On Wednesday, the NYSE almost foundered – a systemic event, in my view. That the most important U.S. stock exchange bumped along the bottom for a while without sinking is nice. That it is still this fragile after so many warnings about over-engineered automated trading is not so. And, that a fundamental risk-management and regulatory failure appears to lie at the heart of this latest near-miss is the most frightening warning yet of how little has changed since the flash crash starkly alerted regulators to risky trading practices. With each trading debacle, investor faith in the U.S. trading bulwark suffers. If suffering turns to fear, a basic premise of U.S. capital markets — we’re different than, say Singapore — is at risk.
It may take time to figure out precisely what went wrong in Knight Capital’s scrambled systems, but one fundamental failing is already evident: the firm rushed a new trading system into the market without adequately testing it in hopes of getting a jump on its competitors. In essence, this is like a drug company taking a promising drug into the market while an early-stage clinical trial is under way so it can get to patients first. It is understandable for the purveyor’s short-term self-interest, but more than a tad risky for the hapless patient. That’s why the FDA doesn’t let drug companies do this.
So, why does the SEC still let trading-system operators go live before their systems can breathe on their own? It’s not that the SEC failed to grasp that this might not always work out so well. Rather, it’s that, after the flash crash, the SEC’s reforms were carefully nuanced so as not to press the industry too hard. When the live-testing concept was broached, some in the industry argued it was too burdensome because they could be trusted not to be rushed. And, so the SEC stepped aside. As we keep learning, self-regulation is a lot more of a prayer than a realistic hope when incentives ride roughshod over internal controls.
Like LIBOR, the Knight case isn’t an isolated boo-boo that can be set aside on grounds that traders will be traders. It too comes after a series of other failures that strike at the heart of market integrity not just because traders can’t be trusted, but also because bosses were distracted and, worse still, regulators were idle or gone. Like bank regulators, the SEC has issued thousands of pages of standards designed to curb malefactors, but these thousands of pages all too often miss basic points. Bank regulators didn’t let ATMs loose until they were sure that cash would come out the slot in the hands of the right customers. The SEC can and should also stipulate that traders don’t take other people’s money until they are absolutely sure that their systems won’t misplace it. How hard is that?