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A Wall Street Fit for C-3PO and R2-D2
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A Wall Street Fit for C-3PO and R2-D2

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Aurora, Il USA
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A Wall Street Fit for C-3PO and R2-D2

Boy, did George Lucas get it wrong! Based on what we all learned back on May 6, 2010, the Star Wars director should have had mechanical servants C-3PO and R2-D2 trading Luke Skywalker's portfolio several thousand times a minute. That would have been a lot more profitable than helping the young Jedi outwit the evil that Darth Vader turned out to be.

That date in May brought the infamous Flash Crash, when the world was shocked into the realization that Wall Street is now dominated by artificial intelligence. We are fast approaching the crash's second anniversary, with regulators not yet fully understanding exactly what caused it.

But this won't stop them from eventually offering a cornucopia of prescriptions to make it look as if they are doing something. This May, both the Securities and Exchange Commission and the Commodities Futures Exchange Commission are expected to announce rule-making processes for regulating high-speed robotic trading.

And don't be surprised if the process takes years. Machines whirl, but regulators plod.

WALL STREET'S ROBOTIC REVOLUTION has been stunning -- faster and more sweeping than the automation of any other industry. Between 60% and 70% of all trades are made by decision-making machines, compared with 20% in 2006, the year before the SEC made equity markets more machine-friendly.

The smart robots simultaneously buy and sell stocks, commodities and futures on multiple exchanges at the speed of light and generally take small profits in seven seconds or less. With 23,400 seconds in a trading day, those incremental gains mount. A high-frequency trader once boasted to me that his machines made him a 300% profit every year.

The souped-up, nitrogen-cooled trading machines are programmed by physicists and mathematicians who have abandoned university labs to join the biggest get-rich-quick scheme since condo-flipping. They view the rest of us as members of the Flat Earth Society.

An individual investor might consider himself a genius if he sells 100 shares of Apple Computer on which he has doubled or tripled his money. But the high-frequency crowd might regard this investor as an idiot because, by doing only a simple trade, he's left money on the table.

The high-frequency trading machine, which can analyze 20 years of market data in the blink of an eye, will sell Apple and simultaneously short related stocks that generally go down when Apple is sold. And the machine will buy related stocks that generally rise when Apple is sold.

Similarly, if a particular commodity always rises when Apple is sold and another always falls, the machine will send the appropriate buy and short orders instantaneously -- even if the reasons for the commodities' moves never become clear.

In the Flash Crash, a tsunami of selling by "smart" machines overwhelmed U.S. stock exchanges, pushing down investors' equity by $1 trillion in just 10 minutes. Even though the markets quickly recovered, the dramatic event so spooked individuals that many have stayed on the sidelines to this day, missing the recent bull market.

Wall Street's regulators instigated the market's transition from man to machine without anticipating all the ramifications. The machines were supposed to replace inefficient middlemen, not long-term investors. This high-speed trading, according to critics, is a big reason that market volatility has been so pronounced in recent years.

LAST JULY, THE FBI AND SEC both started digging into robotic trading in the equities and commodities markets. Critics of the robotic traders say that some of the machines may be manipulating the market. As part of the probe, the SEC issued subpoenas to high-frequency trading firms that traded heavily during the Flash Crash.

This suggests that the agency is having second thoughts about the Flash Crash report it released in September 2010, with the staff of the Commodities Futures Trading Commission.

That report asserted that an unusually large sell order by mutual-fund purveyor Waddell & Reed in the CME Group's S&P 500 E-mini futures market was the snowball that started the avalanche. The Chicago-based CME, the world's largest commodities and futures exchange, is regulated by the CFTC.

We were among the first critics to accuse the regulators of being overly eager to find a scapegoat. Subsequent internal CME Group studies challenged the SEC's finding. In fact, the CME contends that the Flash Crash was limited to the stock exchanges regulated by the SEC. Because these markets are so fragmented and inefficient, the CME asserts, they simply couldn't handle an exceptionally high number of sell orders.

The CFTC has been re-examining high-frequency trading. Its chairman, Gary Gensler, has been telegraphing his intention to announce a formal rule-making process aimed at regulating high-frequency trading. The industry expects him to make an announcement around the anniversary of the Flash Crash.

Whatever is announced will generate headlines and controversy, but be meaningless. The real problem is that high-frequency trading robots have bridged the commodities and equities markets. Yet special interests have convinced Congress not to merge the SEC and the CFTC to create a more rational regulatory regime. This is preserving the perfect environment for inefficiency -- and for future flash crashes.

A Wall Street Fit for C-3PO and R2-D2 - Yahoo! Finance

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