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Investment brands battle “the system”

August 9, 2012

Earlier this month, a rogue trading algorithm, resulted in Knight Capital losing $440 million in just 40 minutes. Basically translated; a piece of computer code ran amok and caused financial chaos.

Knight is an unknown entity to the American public and probably most who trade stocks haven’t heard of them either, but it appears they are, or rather, were a fundamental part of the trading infrastructure.

As Forbes explains.

“Knight is one of the electronic vanguard that has best used automation to become one of the most consequential equity traders in the world.  In fact, many at-home traders might be interested to know that Knight likely makes their trades happen.  The group makes a bunch of its money by taking the constant stream of trades from places such as TD Ameritrade and ETrade and matching them up with orders from other small traders or those from Knight’s own book.  It’s a formula that’s proved lucrative until yesterday, when, in three-quarters of an hour, a set of algorithms may wreck what Knight spent 15 years building.”

The Knight incident isn’t the first of its kind, nor will it be the last, the most significant being the famed “Flash Crash” in 2010, where “sell” algorithms from high frequency traders caused a 1,000 point drop in the market. Most people don’t like to see crashes of this scale, but when you understand that these aren’t caused by human error, but computers, it gets scary, humans are simply far too slow and inefficient for the world of high-frequency trading.

According to Jerry Adler, who just wrote an excellent piece for Wired on high-frequency traders, the impact of the 2010 “Flash Crash” on investor confidence was significant.

“Most of Wall Street looked on the bright side. Because the BATS debacle didn’t precipitate a widespread meltdown across other exchanges, some market observers think that regulations meant to prevent a repetition of the Flash Crash of May 6, 2010—when the Dow Jones Industrial Average fell 600 points in five minutes—did their job. High-frequency traders believe that event has misled the public into blaming them for every financial misadventure since the Great Crash of 1929. “People literally shake when they learn what I do,” says Irene Aldridge, a leading algo trader and a panelist at the Battle of the Quants. In a 100-page report that avoids using the words fault or blame, regulators found that at the onset of the 2010 crash, “HFTs began to quickly buy and then resell contracts to each other—generating a ‘hot potato’ volume effect as the same positions were rapidly passed back and forth.” To someone keeping an eye on their retirement account, that doesn’t sound good; investors have withdrawn more than $300 billion from long-term mutual funds in the two-plus years since then. “When someone can set off a panic with a single bad trade, it creates an environment that’s unfriendly to investors,” Themis Trading’s Arnuk says, “which is why they’ve been fleeing ever since.”

While it’s easier to point fingers at the recession as the key contributor to the lack of investor confidence; the logical argument would be that today people have more critical needs for their money and are uncertain about their future, but it’s clear there’s something significantly “wrong” with the system that’s leading to a massive amount of distrust.

If you are a brand operating in this investment space, the Knight incident was the last thing you needed, two years had gone by since the “Flash Crash”, four years since the 2008 disaster, there’s been talk of “green shoots”, an improving economy and an uptick in consumer confidence which should have formed a foundation to build from.

The world of high-frequency trading is not understood or recognized by your average investor, but the impact of its mistakes have shattered their confidence and there could be more to come.

As Jerry Adler’s piece in Wired explains, high-frequency traders are obsessed with speed because that’s how they make their money. When you are trading such massive volumes you’re are dealing with miniscule price shifts, so you need to act and see fast in order to take advantage.

To get faster, these trading companies are looking at all kinds of potential technological solutions, as Adler found.

“Unlike the New York–Chicago route, the Atlantic Ocean is a highly unsuitable environment for erecting microwave towers. On the other hand, when I raised this point at the Battle of the Quants with Alexander Dziejma, chief architect at a high-frequency trading firm called Dymaxion Capital Management, he scoffed.

“They’re doing amazing things now with drones,” Dziejma said.


Sure, he said. A fleet of unmanned, solar-powered drones carrying microwave relay stations could hover at intervals across the Atlantic. I started to come up with all the reasons that was a crackpot idea, then realized I’d heard 10 crazier things since 9 am that day. “Someone will do this eventually,” he said.”

When you think about investment and brokerage, it’s a business that’s been rocked by the crisis of 2008 and is frantically trying to re-build it’s image. While marketers might talk about the critical importance of brand differentiation, it’s clear that it doesn’t matter who you are, what you do, or what you stand for, it’s the category that’s the problem.

Maybe now is the time for the leading players need to band together and do something to raise the overall profile of their industry, they need to reassure the average investor that despite “the system”, they can be trusted and have adequate safeguards in place to protect their customers.