The software that recently malfunctioned and disrupted trading of Nasdaq-listed stocks was born from a decades-old government mandate, and market experts say it is time for federal regulators to rethink the technology and address its unintended consequences.
The software will be a central topic when the Securities and Exchange Commission meets with the heads of the nation’s exchanges in Washington on Thursday to discuss how to avoid a repeat of the Nasdaq fiasco that unfolded Aug. 22. The exchange halted trading on all its stocks for more than three hours that day, citing problems with the technology it uses to distribute price quotes for all Nasdaq stocks to the public.
The technology has been a source of controversy since its creation in 1975, and market structure experts say the SEC should seize the moment to scrutinize the role of an antiquated software system in a market now dominated by high-speed traders.
Even when the technology is functioning properly, it is slow by today’s standards and inadvertently creates trading advantages for the market’s most sophisticated players, who can get pricing data milliseconds ahead of other investors, market participants said.
“The right system for 1975 is not necessarily the right system for 2013,” said James Angel, a Georgetown University professor. “There will be a lot of pressure on the SEC to do something.”
The agency declined to comment except to say that Thursday’s closed-door meeting, called by SEC Commissioner Mary Jo White, will focus on “systemic resilience issues.”
The technology at issue came about in response to a trading landscape that was dominated by the New York Stock Exchange, which played fast and loose with its trading data, sometimes withholding price information from smaller competitors, Angel said.
To level the playing field, the 1975 law effectively forced the exchanges to pool their trading data and display the best prices for individual stocks. A company’s stock trades on many exchanges, and the idea was to aggregate all the bids and offers and provide an authoritative best price in one consolidated feed for all investors to see.
The aggregation is done by two securities information processors, or SIPs — one administered by the New York Stock Exchange and the other by Nasdaq. It was the Nasdaq SIP that malfunctioned two weeks ago and prompted the halt in trading.
The ensuing chaos was unnecessary, said Manoj Narang, chief executive of Tradeworx, a high-frequency-trading firm in New Jersey. High-speed trading firms, Wall Street investment banks and other sophisticated traders bypass the SIPs, Narang said. They or their vendors get feeds directly from the individual exchanges and aggregate the data themselves.
If all traders relied on vendors, the market would be better off because it would keep functioning even if one vendor went down, said Narang, whose firm sells aggregated data to clients.
There are also competitive advantages to consider, he said. “Even when the SIPs are working as they should, they’re extremely slow, and that puts all those who use them at a competitive disadvantage,” Narang said. “It basically stinks when it doesn’t work and it stinks when it does work.”
Spokesmen for the New York Stock Exchange and Nasdaq declined to comment on the issue.
It is a matter of physics, said David Lauer, an independent consultant on market architecture. There is no way these processors can keep pace with firms that get raw feeds from the exchanges and avoid the extra steps needed to consolidate the data, he said.
“At their best, the SIPs are often a millisecond or a handful of milliseconds behind,” Lauer said. “That’s an eternity to high-frequency traders. When market activity picks up, the SIPs fall even further behind.”
It’s not as if the SIPs aren’t well funded, market observers said. The industry spends tens of millions of dollars each year to maintain the software, Lauer said. But there is no incentive to improve upon its performance, in part because there is no demand for it from the exchanges’ best customers — the high-speed traders.
“It’s naturally in the exchanges’ interest to invest in the things that their best customers are using and that help make their best customers profitable,” Lauer said. “The SIP is not one of them.”
Larry Harris, a business professor at the University of Southern California, said the incentives in the market are warped.
“Everyone is investing to get information out faster,” he said. “Yet the data the exchanges are selling is not making the markets better. It’s impossible to imagine how the larger economy benefits from having prices delivered a millisecond faster than they otherwise would be.”