm, asking for her comments and help so I didn't misrepresent anything. I often find that showing interested parties early drafts of articles gets them to voice their criticisms early, so I can take them into account in later drafts. In this case it didn't work, as the PR person didn't respond with any reasoned argument.. Instead, she went quite ballistic. Even though I hadn't criticized GETCO at all in the piece -- I merely mentioned them as HFT traders, and argued that HFT trading in general may present new kinds of systemic risks -- she threatened to get the lawyers involved if I mentioned GETCO in the article at all.

GETCO is one of the firms mentioned in the NYT article as now hiring lots of lobbyists to prevent any new legislation which might hurt their profits, to hell with the stability of markets as a whole.

To be clear, I don't think these people are evil in any sense. They're trading in a legal way, and what they do brings some clear benefits to markets -- it has lowered spreads over the past decade and has indeed made it possible for many smaller traders to compete with the larger banks. But the HFT traders ought to be honest about that fact that no one -- absolutely no one -- currently knows what kinds of new systemic risks enter a market when it becomes dominated by algorithms making thousands of trades a second. This is new territory, and human intuition just isn't up working out what is likely to happen. Paul Wilmott made this point quite eloquently in an NYT OpEd well before the Flash Crash of 6 May, 2010 proved his concerns to be valid.

Since then, as I've mentioned before, we've had lots of smaller flash crashes, and a really devastating one may strike any day and possibly bring deep damage to the larger economy. Personally, it would seem sensible to put in place a speed limit of one trade per second and be done with it. Do we really need to trade faster than that?