How to lose money - fast!
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Hello and welcome to More or Less on the BBC World Service.
If there was an Olympics for number crunching, we'd be striving for gold. Let me tell you a story about a strange thing that happened last week. The New York Stock Exchange launched a new electronic trading platform. In preparation for this, a company called Knight Capital had created some software to link up with a new platform in order to trade shares on it. The stock market opened and Knight Capital prepared to launch its new software.
There was some problem with the program. We don't know exactly what.
This is Felix Salmon, finance blogger for Reuters based in New York.
They switched it on and immediately they started losing literally $10 million a minute. It looks like what they were doing was they were buying high and selling low many, many times per second and losing $10 or $15 each time. And this went on for 45 minutes and at the end of it all they wound up having lost $440 million.
Oops. But how could a company lose so much money so quickly? This is the latest chapter in the story of something called high-frequency trading. Investors have always valued being the first with the news. One, two, three, four, five, six. One, two, three, four, five. But high-frequency trading is something different. One, two, three, four, five, six. Automatic trades, conducted by computers, each one racing to be first. Humans still watch the systems, but the computers move far too quickly for us to react to everything they do. And at Knight Capital, the computer glitch meant the company was making trades it didn't intend to make. That's how to lose almost half a billion dollars in less than an hour.
What happened when Knight Capital's trading software malfunctioned and lost $440 million?
To give you a sense of how fast high-frequency trading can be, imagine slowing down time so that 10 seconds lasts 30 minutes. In this parallel universe, Usain Bolt ran the 100 metres in just under 29 minutes. It took him 30 seconds just to react to the starter's pistol, and the pistol bang itself lasted two minutes. Let's play you just the B of the bang, just the beginning of a two-minute gunshot sound. And now let me play you some pulses, one pulse for each trade from a high-frequency trading computer. Now that doesn't work. There are still too many trades. In the 16 hundredths of a second Usain Bolt is understanding that it's time to run, an algorithm written into a high-frequency trading platform could complete about 165,000 separate trades.
That's pretty fast. So let's slow it down even more. The 10 second 100 metre race now lasts two months. The 160 millisecond reaction time lasts just over a day and the bang of the starter's gun lasts four and a half days. On that incredibly slowed down timescale, here's how quickly the high frequency trades are happening. and it's getting faster all the time. Now this isn't quite as insane as it sounds. These computers, all competing with each other, are a lot cheaper and more efficient than human traders trying to match bids to buy and offers to sell. So within reason, automated high-frequency trading is a good thing. But it's possible to have too much of a good thing. On the 6th of May 2010, the UK was preoccupied with a general election, but on the other side of the Atlantic, a very different story was unfolding.
We were all sitting around in the middle of the afternoon on a relatively slow news day. And suddenly the Dow Jones Industrial Average was down 600 points in a matter of five minutes. There was this huge crash in the stock market for no reason. And then 10 minutes after that, it went back up again. And no one knew what had happened.
What may have happened was that somebody rather clumsily tried to make a big trade all of a sudden on an electronic exchange called Globex. As the price dropped sharply in the process of trying to find willing buyers, the algorithms of the high-frequency traders plugged into Globex went into overdrive. And the flash crash wasn't just what happened when the algorithms were in a frenzy. It was also what happened when human beings pulled the plug on all of those individual algorithms.
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