Will the Internet Destroy the Stock Market? – Harvard Business Review
Last week, the NASDAQ exchange froze for three hours due to a faulty connection. On Monday, Europe’s largest derivatives market shut down for an hour because of a glitch. Last month, 14,000 people in rural Iowa lost internet access after a minor car crash crushed a cable. In 2011, the entire country of Egypt had a total internet blackout after officials ordered the country’s ISPs to flip a few switches; the Syrian government is now doing the same. In late 2006, most of Asia had the same experience after a minor earthquake cut a transatlantic cable.
In our era of smartphones, iPads, and Wi-Fi, it is easy to forget that the internet is bound by physical infrastructure. Massive servers housed in high rise buildings, transoceanic fiber-optic cables, and myriad routers and switches crisscrossing the globe have transformed not just how we communicate, but almost every aspect of modern society. Generally, this is a good thing. But our increasing reliance on the benefits of this vast network means we must also acknowledge the internet’s limits and the potential consequences of exceeding those limits.
All networks grow until reaching a breakpoint, a point at which the carrying capacity of the system is exceeded. The result is a crash. We see this in nature (ant colonies, for example, only grow to a certain point before retreating), in the brain (neurons multiply exponentially in a child’s brain but shrink down to a fraction of their maximum level by adulthood), and in technological networks (remember MySpace?). Now that the world is dependent on the internet, economies and markets are bound by these limits as well. Pushed past the breakpoint, all systems risk collapse.
The stock market in particular is at risk of hitting a major breakpoint. The stock market was intended to be a long-term vehicle for companies to raise money and for investors to reap the rewards after their money was utilized to grow those companies. Investors periodically assessed the health of their portfolios and made decisions to buy or sell certain stocks based on past success and an educated guess of future performance. Over the long term, markets are efficient and generally increase in value. In the short term, however, there are market inefficiencies and fluctuations, which traders speculate on for short term gains and losses.
This type of short-term trading is tantamount to legalized gambling. While it has been around since the beginning of the stock market system, in the 21st century, it has been taken over by internet technologies and accelerated beyond recognition. High frequency traders use complex algorithms to exploit micro differences in trading prices over time — not years, months, or days… but seconds and milliseconds. Admittedly, fund managers cannot even explain the algorithms because the networks learn as they go and change algorithms accordingly. The computers far exceed human ability to compute, calculate, and predict, and they pick up on and exploit tiny factors that no human brain can recognize. I would go as far as saying that there is actually an artificial intelligence at work here, which none of us fully understand.
Increasingly, winners at this new stock market game are determined not just by the fanciest algorithms but also by the speed of the hardware that provides access to the information needed to plug into the algorithms. The process is already fast — news of an event goes from the wire to a trader’s computer network in milliseconds. But the difference between recognizing and reacting to that data nanoseconds faster can mean billions lost or gained. These tiny fractions of a second (much, much faster than a blink of an eye) are so important that some traders have gone to great lengths to improve their speeds. Many have purchased dedicated internet cabling, some have gone so far as to move their computer networks to be in close physical proximity to the data centers of the stock exchange and news outlets, paying hundreds of millions of dollars for direct access.
Untold fortunes have been made as a result. But problems have surfaced. In June, Thomson Reuters came under fire for allowing its elite clients to see consumer confidence data 5 minutes and 2 seconds before the general public gained access. On one day — May 17, 2013 — over $100 million changed hands before the rest of the public even knew an event had occurred. This event didn’t lead to a crash, but it could have. That is what happened a few years prior when high frequency trading contributed to the May 6, 2010 “Flash Crash” in which the Dow dropped 1000 points in minutes, only to recover a few minutes later. Computer networks are working faster and more efficiently than the markets can bear. Is this a foreshadowing of what is to come?
The stock market was meant to work as a long-term system. Applying these short-range game tactics — and make no mistake, anytime you’re trading stocks on a short timescale, you’re playing a game — is risky, especially at the speed at which we’re now moving. A rational solution would be to limit the amount of trades any individual or group could do on a single stock. But there is very little appetite for that. Yet without slowing down the network, we are allowing it to move towards a cataclysmic breakpoint, perhaps leading to an implosion of the whole stock market structure or the global economy itself.
Anytime a network goes through a breakpoint, there are two possible outcomes. More often than not, the network implodes and dies. 90% of all animal species never make it through a breakpoint; the survival rate is even worse for new businesses and technologies. But systems leveraging a network, those relying on existing network infrastructure, usually fare better. The stock market is such a system. So long as we do not allow it to be abused, our markets will grow stronger and become more efficient. To do so, however, we must paradoxically slow down the system to allow for maximum efficiency.
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Will the Internet Destroy the Stock Market? – Harvard Business Review
