Darkness in the trading ecosystem

Book review of Darkness By Design: The Hidden Power In Global Capital Markets

What’s the difference between, say, 30.79 milliseconds and 29.29 milliseconds, where one millisecond is one-thousandth of the smallest unit of time on your wristwatch? One-and-a-half milliseconds and a few million dollars or more, made or lost, Walter Mattli would have you know in his book Darkness By Design: The Hidden Power In Global Capital Markets as he takes you on a trip into the sinister world of stock market deals based on algorithmic trading.

Mr Mattli, a professor of international political economy and a fellow of St John’s College, Oxford, paints a gloomy picture of the state of affairs in securities trading and laments the systematic decimation of the traditional floor-based co-operative stock exchange model, and its subsequent replacement with opaque, greed-driven, supercomputer-based split-second buying and selling of instruments. The author also blames unabated market fragmentation, brought on by rapid globalisation and the spate of M&As and corporate restructuring, for handing over the reins of the trading business to a few players. 

This clutch has been using both its financial muscle to frenetically invest millions of dollars in fibre-optic networks to stay ahead of the competition and its political clout to change the core membership structure of the stock exchange. Obsessed with speed, these corporations, to whom membership to a platform like the New York Stock Exchange was off limits by decree at one point, were willing to pay top dollar for speed once they got one foot in after years of lobbying and silently calling the shots on the preambles of the exchanges that once regarded them as persona non grata. In 2010, for instance, traders were paying as much as $14 million for a leased line that gave them a 1.5 millisecond information edge over their immediate rivals who were hooked onto a Chicago-New York network. The arithmetic made sense simply because a one millisecond advantage could translate into a gains of $100 million a year, the author explains.

If that hasn’t left you astounded, Mr Mattli informs you that milliseconds are now passe, and that microchips today capable of doing trades in just about 740 nanoseconds — one nanosecond is a billionth of a second — and efforts are on to achieving speeds in picoseconds, or one-trillionth of a second.

The quantum leap in automation has also rendered political boundaries redundant, allowing for trading across markets the world over, fostering fierce competition in domestic and cross-border arbitrage, and giving rise to a slew of financially engineered products in the trading universe. 

So how has all this changed the trading landscape? Mr Mattli convincingly argues that it has eradicated what he calls the honest broker-partner model and replaced it with a handful of giant corporations that strictly cater to a wealthy clientele while simultaneously cornering the profits in off-market deals using supercomputers in locations miles away from the trading floor. In effect, this lot has virtually killed traditional stock exchange. The author buttresses his argument with statistics and other evidence. Consider this: The New York Stock Exchange, the global leader in securities trading for much of the 20th century, saw its overall share in the domestic market decline from 80 per cent to about 24 per cent in the past decade, even as there was a spike in the number of orders from a few million daily to several billions today.

In all of this, the small investor seems to have lost out, despite the quantum leap in efficiency and rationalisation of brokerage costs. Mr Mattli cites a 2014 US survey in which a staggering 70 per cent of financial industry participants believe that the current capital market ecosystem is unfair to investors, while only 18 per cent believe it is fair.

The author comes down heavily on what he describes are bad market governance, in which “scammers will scam as long as deception, manipulation, or misrepresentation pays”. While he comes down particularly hard on collocation for concentrating power in the hands of a few, Mr Mattli also points out to more disturbing signs of this transition to an entry-barrier-driven business, such as the series of flash crashes in which markets nosedive for no apparent reason, only to recover within minutes. Within this domain, there are large erratic price swings in individual stocks over milliseconds, which he explains are daily occurrences in today’s markets. He adds that one source identified as many as 18,500 such mini flash crashes between 2006 and 2010 in the US stock exchanges alone.

But there is a pinhole in Mr Mattli’s dark world that lets in a little bit of sunlight to dispel the gloom. The author praises recent regulatory initiatives by the US SEC to monitor alternative trading systems, although he does mention that its response to the so-called dark pools has been delayed. But the US isn’t alone in clamping down on opaque trading practices. References have also been made to the initiatives by other regulators, such as the 2012 expansion of market integrity rules by the Australian Securities Investment Commission and the adoption in 2014 by European regulators of the Market in Financial Instruments Directive reforms, which came into effect in 2018.

Mr Mattli’s book is a delightful chronicle of the changes in the way trading-related information has flowed, right from the days of America’s first stock exchange in Philadelphia, when express coaches were used to deliver news, to the advent of wire services, courtesy a certain Mr Paul Reuter, to the present era of nanoseconds. You don’t necessarily have to be an investment buff to want to pick up this one, and even a mild interest in modern American history is sufficient for one to buy it.

Darkness By Design: The Hidden Power In Global
Capital Markets
Walter Mattli
Princeton University Press, 248 pages, $29.95