Review: The Wall Street Code

The Wall Street Code, the latest installment in Dutch media outlet VPRO’s Backlight series was released last week. Following up on past efforts like Quants: The Alchemists of Wall Street and Money and Speed: Inside the Black Box the folks at VPRO take the opaque world of modern day market-making and high frequency trading (HFT) and render it not just accessible, but riveting.

The documentary included a number of impressive interview subjects, including the founder of Interactive Brokers, Thomas Peterffy; CEO of market data provider Nanex, Eric Hunsader; ex-Citadel quant David Lauer; and Trading Machines founder, now self-styled Wall Street pariah, Haim Bodek.

The Wall Street Code portrays the state of our capital markets infrastructure as Rube Goldberg meets the Wild West. While a touch heavy-handed at times, the movie makes a compelling case for closer public scrutiny of the stock exchanges (at the very least).

Bodek’s story provides a convenient journalistic vehicle as a former ‘insider’ of the high frequency trading world, now speaking out against the system he helped to build. His cocktail party anecdote of learning that the exchange he traded on had been systematically disadvantaging his firm’s orders for months, while possibly apocryphal, is illustrative of the inherent conflict of interest between the exchanges and their best customers: the high-volume high-fee HFT shops.

In classic follow-the-money fashion, the filmmakers cut to ex-Citadel quant David Lauer nervously chuckling about being ‘terrified of Citadel’s lawyers.’  Joking aside, Lauer goes on to give a chilling account of standing shoulder to shoulder with a phalanx of PhDs and software whiz kids “staring into [the] oblivion” of an empty order book on May 6, 2010 – now known as the flash crash.  As David realizes that for full minutes on end the US stock market has virtually ceased to exist, his faith in the system begins to be eroded – eventually leading him to leave his career on Wall Street.

Somewhat disappointingly, the documentary forgoes an in-depth post-mortem on the flash crash; the most commonly accepted (but wholly unsatisfying) culprit being a $4.1 billion dollar contract sale on the Chicago Mercantile Exchange (CME) by a single firm, Waddell & Reed. Outlined in a 104 page SEC report issued in September of 2010, the sale is thought to have acted as a trigger for a positive-feedback loop of escalating HFT trading volume (HFT firms traded nearly 27,000 contracts in 14 seconds with only a 200 contract net change), which in turn triggered a virtual shut-down in liquidity in the equity market for minutes on end resulting in a free-fall of asset prices which was eventually halted by an automated Stop-Loss 5-second trading pause in the CME market.

Instead we get an accurate, but not particularly productive portrayal of the market as a ‘complex system’ – a behemoth that’s grown in size, speed and complexity to a level that is simply beyond human control. Sure, in the atmosphere a butterfly may flap its wings in Tokyo and trigger hurricane off the coast of Florida without a prayer of human intervention. But stock exchanges and the regulations that define their function are very much man-made entities. Just as the exchanges fought off technological advancements in automation through the 80s (don’t miss Petterffy’s description of the proto-iPad and anecdotes about hacking computer keyboards on the options floor) to protect their paper-slip-and-yelling-sweaty-trader business model, we can only expect them to fight today to protect their ultra-low latency profit centers. To blame the market’s instability issues on irreducible complexity is no better than blaming your spouse when your BMW’s check-engine light comes on for the 400^th time, yes – the system is over-engineered, but that doesn’t mean we can’t take action to simplify it again.

Put another way, in a world where profit is driven by turnover rather than growth – should we really be surprised when we end up with a system optimized for churn rather than stability?

For more reading on a number of suggestions aimed at simplifying markets and returning control back to investors see the SEC’s report. Or, for the non-governmental perspective, Nanex has conducted their own independent and extremely worthwhile study of the flash crash and make three of their own recommendations. (Nanex’s CEO Hunsader was interviewed for The Wall Street Code, and is a vocal advocate for reviewing market regulation)