The Rise of the Machines

It used to be that we had rogue traders. Now we have rogue programs.

Not so many years ago rogue traders could bring down a bank, or at least a bank’s trading floor. In 1996 Nick Leeson lost about $1.3 billion, forcing Barings Bank into the arms of Dutch giant ING. In 2002 John Rusnak lost about $700 million for Allied Irish Banks trading foreign exchange options. Societe Generale Bank and Union Bank Switzerland both lost billions when two of their traders—Jerome Kerviel and Kweku Adoboli–went rogue.

It’s so easy to do, or at least it used to be. Trading transactions were done over the phone. Interaction among traders was constant. There was a continual buzz around the firm’s trading desk, with cries of “Done!” or “Not done!” flying out. Amidst all the noise and confusion, a few trades could be hidden away. When you deal with hundreds of transactions every day, setting one or two aside is tempting. After all, the thinking went, a losing trade can be reversed; all it takes is one more winner, with just a little higher stake.

But if the losses mount up and the trader’s activity is revealed, the music stops and there’s an investigation. Often these rogue traders are found to have violated securities laws and go to jail for several years.

But with Knight Capital the game has changed.

Over the last several years traders have been increasingly replaced by algorithmic programs. First stocks, then government bonds, and soon foreign exchange and other financial instruments are being exchanged from firm-to-firm on a microsecond basis by competing computers. This increased interaction improves the market’s liquidity, at least in theory. Earlier this month, though, an errant program at a small market-maker transacted billions of shares of stock over two hours rather than two weeks. Knight was forced into the arms of another firm.

As labor is replaced by capital, rogue traders will go the way of the snake oil salesman. But watch out for the algorithms!

Douglas R. Tengdin, CFA
Chief Investment Officer
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