Industry in Denial: Market Structure Is the Root of Recent Problems

The capital markets is the only industry in the world in which the accepted norm is to tolerate major screw ups. You know, because in financial services, compliance is really hard and there's no way everything can be tested and monitored in advance. Yesterday's trading problem at Knight Capital is just the latest example.

For a frame of reference, can you imagine airlines responding after a tragic accident with something along the lines of: "Yes, this incident was horrible, but we have so many planes and inspecting them takes so much time and is so expensive. Accidents like this are bound to happen again. Sorry."

Or General Motors saying: "It's a shame that some engines in our cars explode without warning, but, hey, we make so many cars, and there is no way we can make sure every car works like it should."

Granted, a failure at an airline or an auto company could cost many lives, while a failure in the financial services business just means lost money. But in almost every other industry -- consumer goods, housing, food and beverage -- the response after a product failure is swift and decisive. "We'll fix it immediately and take steps to make sure it doesn't happen again."

[For more on how newer rules can help market participants monitor and possibly prevent trading errors, read: FIX Protocol Risk Checks Take Aim at Fat Finger Trades, Errant Orders.]

In the financial markets, however, every time there is a rogue algo, flash crash, IPO failure or exchange outage, the response is, "Whoops, sorry. We're trying to figure out what went wrong. But it's complicated, and it may take a while. However, next time -- and there will be a next time -- it will be caused by something we didn't think we should test, or didn't test enough. But keep on trading anyway!" Many in the industry say there is no way the electronic markets could ever be truly monitored and already have thrown in the towel.

No wonder trading volumes continue to slide and investors are running for other asset classes. Investors don't trust the markets, and with good reason. If the regulators and market participants can't even figure out what causes these huge trading errors, what are individual investors supposed to do? Blindly put their hard-earned cash into a market that may, or may not, work the way it should? Take part in a system that might, or might not, put the average investor at a disadvantage because it is geared toward high-speed traders and large brokers? Put their money in a fast, fully electronic market that is operating with a set of regulations and oversight that is better suited to slow, manual trading?

It's pretty clear investors have had enough and are going elsewhere. The trading volumes and outflows from investment funds prove it. The numbers don't lie. But the industry remains in denial. "A lack of confidence in the economy," "uncertainty" and "excessive regulations" are the excuses when executives from financial firms try to explain why investors are sitting on the sidelines.

Investors' lack of confidence, however, is not solely based on economics. True, the economy continues to struggle. But the confidence crisis has more to do with the structure of the markets. Investors watch high-speed traders regularly jump in front of their orders and make profits on millions of small transactions. Yet average investors are told that the high-speed trader's profits don't come at the expense of investors and that investors actually benefit from the added liquidity. Yeah, right.

If there is "uncertainty," it is not because investors are concerned just about the direction of the economy. Good investors can make money in good or bad economic cycles. Investors are uncertain if the marketplace is a fair place to trade. Are investors at a disadvantage when they come up against fast electronic markets? Are investors getting front-run by brokers and HFT shops? Do the markets really still serve their original purpose as a place to raise capital?

Finally, investors are not concerned about excessive regulations as much as the talking heads on Wall Street would like everyone to believe. Investors are concerned that the regulations and regulators governing the markets are old, out of date and out of touch. The rash of recent incidents -- from Knight's system problems on Aug. 1 to the much covered Facebook IPO debacle -- suggests that regulators have not been able to keep up with the fully electronic marketplace. This has certainly undermined investor confidence. Investors want to see that regulators are a step ahead of the markets and that the market participants themselves are on top of their own technology. But when it takes days or weeks to figure our what went wrong, investors find good reasons to doubt the marketplace altogether.

Hopefully, Knight's recent trading troubles will serve as a wake-up call to the marketplace. Instead of pointing fingers at regulations, a shaky economy and anything else that serves to deflect the focus from the real problem, capital markets firms need to look inward and fix their own problems. Travelers don't fly on shoddy airlines and consumers won't do business with suspect manufacturers. So why should investors tolerate a suspect financial marketplace that is shaky and unstable?