The Risk of a “Splash Crash”

by Kevin D. Freeman on June 2, 2011

One of the serious problems we face is the disconnect between financial market understanding and national security expertise. This has been a major educational challenge over the past few years. We have documented that America’s competitors dont see a gap between the economy and warfare. In fact, they see the two as intricately intertwined.

Not so long ago, America was the leader in Economic Warfare understanding. President Roosevelt promoted economic weaponry as a major effort during World War II. In fact, he actually created a Board of Economic Warfare (Board_of_Economic_Warfare).  President Reagan also used economic tools to combat the Soviet Union (Reagan’s strategy).

Unfortunately, both national security and financial markets have become so sophisticated that their study has evolved into highly specialized efforts. One of the primary roles we have provided is to help policymakers and thought leaders in those specialties to alter their focus and see the bigger picture. One such area to be examined has to do with high-frequency trading based on computer algorithms. We have already shown that these algorithms have been the subject of theft attempts. We have also explained that last year’s “flash crash” was directly related to high-frequency activity. Now, there is a report published in Barrons that helps bridge the gap with clarity. Here are some excerpts:

The possibility of a splash-crash nightmare springs from John Bates, the affable chief technology officer of Progress Software (ticker: PRGS), a $1.89 billion company whose worldwide headquarters is in Bedford, Mass. Bates has an impressive résumé, including a doctorate in computer science from Cambridge University. He’s also a member of a panel of technology experts that advises the Commodities Futures Trading Commission.

“I think there is an extreme risk of seeing this because we’re not serious about putting measures in place to police against it,” says Bates…

HIGH-SPEED COMPUTERS TRADING millions of times a day on multiple exchanges around the globe have in effect linked once-disparate markets into an unstable, volatile whole.

Some of the programs even react to breaking news stories, translated for their consumption into algorithms by companies including Dow Jones, the parent of Barrons, and Reuters. Each second, these talented robots monitor dozens of pricing relationships for multiple securities and commodities on many exchanges and buy or sell whenever an arbitrage opportunity arises. Many of the machines are plugged right into the exchanges’ computers to give them an extra speed advantage. They need it. Some of these opportunities are so fleeting—we’re talking milliseconds—that they are invisible to us mere mortals.

The machines typically hold the stocks from two to seven seconds, realize a portion-of-a-penny profit, and repeat the process, over and over. The pennies accumulate into astronomically large heaps. Estimates of the unregulated, secretive industry’s profits for 2009 ranged from $2 billion to $5.6 billion.

Oversight of robotic trading is so slight that regulators have little idea of its impact. Progress Software’s Bates frets that, absent more oversight, terrorists wielding the smart machines could attack the markets in an attempt to cripple our economy. Regulators counter that it would be much more difficult for hackers to infiltrate a stock exchange than, say, a company like Sony (SNE), the recent victim of a crippling criminal cyber attack. But it isn’t impossible. Imagine an agent working for a foreign government infiltrating a firm that owns robots and infecting one or more of the machines with a malicious virus.

There’s also circumstantial evidence that some of the robots are mechanized Ivan Boeskys, attempting to manipulate prices. “Everybody knows it,” says Bates. “The regulators know it. So do the exchanges. They should begin actively policing trading.”

Bates isn’t a lone voice. Other market experts agree that a bigger flash crash is possible. Joe Saluzzi of Themis Trading in Chatham, N.J., warns that fixes like the circuit breakers are Band-Aids: “Even if regulators had their 10% limit-up/limit-down circuit breakers in place for all stocks, the market could still drop 10% in a matter of seconds or minutes. This will shatter already-fragile investor confidence.”

Over the past decade, the issue of Cyber Warfare has finally emerged at the highest levels in our National Security apparatus. In fact, it was just this week that The Wall Street Journal
published an article stating that the Defense Department could consider a cyber attack could to be an act of war:

“The Pentagon has concluded that computer sabotage coming from another country can constitute an act of war, a finding that for the first time opens the door for the U.S. to respond using traditional military force.”

We are making serious efforts so that the Pentagon also recognizes the very real threats of financial terrorism and economic warfare. Financial market manipulation is every bit as serious as a cyber attack. In fact, the two together make a deadly combination.

All posts Copyright (c) 2011 Kevin Freeman, All Rights Reserved

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