At 2:45p.m. on Thursday, May 6, George (Gus) Sauter
received a frantic call from one of his traders to get in front
of a Bloomberg terminal. The Dow Jones industrial average,
already down 3.9 percent that day on fears about Greece, was in
free fall. In just five minutes the index plunged 573 points.
Less than two minutes later, the Dow had rocketed back up 543
points, going on to finish the day down 3.2 percent.
"It was just crazy," Sauter, chief investment officer of
mutual fund giant Vanguard Group, told me a few days later. "I
had to go to our fixed-income building, about a five-minute
walk from my office. By the time I got there, the market had
Crazy, indeed. The aptly named "flash crash"
temporarily wiped out more than a half trillion dollars in
equity value, shaking what little faith nervous investors had
in U.S. markets. Shares of Dow component Procter & Gamble
Co., the ultimate defensive blue-chip stock, dropped more than
one third in a matter of minutes before recovering almost as
quickly, all for no apparent reason. A few other large U.S.
companies, including accounting firm Accenture, saw their
stocks trade as low as a penny a share, only to close not far
from where they had begun the day (nearly $42 a share in the
case of Accenture) — again, on no news. By the time
the dust settled, a whopping 19.3 billion shares had changed
hands, more than twice the average daily U.S. equity market
volume this year and the second-biggest trading day ever.
But for me, the single most amazing fact about the flash crash
was that no one had a clue as to what had triggered it. Not
that I should have been surprised, based on the conversation
I’d had two days earlier with Mary Schapiro,
chairman of the Securities and Exchange Commission. Schapiro,
whose organization is charged with maintaining "fair and
orderly" markets, explained to me how the SEC did a detailed
study after the October 1987 crash to reconstruct what had
happened. "We’ve lost some of the capacity to do
that given the dramatic volumes of trading that exist today,"
Schapiro said. "But we need to be able to do that to understand
where are the vulnerabilities in our marketplace and what are
the practices that have the potential to hurt investors and the
marketplace in the long run."
In 1987 the SEC had a much easier task because the vast
majority of listed U.S. equities were traded in one place
— on the floor of the New York Stock Exchange, where
specialists employed by the Big Board’s member
firms made a market based on an open-outcry auction system.
Today, as a result of a series of regulatory changes designed
to increase competition and make the market fairer for
mom-and-pop investors, only about one quarter of all U.S.
equity trading occurs through the now publicly held NYSE
Euronext. And the majority of that trading is done
electronically, either by the new NYSE floor specialists,
called designated market makers, or on the fully automated NYSE
Arca platform. The rest of the trading in U.S. equities is
spread across a wide range of venues, including the three other
major exchanges (Nasdaq Stock Market, BATS Exchange and Direct
Edge) and dozens of broker-dealer-operated trading systems,
electronic communications networks (ECNs) and dark pools, where
buyers and sellers are matched up anonymously.
The past decade of fragmentation and automation has
given rise to a whole new type of professional trading firm:
one that uses sophisticated computer algorithms, often running
on servers housed right next to exchanges’ own
machines, and high-speed market data feeds to buy and sell
securities in rapid-fire fashion. Some of these high frequency
traders place hundreds of millions, even billions, of buy and
sell orders a day, continually canceling and replacing them,
and are likely to be on the other side of your trade. Not that
you’d know who they are — proprietary
trading firms are not required to disclose their identity
— or recognize their names. The bulge bracket of high
frequency trading includes firms like Allston Trading, DRW
Holdings, Global Electronic Trading Co. (Getco), Hudson River
Trading, Quantlab Financial, RGM Advisors, Sun Trading, Tower
Research Capital and Tradebot Systems.
High frequency trading has become a multibillion-dollar
business, accounting for an estimated 50 to 70 percent of the
total U.S. equity market volume on any given day. Since last
summer it has also been a lightning rod for the populist anger
directed at Wall Street, despite the fact that most of the
largest high frequency firms operate far from the canyons of
lower Manhattan, in places like Chicago, Kansas City and
Austin, Texas. Critics accuse high frequency traders of being
fair-weather market makers who, unlike the former NYSE
specialists they’ve largely replaced,
don’t have a legal obligation to trade during
periods of stress. They also say that the growth in high
frequency trading has created a two-tiered market of technology
haves and have-nots that is unfair to long-term investors and
poses potential systemic risks.
I grew interested in high frequency trading last year when I
was writing a feature on hedge fund firm Citadel Investment
Group (more on that later). As an editor, however, it
wasn’t until January that I was able to dig into
what I soon learned is an incredibly arcane world. My first
stop was a company called Pragma Securities, an agency-only
brokerage firm that aggregates more than 40 different dark
pools, electronic trading venues and open market destinations
into a single liquidity source for clients. Douglas Rivelli and
David Mechner, Pragma’s co-CEOs, spent two hours
at the firm’s spacious New York offices taking me
through that world.
High frequency traders, Rivelli and Mechner explained,
generally fall into one of two camps: proprietary trading shops
that act as electronic market makers, using computers to
generate and adjust buy and sell orders automatically
throughout the day, and hedge funds that specialize in
statistical arbitrage, seeking to exploit pricing
inefficiencies among different securities and asset classes.
The distinctions between the two sometimes blur, however, as
proprietary trading firms often try to capitalize on some of
the same buy and sell signals that statistical arbitrageurs use
and hedge funds trade on ever-shorter time horizons. High
frequency firms are best known for trading equities, but they
also trade futures, options and foreign exchange —
basically, anything that can be traded electronically. High
frequency trading is also an increasingly global phenomenon,
gaining ground in both Europe and Asia.
One thing is clear: Hedge funds don’t
like to be called high frequency traders, as I quickly
discovered after visiting with some of the biggest quantitative
managers, including AQR Capital Management in Greenwich,
Connecticut, and D.E. Shaw & Co. and Renaissance
Technologies Corp. in New York.
In the wake of the flash crash, as people scrambled to
determine what had triggered the market plunge, it
didn’t take much longer than the 400 to 600
microseconds (millionths of a second) that high frequency
traders typically need to identify and place a trade for
fingers to start pointing at them. "The potential for giant
high-speed computers to generate false trades and create market
chaos reared its head again today," Delaware Senator Ted
Kaufman said in a statement released that same afternoon. When
I caught up with the Democratic lawmaker a week later, he was
even more incensed, pointing out that regulators still
didn’t know what had caused the flash crash.
"We have a 300-pound gorilla in the room, and
we’re saying that we’re going to keep
it in a cage somewhere," he told me. "This thing will be 600
"But isn’t part of the problem that there are 300
gorillas?" I asked, referring to the fact that an estimated 200
to 400 firms do high frequency trading.
"Good point," he replied. "We have all these gorillas, and
guess what? We put them in zoos where the people running the
zoos don’t have enough information and authority
to take care of them."
Kaufman’s interest in high frequency trading
predates mine. When he was sworn into office in January 2009 to
fill the Senate seat of his former boss Joe Biden, Kaufman was
hell-bent on making sure that everybody responsible for the
2008 market meltdown paid for their actions. He soon focused on
short-selling, urging the SEC to reinstate the uptick rule
requiring short sales to be filled at a higher price; the rule
had been eliminated in 2007. He told me that when he was in
business school in the 1960s, it was "an article of faith" that
the uptick rule was "one of the two or three things that helped
deal with predatory bear raids." As a result of his interest in
short-selling, Kaufman said, his office started getting calls
from some fairly sophisticated people, including former Wall
Streeters, telling him that if he thought that practice was
bad, he should look at high frequency trading.
Kaufman likes to draw an analogy between high frequency
trading and the swaps market. "With synthetic derivatives, you
had a lot of money at stake, no transparency and then a major
meltdown," he explained to me. "If you look at high frequency
trading, I think the same Kaufman formula works."
A graduate of the Wharton School of the University of
Pennsylvania, the 71-year-old Kaufman is a quick study and
understands markets. If I were a high frequency trader,
I’d take him seriously.