It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week. — John Maynard Keynes, 1936
On a few days recently, some Keynesian farmers who work for major Wall Street and LaSalle Street firms tapped their computers, saw an overheated market and decided not to bid for stocks. They sat on their hands while billions of the world`s invested capital was sold, plunging popular stock indices down at alarming rates.
Despite today`s bull market euphoria, concern exists about whether the increasing speed, scope and cheapness of financial trading might make the next bear market even more raging than this bull market has been so far.
”We have to preserve the high level of investor confidence,” said Richard Grasso, executive vice president for capital markets at the New York Stock Exchange. Many small investors believe robots have taken over the trading on most exchanges. Many megabuck traders are worried as well for other reasons.
Nearly a year ago, Byron R. Wien, managing director and head of U.S. investment strategy for Morgan Stanley & Co., wrote: ”I worry that if we ever have another bear market, the unwinding of futures programs will accentuate a market decline as the underlying . . . stocks are sold.”
Other Wall Street experts share Wien`s concern. In a typical program trading strategy, an institutional investor takes a major position in a basket of stocks representative of the stock market itself and in a corresponding contract for future delivery of that basket. He takes these positions to gain either a quick profit or a hedging opportunity.
A money manager hedging the investment in his basket, a technique known as portfolio insurance, may try to sell the entire basket suddenly–like Keynes` farmer–when stock prices are dropping. His decision, designed to protect his investment, often worsens the market decline for others. The decline can be accentuated further if the market at that moment is in a confused state and enough institutional buyers aren`t bidding to buy stocks.
These are the kind of trading events that contribute to wild days on the exchanges. Contrary to some suspicion, computers don`t dictate trading strategies, but they do speed the development and execution of those strategies and can exaggerate sharp rises and falls.
”You can`t have everyone trying to use portfolio insurance,” said Kenneth R. French, an associate professor at the University of Chicago Graduate School of Business. ”It would require everybody to sell the market at the same time.”
Several studies have shown convincingly that the stock market these days is less volatile, in terms of erratic price movements, than in the past, both in interday and intraday trading. Moreover, on a percentage basis, many of the recent daily moves in the Dow Jones industrial average and other popular indices were not particularly dramatic.
Yet Keynes` allegory about the risk of market liquidity raises troubling questions as capital and money markets become a single, fully integrated phenomenon, trading stocks, bonds, currencies and commodities 24 hours a day around the world.
Historically, major financial market disruptions resulted from major news events, such as former President Eisenhower`s heart attack in 1955 and the assassination of President Kennedy in 1963, when the New York Stock Exchange closed.
But no such news had occurred last Jan. 23, when the closely watched Dow industrial average in just over an hour swung from up 64 points to down 51 points. That`s a fall of 115 points, more than 5 percent. And no big news last Sept. 11 precipitated the drop of 86 points, a 4.6 percent decline, in the average that day.
By anyone`s measure, those days, which both set record Big Board share trading volumes, were wild days on Wall Street and LaSalle Street. Amazingly, no one fully understands what happened on days like that, and no one can say they won`t happen again.
In the process, many individual investors are being scared out of the market, taking with them their collective insights and common sense that enable financial markets to reflect long-term economic reality. Global banks and investment houses that can afford the talent and technology needed to keep up have become the proxies for individual investors through such mechanisms as mutual funds, pension funds and insurance.
Paul Rachal, president of Chicago-based Internet Corp., a developer of computer software for global trading operations, says the domination of these institutional investors, with their massive capital resources and inventories of financial instruments, stabilizes markets.
”With institutions that are purely oriented toward making a profit and controlling risk, you`re much less likely to have emotionally based selling and short selling,” he said. ”An institution is very cold and calculating about such things. They look at fundamentals and opportunities.”
The risks in emerging trading technology that Rachal and others see are more subtle, and their solution may be more technology, not less.
In the name of immediacy and efficiency, technology has come in a big way to financial markets around the world.
In the first place, today`s buying and selling are propelled by opportunities to enhance investment returns through quickly acting on fresh bits of information, however fleeting, about the world and the markets themselves. The information genie, a child of technology, cannot be put back in the bottle.
Moreover, computers now enable institutional investors swiftly and cheaply to trade baskets of securities virtually in a single stroke. In turn, they can profit from tiny relative price movements among currencies, securities and commodities and their derivatives in the futures and options markets. The concept of a ”global book” reflecting all money and capital markets is reality now.
”Technology was viewed as a threat,” said the NYSE`s Grasso. ”It is now viewed as a competitive tool. Machines don`t get tired; people do.”
However, the inevitable urge to innovate with even more elegant communications and computing systems, not to mention more elaborate trading strategies, has left many financial professionals behind the times. Many laymen, understandably, are bemused, skeptical and even fearful.
”There were very few automobile accidents in 1869,” quips Merton H. Miller, professor of finance at the University of Chicago Graduate School of Business. ”Anytime you make it easier and cheaper to trade, there`s going to be more trading. And since some trading is foolish trading, there`s going to be more foolish trading.”
In addition, the speed and efficiency with which information can be learned and trading strategies can be concocted don`t yet match the speed and efficiency with which trades can be executed and verified. The fear, therefore, is not that transaction volume will accelerate but that trading will be hamstrung as traders wait to figure out what`s going on in fast markets.
Sophisticated traders on the sidelines can be more disruptive to money and capital markets than traders in the markets. That`s one explanation of what happened Jan. 23.
”When we don`t know where the markets are trading, we`re not going to trade,” said a program trader for a major Wall Street firm. ”We`re more active on stable days.”
In a broader sense, ”Institutions are trading instruments that change their risk exposure very rapidly across many time zones,” Internet`s Rachal said. ”It greatly complicates the problem of knowing what an institution`s risk exposure is. If you don`t know what your risk exposure is, you can`t manage it.”
John S. Lee, a broker with Oberweis Securities in Waukegan, said that getting trades confirmed has been a major headache on high-volume trading days. Like many brokers, Lee tries to use the options markets to hedge investment exposures and enhance the return on his underlying stock strategies.
Recalling the wild Jan. 23, he said, ”We were going by guessing, because we weren`t getting reports back.” Like many of his peers, Lee often suspects trading floor mischief when he doesn`t know quickly what`s going on. Of course, information gaps are the penalty retail brokers and investors pay for not owning their own seats on an exchange.
But Lee believes the solution is more automated trading. He fears that traders may play favorites in timing their trades for small investors and big customers.
”I know a lot of people are scared of computers, but the computer doesn`t know you`re a big guy or a little guy. When the human element is out of there, the general public will say, `I stand a chance.` ”
For that reason, Lee likes electronic systems such as the Retail Automatic Execution System (RAES) on the Chicago Board Options Exchange, which automatically executes public customer market orders for 10 options contracts or less. Market makers, who use their capital to assure active markets on the buy and sell side, voluntarily agree to take the other side of the trades.
Ironically, communication lags can benefit the little guy at the expense of the professional. On Jan. 23, for example, many CBOE market makers participating in the RAES system got stung by having to automatically accept public orders when market prices were moving ahead of the prices being quoted on RAES. Some estimates put their losses at $3 million to $5 million that day. With RAES, ”You can`t step out of the pit,” said Alex Jacobson, senior staff instructor at the CBOE`s Options Institute. ”On that Friday, no matter what a market maker did, it was wrong. There were too many people anxious to sign up for RAES on Monday.”
Chicago Mercantile Exchange employees worked the following Saturday to clear the heavy load of so-called out-trades, trades that weren`t properly matched during the trading period.
These back-office problems, which the exchanges claim they are solving through additional investment in technology, reflect a hot debate about the efficacy of trading rules and traditions among the various exchanges in New York, Chicago and elsewhere.
Specialists on the NYSE note proudly that their job assures that trades, big and small, are matched and reported quickly and accurately. (Specialists try to assure an orderly market in particular stocks by buying or selling to meet market demand.)
Advocates of the so-called open-outcry pit trading employed on such exchanges as the Chicago Mercantile Exchange respond that their system assures greater market liquidity and more competitive pricing.
In addition to these disputes, electronic trading innovations in London and elsewhere suggest there may be no need for trading floors. In these systems, market makers place bids and offers from their separate offices through computer networks.
”Each market seems to have a sphere of its own, and they don`t mesh well,” said Miller of the University of Chicago.
The lack of market synchronization, which is a product of exchange culture and politics as well as technology, compounds the uncertainty caused when technology at one end of a trade is better than at the other end.
