Nasdaq glitch an automation flashpoint

The second largest stock exchange in the US has had its fair share of headaches thanks to automated trading and the latest IT scare looks set to lead to further regulatory scrutiny. But automation doesn't have to mean more risk.

The US’s second largest stock exchange, NASDAQ, suspended all trading for some three hours last week, August 22, due to technical problems with the dissemination of vital trading information, i.e. its market data distribution. This latest IT glitch for the capital markets is likely to lead to further regulatory scrutiny and more stringent rules.

The latest glitch

As home to the world’s most automated capital markets, the US is also the most susceptible to technical snafus, and we have seen a succession of them in recent years. There was the Flash Crash of May 2010, when during 20 mad minutes entire swathes of blue chip securities were reduced to penny stock status by some bogus sell orders. Then there was Knight Capital, which last year lost $US440 million in 45 minutes when one of its trading algorithms went rogue. Just a day before the NASDAQ shutdown, a system at Goldman Sachs cost the investment bank an estimated $US100 million by confusing expressions of interest with hard orders and spraying them out to three different exchanges.

NASDAQ itself is no stranger to such problems. When its systems snarled up during last year’s Facebook IPO, the market chaos that ensued resulted in a $US10 million fine from the SEC and some $US60 million in reparations to companies that had lost revenue through its technical shortcomings.

Automation doesn’t always mean greater risk

It could be argued that the more you automate a given system, the more you are at risk from system failures, and certainly the evidence from the US would appear to support that view.

But then other still more critical infrastructure, such as missile defence systems and nuclear power stations, are just as automated and we don’t hear of a computer glitch inadvertently blitzing an unsuspecting city or a database failure causing a reactor to go out of control. Even Fukushima was triggered by a natural disaster, and of course before any US missiles start flying there is still human intervention in the form of the famous red button.

That more regulation will be forthcoming seems to be a given in this situation: SEC chairman Mary Jo White said as much on the day of the NASDAQ shutdown when she commented that the incident should “reinforce our collective commitment to addressing technological vulnerabilities of exchanges and other market participants.” So expect more regulation.

Now, while further safeguards are always welcome in areas such as missile systems and nuclear generation, there will be voices of protest raised against more compliance requirements in the capital markets.

They will argue that increased regulation equals reduced agility for market participants, as they face more hoops to jump through and more investment in order to make those jumps.

Still, in the context of the capital markets, the situation is something of a self-fulfilling prophecy

  • the competitive environment forces companies to increase investment in automation.
  • the impact of technical glitches is thus amplified by the degree of automation prevalent in the market.
  • the regulators fret about the systemic vulnerability of automation and so pass more rules to try to safeguard the markets.

Bulletproof safeguards

This whole process can be avoided, at least on the buy side, by opting in favour of a long-only, aka buy-and-hold, investment strategy, and there are definitely arguments for such a move. The sell side has no such options, however: it must live by the sword, and thus potentially die by it.

Similarly, the trading venues have no choice but to invest in faster systems if they are to continue to attract investors.

Clearly, the ideal scenario would be for all those investing in increased automation and higher speeds to also invest heavily in the technological safety nets required to avoid glitches like the one on NASDAQ.

Until those safeguards are completely bulletproof, however, they will have to put up with increasingly stringent regulation and make the investments needed to comply with it.

Rik Turner is a senior analyst on Ovum’s Financial Services Technology team, focusing primarily on the financial markets area and, in particular, on capital markets infrastructure.