June 04, 2008, 11:54 AM — Novelist Matthew Klein concocted a flamboyant fictional character in his book, Con Ed, who claimed that his dotcom company had the technology to accurately predict the stock market. Wall Street observer Matthewsuch things were already happening in real life; and then dotcom entrepreneur Matthew Klein founded Collective2.com and made it into reality. In a behind-the-scenes look at how today's traders operate, we see that much of the decision-making really is made by computers -- and that Wall Street will never be the same again
We always see images in the movies of frantic traders shouting and waving pieces of paper, is it really still like that?
I don't think there have been pieces of paper or frantic traders since the Reagan administration. The popular image of human beings doing most of the trading and speculating on Wall Street disappeared in reality long ago. Today the biggest volume is traded by computers and software. Almost every investment bank has a proprietary trading arm that uses algorithmic trading methods to make decisions in an automated fashion. And while there are still human beings that make trading decisions -- let's call them "discretionary traders" -- these human beings ultimately rely on computer programs to make their trades happen. They rely on sophisticated computer programs to execute their trades in a very clever way, to send them down to the electronic markets, and to disguise their intentions so that their competitors don't know what they're up to. To summarize, computers do almost everything for traders nowadays.
When did computer automated trading first start to appear?
You began to see computerized trading with the rise of the minicomputers in the early to mid 80s. But computerized trading first burst onto the public consciousness after the market meltdown of 1987. You may recall that was when the stock market plunged almost 30 percent in just a few minutes. Congress held hearings to investigate what happened, because as you know, Congress is always interested in putting blame on someone that's not Congress. And what they concluded was that computerized trading was to blame for the meltdown, because all the computers and the software engaged in the same strategy simultaneously, so that everyone kept selling and selling and selling, which made the market drop precipitously. So that was the first public evidence that computers were trading large amounts of volume. But clearly that had been going on for several years before, in a more discreet fashion.
So was it as Congress said, were computers responsible for that crash?
While that's the popular conception, I don't believe that's what actually happened. There have been academic papers analyzing the crash of 1987 and they come to a similar conclusion. If you look at the actual historical events, markets melted down simultaneously across the world during a 24-hour period. The Asian markets melted down first, hours before the American market, and there was no computerized trading in the Asian market at that time. Computerized trading was an American innovation that hadn't yet been put to use in Asia. So there's a lot of evidence that the crash had much more to do with macroeconomic factors and overpriced stock markets worldwide than computers. But computers are a nice villain because nobody really takes the fall when a computer is responsible.
But regardless of the crash, and Congress placing the blame, for better or worse on computers, is automated trading still prevalent today?
Yes, and what's really interesting about automated trading and where it's gotten to at this point is, like all technologies, it has become more democratized. What used to be something that required a team of PhDs and expensive minicomputers in air conditioned rooms now has filtered down to the masses. And now there are people who trade in their homes using automated trading strategies that are more complex than some of the strategies that the investment banks were using 27 years ago. So it's a case where technology has improved exponentially and has become exponentially less expensive, so that now even traders in their pajamas can take advantage of automated trading techniques and strategies.
