Robo Trades Distort Markets: Impact on Investor Confidence

Yesterday, US stocks experienced a brief plunge in price due to a bogus tweet on the Associated Press' Twitter page regarding explosions taking place at the White House. While the market impact was literally momentary, the larger issue of investor confidence plays to the narrative that the financial markets are truly not the domain of the average investor. Yet another example that it’s not your grandfather’s stock market any longer. And such thinking impacts the average investor’s confidence in the system that financial innovation has wrought.

Here’s an excerpt from CNBC regarding the incident:

"When the market  briefly skidded after a hacked AP Twitter account reported explosions at the White House, we saw the first real-time demonstration of robo-trading riding on the back of social media.

The plunge in the market was so quick that it obviously was not the result of individuals reading the phony news and deciding what action to take. Computers were making the trades-or, more precisely, ending the trades.

"It’s not so much that the computers initiated trades. What happened is that they canceled the orders, so the bids come out of the market. That causes a crash," a person at an algorithmic trading firm explained.

The Twitter data stream has been available to high frequency traders since at least 2009. That’s when a company called StreamBase began to incorporate Twitter in the firm’s “complex event processing” service, which is basically a platform that aggregates data from a vast array of sources for hedge funds and investment banks."

and this further in the commentary

"None of the big algorithmic traders I called would explain how they use Twitter, which is not exactly surprising. The algorithmic guys never want to explain anything to anyone.

But one person inside an algorithmic trading operation at a major U.S. bank said that his unit’s software is programmed to detect major events occurring on Twitter.

In some ways, this is a very old story. Traders have been scraping data from every imaginable source for as long as we've had trading. And tech-savvy traders have been scraping the internet for a long time.

What makes this new is that the world’s fastest news delivery device-Twitter-is now mixing with ultra-fast trading, often without any human intermediary. But in order for this to work well, safeguards have to be put in place to guard against errant news on Twitter triggering trades.

"You have to be careful with Twitter because there is so much noise. So you build a system of weighting into the algorithms, giving more weight to more credible sources," the trader at the U.S. bank said.

The possibility of the account of a reliable news source being hacked can break theses checks, however.

"There’s going to be a lot of rethinking in light of today," the trader said."

Public Policy Implications

Financial innovation, like any tool, can be used for good or ill. It is when the new players, new products, and new processes impact the more meaningful domain of investor confidence and, thereby, impact the capital raising function of the capital markets, which can then impact the very significant domain of consumer psychology, then the negative effects may not be obvious but common sense tells us they are there.