The second session of the Securities and Exchange Commission’s Technology and Trading Roundtable began with an instructive presentation by M. Lynne Markus, a professor of information and process management at Bentley University who studied the role of technology in the mortgage crisis under a grant from the National Science Foundation.
She recounted how the complexity of automated underwriting and its interaction with virtually all of the participants in the industry, as well as consumers, grew from its inception in 1994 as a discreet innovation until it could threaten the entire financial system roughly 10 years later.
Over that period, the lending process was simplified and automated, participants became more confident in the process, technology was extended to virtually every task from appraisals to servicing, tasks were restructured so that no one could see the entire process, fraudsters learned how to exploit the system and the origination-to-securitization chain was sped up to an extent that enabled it to fuel the mortgage and derivatives bubbles.
Just as her audience might have been catching their breath, she hit them with the conclusion: “Trading technology is even more complex and interconnected than mortgage technology and even more vulnerable to errors, disruptions and crises, and the events of the last few months are the ‘new normal.’”
After panelists explained how good their systems and processes are and proclaimed their devotion to supporting the integrity of the securities markets, the discussion turned to the idea of “kill switches.” All of the panelists supported this idea, but they differed as to how it should be implemented.
A large part of the attraction is that, as explained in the morning session, the Knight Capital incident began as a software glitch and then got out of hand because the Knight people were unable to shut it down. If a kill switch could have been thrown in the first few minutes, the market would have been spared, and even the damage to Knight, whose very existence was threatened, could have been reduced.
However, in some scenarios, the kill switch might aggravate whatever irregularity is taking place.
On CNBC Tuesday, billionaire investor Mark Cuban railed against the very idea and demanded instead an end to high-frequency trading on the ground that it serves no actual purpose in providing liquidity to the market.
A common scenario would be that when a trading venue had reached 70 percent of its preset limit, there would be a phone discussion about whether there was a problem, whether perhaps the limit should be raised and there was even a suggestion that the kill switch could be thrown if that would be in the best interest of the market.
One panelist worried that the limits might be set so high that the kill switch wouldn’t work as intended. SEC Chairwoman Mary Schapiro was uneasy over the prospect of phone chatter, warning, “It only takes a couple minutes for enormous damage to be done.” A panelist questioned whether the objective would be to protect the market or to keep a given broker-dealer from losing money.
The movement for a kill switch is definitely gaining momentum, but it could be thwarted by its complexity and by the dysfunctional condition of the SEC, which would have to implement it.
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