Strap In – It Could Be a Bumpy Ride

With Labor Day fading fast in the rear-view mirror, institutional traders are turning back to their screens for the long haul through Thanksgiving to the winter holiday season. Whether still working from home or having returned cautiously to a socially distanced trading room, many will have an unusual sense of trepidation. Alongside the pandemic’s lingering and unpredictable impact on economic growth and asset prices, politics also has a significant capacity to surprise.

In some respects, traders could not be better prepared for the unexpected. With very few casualties, the institutional buy side took the first quarter’s record-breaking volumes and volatility in its stride. As well as anecdotal evidence, the resilience of market structures and the fitness of the traders’ toolbox for the challenges ahead has been verified by the Securities and Exchange Commission, in its recent ‘Staff Report on Algorithmic Trading in US Capital Markets’. 

US equity indexes might have fallen back from last week’s highs, but with the Federal Reserve committed to doing whatever it takes to support the economic recovery, there are many reasons to expect this bull run to maintain momentum. On the other hand, a political failure agree on a new fiscal stimulus package could test investors’ nerves, especially with the risk of a disputed presidential election looming in the background. The growing influence of retail flow may also add spice. 

But the experience of the pandemic panic gives cause for confidence. Not only are traders newly battle-hardened, the SEC’s report to Congress on the risks and benefits of algorithmic trading observed the US equity markets “functioned without significant technical, or logistical, disruption” in the pit of the crisis. Inevitably, there were costs to the disruption. Normalized spread costs increased by 7.2 times for S&P 500 stocks, and 4.1% for Russell 2000 stocks, according to one study cited in the report, but despite severe stress markets overall proved “resilient, efficient and transparent”. 

That there were no serious failures is perhaps remarkable when one considers the risks arising from today’s complex fragmented and highly automated US equities market landscape, with its 15 national securities exchanges and more than 30 alternative trading systems, plus multiple single-dealer platforms and other forms of order matching. The SEC’s list of operational risks imposed by the interaction of automated and algorithmic trading techniques reads like a charge sheet, covering improper development, testing and implementation of algorithms, inadequate risk management controls at individual firms, failure to impose adequate post-trade surveillance or to maintain proper controls around data integrity. 

But the examples cited in the report are largely from an almost bygone era, taking place almost exclusively prior to 2015. The fact that the Flash Crash of 2010 erupted amid the turbulence of the European sovereign debt crisis shows how market crises can expose systemic weakness in a time of intense innovation. The fact that the pandemic spawned no obvious sequel a decade later can be seen as testament to the effectiveness of the system of circuit-breakers, supervisory procedures, algorithm usage guidance and monitoring capabilities incrementally imposed by regulators in the crash’s aftermath. 

It might also reflect the maturity of the algorithmic trading and its advanced state of concentration.

The SEC report points out that “many of the core types of algorithms are more or less similar across brokers”, noting also the findings of a recent study, which estimated that two-thirds of institutional order flow is executed via the algorithm suites of the three largest brokers. 

Indeed, the abundance of choice and the concentration of business is a common theme in today’s US equity trading landscape, with the leading ATSs and internalizers increasingly dominating their respective sub-sectors in terms of market share. Viewed from some perspectives, the complexity and duplication can seem wasteful and messy. But it is the overall performance of the ecosystem that ultimately counts, rather than individual elements. 

Before reaching its unsurprising but unarguable conclusion (spoiler alert: a continuing increase in algorithmic trading will bring ”benefits and risks to our capital markets, including new and emerging risks”), the SEC notes supervisory measures both current and under consideration. Those looking for more simple and elegant market structures might be disappointed by this section, which lists multiple tweaks, refinements and reforms to the oversight and structure of the US equities market. But complexity acquitted itself fairly well in Q1 2020, and too much simplicity has risks of its own, some of them existential to the trader. 

As the old joke has it, the trading room of the future will require just one computer, one man and his dog. The computer executes the trades, and the man feeds the dog. The dog, of course, is there to stop the man from touching the computer.  

Chris Hall is a Senior Correspondent for Traders Magazine. Chris can be reached at