From The Conversation
Ask people on the street what mental image they associate with the words “stock exchange,” and you’ll likely hear about a large imposing building in the middle of New York or Chicago. Inside the building there is a huge space crowded with traders in multicolored jackets screaming and gesticulating to each other.
Until ten years ago, that would have been a pretty accurate description of a stock exchange. Today, however, almost all trading is done by algorithms firing digital commands traveling near the speed of light to rows upon rows of computer servers sitting in nondescript suburban warehouses.
The transition from human to electronic trading came with the promise of using faster and cheaper technology to drastically lower the costs of trading shares and to make it much easier to determine the most up-to-date prices for all market participants (commonly known as price discovery).
Certainly, for investors who want to buy or sell one hundred shares or a couple of futures contracts, the promise of automation seems to have been realized. They can now trade at lower transaction costs, connect to more buyers or sellers and take advantage of prices that can be discovered around the clock.
But with all that speed, automation and complexity comes the risk that a string of problematic ones and zeros could cause a market meltdown, even if only a temporary one. As both computing power and communication speed continue to grow, the intensity of these disruptive events will only increase as well, making it essential to diagnose the root causes and craft safeguards that prevent or mitigate them.
Read the full post at The Conversation.
Andrei Kirilenko is the Professor of the Practice of Finance at the MIT Sloan School of Management.