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Is Trading Software The Black Swan?

When people think of investment risk, they normally think about slow GDP growth, poor earnings, high inflation or interest rates. There is the occasional black swan that may come around like a war, or a drought or some disaster. What about software glitches? Software has always been prone to mistakes, but have the stakes grown so high now that software is a risk onto itself?

Back in 1987, one reason for the stock market crash was the trading of derivatives. The reason why this was a risk was because of their size and speed in trading. A related cause was program trading, which is when trading is automated according to some rules or algorithms that trade indiscriminately once a signal or an indicator is hit. Once the stock market crashed, regulations were brought in that included circuit breakers based on rapid price change. (8)(9)(10)

We then had the Quantitative Manager meltdown in 2006 where similar models were used by the same firms, exasperating the market movements and causing some money managers to lose money very quickly. The software they were using was not faulty, but the speed at which the software did its trading and lack of human judgement exaggerated the losses that occurred. (13)(14)

We experienced the Flash Crash in May of 2010. This was investigated and the answer given as to why it happened was software related. Given the speed of the drop and the volume of shares trading, software was definitely involved as manual trading cannot be executed this quickly. Since then we have seen a proliferation of high frequency trading in many traded markets. (6)(7)(11)(12)

The latest issue regarding software was Knight Capital who lost over $400 million within an hour of trading. The was due to a software glitch where some parts of the trading software were not updated. (1)(2)(3)(4)(5) Doesn't this happen all the time in the world of software? If such an extreme event can happen by something as routine as a software update, what does this say about trading going forward? Automation and trading on networks is already the standard, and it will likely get faster. If a software glitch hit a large bank or the Federal Reserve and trillions of dollars were dumped on the market, wouldn't the systemic effects be huge? Can this be rectified the day after the event if all of the valuation of the securities has disappeared?

Aside from the usual risks of investing, the trading platform may be scrutinized as the fastest growing risk of the future, and due to the split second amounts of time to recognize and to fix glitches.

Sources:

1) http://www.businessweek.com/news/2012-08-14/knight-software

2) http://www.guardian.co.uk/business/nils-pratley-on-finance/2012/aug/06/knight-capital-computer-glitch-trading

3) http://www.businessinsider.com/knight-capital-trading-glitch-prompts-new-sec-regulation-on-high-frequency-computer-trading-2012-8

4) http://www.theglobeandmail.com/report-on-business/international-business/us-business/knight-capital-teeters-after-440-million-trading-glitch/article4458628/

5) http://dealbook.nytimes.com/2012/08/02/knight-capital-says-trading-mishap-cost-it-440-million/

6) http://www.economist.com/blogs/newsbook/2010/10/what_caused_flash_crash

7) http://www.sec.gov/news/studies/2010/marketevents-report.pdf

8) http://www.stockpickssystem.com/1987-stock-market-crash/

9) http://www.investopedia.com/features/crashes/crashes6.asp#axzz23llP28tz

10) http://hnn.us/articles/895.html

11) http://topics.nytimes.com/topics/reference/timestopics/subjects/h/high_frequency_algorithmic_trading/index.html

12) http://www.johnlothiannewsletter.com/2012/08/august-7-2012-china-moves-to-algorithmic-trading-tech-caused-trading-halts-on-tokyo-and-spanish-exchanges-warsaw-exchange-targets-derivatives-growth/

13) http://www.next-finance.net/Quant-funds-in-turmoil

14) http://mitsloan.mit.edu/finance/pdf/Lo_Quants.pdf

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.