We hear all sorts of reasons the little guy won’t buy stocks these days but the below graph, courtesy of a Chicago Fed study, might explain a lot of it.
The above chart shows an astounding percentage of market trades going through no human involved trading systems known as high frequency trading.
The Chicago Federal Reserve paper, How to Keep Markets Safe in the Era of High-Speed Trading, prattled of a laundry list of the most recent high frequency trading debacles including Knight Capital as well as others. Yet in spite of these increasingly frequent stock market disasters, even basic risk controls are not implemented. Why? They claim it would slow down their trading systems.
Industry and regulatory groups have articulated best practices related to risk controls, but many firms fail to implement all the recommendations or rely on other firms in the trade cycle to catch an out-of-control algorithm or erroneous
trade. In part, this is because applying risk controls before the start of a trade can slow down an order, and high-speed trading firms are often under enormous pressure to route their orders to the exchange quickly so as to capture a trade at the desired price.
While the paper focuses on events, contained within is a solid example of really bad software engineering. The Chicago Fed found code wasn’t even tested, literally changes are being made on the fly on live production servers not just putting those trades at risk but the entire system as well.