Market Structure Matters.™

We Risk Everything When We Risk Nothing
Haim Bodek


(originally published in NRC Handelsblad, 8/30/2014 in honor of the Veerstichting Symposium)


Somewhere along the line, Wall Street created a myth, namely that its primary function is to take big risks in a smart way. This is far from the truth. The Wall Street I know is not about taking big risks, but rather limiting them.

Nowhere is the risk-aversion of Wall Street more apparent than in the business of high-frequency trading (HFT), where high-turnover strategies that trade in milliseconds account for an estimated half of U.S. stock trading volume. High frequency trading takes the notion of risk-intolerance to an entirely new level.

High frequency traders are obsessed with eliminating potential losses. To make consistent profits, we seek to find a consistent advantage - an edge - over the market. Then we do everything we can to lock down that edge by eliminating every factor that adversely impacts performance.

High frequency traders want to mitigate, neutralize, offset the unexpected result. We talk about "bleeding" risks into the market, which means hedging our bets or simply "flipping" out of trading positions altogether. Often we hold risks for less than a second. In the high-frequency trading space, risk is the enemy.

It is in the HFT space where I have made my mark, evolving from an executive and practitioner into a critic and whistleblower. Three years ago, I went to regulators with allegations that exchanges accommodated HFTs with features that served to supercharge their profits. More recently, the Wall Street Journal reported that a major exchange is in settlement talks with regulators in connnection with these concerns.

How did the HFT industry get to a point where public, regulatory, and legal action has culminated in what is commonly referred to in the U.S. as a "market structure crisis"? I think the answer is based in the very way the HFT industry thinks about risk.

In an effort to get an edge over the market while minimizing the potential for loss, HFTs took significant regulatory risks in order to reduce more readily-observable trading risks. HFTs increasingly focused on cheats, exploits, and regulatory circumvention in order get an edge over the competition and the public customer.

For-profit exchanges were an essential part of the process, assisting high-frequency traders in circumventing the very regulations that exchanges were mandated to protect. Collectively the array of advantages afforded to HFTs by were referred to by exchange insiders as "guaranteed economics."

As the HFT industry evolved, it became more of a risk not to use the unfair advantages. And now with mounting regulatory and legal actions, it appears the industry will be paying the price for its obsession with generating near-riskless profits through artificial means.

What lessons might be learned from the unnatural and unwarranted growth of the HFT industry? I think the answer also centers around the concept of risk, and specifically in how our collective society responds to the symptoms of systemic risk.

Clearly, with regard to high-frequency trading practices, we were not vigilant. Perhaps it was because we found vigilance to be an inconvenience, especially with regard to the obscure topic of how the plumbing of our markets function.

The complexity of our global interconnected systems can be overwhelming, and most of us often assume the there is some higher authority that is much more qualified to address the problems we see. And then we wait until things worsen.

Most of us assume that we are not qualified enough or not powerful enough to challenge the status quo. We rely on authority to address the systemic flaws in our society. And this is perhaps our greatest mistake.

From internet privacy, to cybercrime, to high frequency trading, we just assume there is someone smarter out there whose job it is to take care of the collective good. However, my personal experience tells me that this it is exactly the sort of myth that got us into this predicament.

As a whistleblower, I have learned that the greatest risk is to our collective prosperity is our unwillingness to take risks to confront the visible failures of the systems we depend on. Most often, it appears that we are all equally fearful that we might change things for the worse in our attempt to change things for the better. And hence we do nothing.

If we indeed want to fulfill our societal ideals, we need to have the risk-tolerance to assert our own collective authority as a democracy over the very systems we rely on, especially when we all clearly have the sense that things have badly veered off course.

If we want to find the right way forward for the collective good, we need to challenge the complex systems upon which we depend through our own vigilance, unafraid of the backlash that comes because we are proven wrong or, even worse, proven right.

In a sense, we must all become whistleblowers, alerting one another to the systemic risks to which our interconnected societies are exposed, whether it is an encroachment on civil rights and privacy, criminal and fraudulent activity, or the greater issues of doctrines of hate and threats to the democratic process.

From the perspective of a whistle-blower that has successfully assisted in addressing systemic flaws in our global marketplace, I can tell you with complete certainty that with regard to the complexity of our global society and its systems of governance and technology there is no absolute authority.

When one realizes that in the absence of absolute authority that it not only a right, but a moral and ethical obligation to work to change the world that is into the world that should be, then one finds oneself at a new starting point of uncertainty, proverbially with one foot dangling over the precipice.

And suppose we do indeed find the courage to take one more step forward based purely on our own conviction that we can make meaningful change; then perhaps it is because we understand that in this complex and uncertain world, our greatest risk is that we each risk nothing.