I have been reading with great interest Frank Partnoy's new book, Wait: The Art and Science of Delay, which argues that: "Even as technology exerts new pressures to speed up our lives, it turns out that the choices we make––unconsciously and consciously, in time frames varying from milliseconds to years––benefit profoundly from delay. As this winning and provocative book reveals, taking control of time and slowing down our responses yields better results in almost every arena of life … even when time seems to be of the essence."
Frank's book thus immediately sprang to mind when I read an article in today's WSJ about the increasingly probable collapse of stock trader Knight Capital management:
As Knight Capital Group reels from damage inflicted by a computer-trading malfunction, the episode highlights a risk that had previously garnered little attention: Ever-faster stock trading and complicated markets are putting greater strains on the ability of brokerage firms to manage their financial risks.
Many of the fears originate from within the industry. "We have created a situation that is beyond our ability to control," said Thomas Peterffy, founder of Interactive Brokers Group and a pioneer in electronic trading. "These problems will continue if we don't slow things down." ...
"Speed and risk management have an inverse relationship," says Kevin Cronin, director of global stock trading at InvescoLtd., which manages $647 billion. He notes that Knight's computer error only had a fleeting impact on the prices of 150 stocks out of the entire market and still badly hurt a "great participant" in the market. "To me, it highlights…that there is too much focus on speed."
Too much focus on speed. Continuing problems if high frequency trading isn't slowed down. Well, guess what? That's precisely the point Frank makes in Chapter 3 of Wait, in which he takes up "High-Frequency Trading, Fast and Slow."
In it, Frank points out that 70% of US stock transactions now involve high-frequency trading by computer programs rather than people. He tells the story of how trading firm UNX lost money as its trades got faster and then made money once they slowed down the rate at which their computers traded. From it, as well as both rigorous studies and compelling anecdotes, he concluded that computerized trading works best when the computer program is designed "not necessarily to be first, but to be just right." In contrast, when the programs are designed to be first, you can all to easily get a cascading effect as multiple high-frequency trading computers trading across multiple markets begin affecting one another's programmed decision making. The result can be a flash crash, such as the one he describes that took place in 2010 when Waddell & Reed's computerized high-frequency trading in so-called "E-mini" futures contracts briefly tanked the entire stock market.
Partnoy is no radical reformer. He correctly acknowledges that high-frequency trading has positive benefits, improving liquidity and reducing volatility.
Instead, Partnoy wants the system to optimize delay rather than trying to minimize it. To be able to speed up when appropriate, but also to slow down when appropriate. To prove his point, he reviews how successful high-frequency trading firms are training their employees to think strategically, not just quickly.
One wonders how much the folks at Knight Capital would have benefited if they had rad Partnoy's book and implemented his suggestions? I suspect quite a lot.
The Knight Capital mess is already attracting attention from regulators. Presciently, Partnoy has advice for them as well. He proposes that "instead of trying to keep up with the markets, regulators could help them slow down by introducing explicit pauses." In addition to obvious proposals, like the circuit breakers stock markets already use to slow trading when market decline rapidly, Partnoy has a clever out-of-the-box idea: "force [traders] to take a lunch break."
Partnoy's unique status as a legal scholar derives in large part from the fact that he has life experience few other law professor can match. For example, he worked as a trader in Morgan Stanley's Tokyo office in the 1990s. In Wait, he reminisces about "the positive impact of the required ninety-minute lunch break." He relates that "the pause in trading led to more rational thinking about the trading day."
The thought of the SEC trying to design a mandatory lunch break rule amuses. And Partnoy explicitly acknowledges the enormous political opposition such a proposal would face. Yet, it is precisely this sort of out-of-the-box thinking that lends Wait so much value.
If we can get really smart traders and regulators thinking outside the box about how to optimize delay--rather than minimizing it--we might have fewer Knight Capital cases. And we might delay the day that a Knight Capital-like case cascades into a disaster that manages to take down the entire market.
Getting more of the right people reading Wait would be a good place to start.