“It is the paradox of the close call. Probability wise, near misses are not successes. They are indicators of near failure. And if the flaw is systemic, it requires only a small twist of fate for the next incident to result in disaster. Rather than celebrating then ignoring close calls, we should be learning from them and doing our very best to prevent their recurrence. But we often don’t. People don’t learn from a near miss, they just say, “It worked, so let’s do it again.” Other studies have shown that the more often someone gets away with risky behavior, the more likely they are to repeat it. Modern disaster prevention can and should be about stopping trouble before it strikes, not cleaning up afterward.”

-Ben Paynter, Wired Magazine



The near miss is a misnomer. As George Carlin once said, what we really mean is a “near hit.” Carlin, whose wonderful use of language made his comedy that much sharper, used to say “A collision is a near miss . . . Boom, they nearly missed — but not quite.”

The markets have had a series of “near misses” over the past few months — assorted single stock flash crashes, trading glitches, even the Facebook IPO were all market structure collisions. The snafu with Knight Trading as they were testing new algo trading execution software was reputed to cost them $10 million per minute — about $167,667 per second.

It is becoming readily apparent that The replacement of specialist and market makers with algo bots and HFTs is the underlying cause of this crumbling capital markets infrastructure. Do not think that the equity markets are any better than the US electrical grid or roads and bridges and tunnels — the virtual market is crumbling even faster than our bridges can rust.

The lawyers at the SEC have not quite wrapped their heads around this. They too suffer from a structural defect — they are organized as a law firm. As we have suggested previously, they should be organized more like a large investment bank — with different divisions set up parallel to the divisions and actions of different major Wall Street Actors.

Regardless, it is increasingly clear that we are playing long odds, and assuming that snake eyes will never be rolled. The probability is that will eventually be a losing bet. Anytime we have a nonzero possibility of something occurring, the proper question is not WILL something happen but WHEN.

The sooner the market regulators figure this out, the better off investors will be. Until then, we have a Central Bank driven market (if not quite CB run economy, as Congress has abdicated their role). The hated phrase Risk Off/Risk On actually translates into “What will bankers do next? Here is my guess and here is my bet.”

As noted above, “if the flaw is systemic, it requires only a small twist of fate for the next incident to result in disaster.” That is what we have today. The combination of HFT/Algos and Central Bank intervention has turned the concept of fundamental investing into a quaint anachronism.

“Modern disaster prevention can and should be about stopping trouble before it strikes, not cleaning up afterward.” I suspect that one day, things like macroeconomic trends and earnings will matter much more than they do today. It is likely going to take a significant dislocation to get there. . .



Category: Markets, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “Market Structure & The Near Miss”

  1. jhellman says:

    Unfortunately, it will probably take that significant dislocation for change to come, and even then the cynic in me doubts it will be a change for the better. What troubles me the most is that, despite seemingly endless calls to action by those of us “in the trenches” of the market, it all seems to fall on deaf ears. Why isnt someone like Joe Saluzzi actually in a position of influence ? Or yourself ? That, to me, is the great disconnection. The individuals who actually have the wherewithal to make change happen don’t come from the industry and thus dont REALLY get it. Imagine if one of us portfolio managers/analysts/traders was tasked with running an agency that oversaw the legal industry.

  2. [...] Trading’s problems just bring that time bomb a little closer to the surface. Some will say that Knight was careless and should have tested their [...]

  3. Orange14 says:

    My very first trade in the market came way back in 1965 when I sold some Pacific Telephone and Telegraph stock that I received as a present, marking the beginning of my investing career (which has largely been positive). Of course this was back in the days before discount brokers, the Internet, wide-spread introduction of mutual funds, day traders, etc. Trades were not filled instantaneously and problems in executing them were rarely (don’t know whether ‘never’ is the correct term here) seen. With the advent of high speed computers we now see a fair number of near misses/hits and I wonder whether we really need to have trades filled in a millisecond. Perhaps the one simple solution (I’m always in favor of simple solutions) is to build in an appropriate time delay (and I will leave it to the experts such as BR to define this) that would slow things down so possible corrective action can be taken before things get out of hand. Maybe this works maybe this doesn’t but the current system is just too problematic.

  4. streeteye says:

    Same applies to ‘the men who saved the world’


    should have been asking why it kept needing saving from Mexican crisis, LTCM, Russian crisis etc.

  5. 873450 says:

    ” … the more often someone gets away with risky behavior, the more likely they are to repeat it.”

    John Meriwether

  6. b_thunder says:

    “The combination of HFT/Algos and Central Bank intervention has turned the concept of fundamental investing into a quaint anachronism. ” – a very strong statement, especially coming from The Big Picture, not ZeroHedge.

  7. PeterR says:

    Genius video, thanks!

    HAL refrains from further comment . . . .

    for now . . .

  8. dss says:

    The markets have already had a crash of epic proportions in the Flash Crash, what are they waiting for?

    What finally get’s their attention? A total international meltdown that can’t be undone in one day?

    No one has faith in the integrity of our banks, our exchanges or our regulators. Yet the market is still open for business. How many stealth programs instituted by the smartest players are just sitting there waiting for the next crash which is inevitable?

  9. kek says:

    What is the evidence that the US has a crumbling electrical grid? A 100 year old oak taking down a neighborhood doesn’t count.

  10. denim says:

    Economics is a system and stock market trading is a system. Many things can be modeled as a system. Designing and running HFT algorithms is a job for a systems engineering team… just ask Knight. Step one of the systems engineering teams job:
    “State the problem”
    “The problem statement starts with a description of the top-level function that the system must perform or the deficiency that must be ameliorated. It includes system requirements stated in terms of what must be done, not how to do it. It might be composed in words or as a model. Inputs come from end users, operators, bill payers, owners, regulatory agencies, victims, sponsors, Marketing, Manufacturing, etc. These are called stakeholders. Identifying the stakeholders is an important initial task. In a modern business environment, the problem statement starts with a reason for change followed by vision and mission statements for the company. The problem statement is one of Systems Engineering’s most important products. An elegant solution to the wrong problem is less than worthless.”

    I repeat, “less than worthless.”

    System engineering sprang forth from the military and was broadened in scope by the NASA space agency as well as the global automotive industry. A winning defense, a successful moon round trip, and dream cars are all proof of the value of having top notch system engineering teams work for the country.

    If an economically savvy economist is also as disciplined as a system engineer, you will have a real winner. Even maybe Nobel.

  11. willid3 says:

    not sure that economics is a system (its not a science either. maybe its more of a theory of how things are suppose to work. but don’t?).
    while trading is system based, with probably lots of parts (like any of them of any size has). and you describe the standard methodology of designing a system (or even changing one).
    what probably tripped up Knight is a few problems I have noted in my years in IT. one we know where we ant to go (sort of. seems always subject to change. usually at the last minute. and that usually always ends up creating or help create a disaster). but we dont know how we want to get from current state to new state. and testing of the changes seems to always be at best half baked at best. usually an after though (maybe we should test it?). possible reason for their failure? not having senior staff deeply involved? taking to long to implement? not knowing how to implement without causing a problem? lackadaisical testing at best?

  12. RW says:

    Private enterprise has a wide solution set but there are some tasks very near or outside the boundary of that set. Government has another solution set some of which overlaps private enterprise some of which does not. Sometimes they augment each other, sometimes they impede.

    An inability to tell the difference and/or excessive devotion to one or the other set leads to erroneous problem definition and inappropriate solution selection.

    That kind of bias can also lead to bad history as I was reminded recently when L. Gordon Crovitz made the ludicrous claim that government invention of the internet was an urban legend. David Warsh sets the record straight (funny how often that needs to be done these days) and the internet is seen as a case in point for cooperative effort: Government takes the initial risks while providing a non-proprietary framework out of which an acorn is born and planted in the fertile soil of a public commons, a wide open and level playing field; the energy of enterprise could took it from there and did.

    But speaking of acorns and mighty oaks the following took 30 seconds on google:

    Report Card for America’s Infrastructure: Energy publication of the ASCE

    Abstract: The U.S. power transmission system is in urgent need of modernization. Growth in electricity demand and investment in new power plants has not been matched by investment in new transmission facilities. Maintenance expenditures have decreased 1% per year since 1992. Existing transmission facilities were not designed for the current level of demand, resulting in an increased number of “bottlenecks,” which increase costs to consumers and elevate the risk of blackouts.

  13. farfetched says:

    Denim nails it. When a risk taker can externalize risk, you can count on a disaster.

    Seriously, are we to believe Knight couldn’t test this system offline? Anyone that stupid should immediately be subject to Darwinian extinction.

    From druggies to bankers, externalizing risk leads to more and more risky behavior.

    Look around at this risk model. Nuclear energy, banks, Wall Street black boxes, air traffic control, drunk and drugged drivers, cruise ships, oil tankers….the list of current examples is endless.

    Apparently we humans have a gigantic death wish as we are fricking lousy at assessing and minimizing risk.

  14. Laocoon says:

    BR, that’s a great point about the SEC being organized like a law firm. To follow on, it’s not just the organization but the training/mindset of lawyers that structurally risks missing the ‘big picture.’

    Lawyers can derive great answers and amazing strategies but can miss the context. By their training to narrow down, they can miss the real-world workings. Just because it’s legal [or because one can argue effectively that it's legal] doesn’t mean it’s ethical, nor is it necessarily good business. It’s definitely time for the SEC to include some inductive reasoning as well as deductive reasoning. It’s not just where the loopholes are, but the question of where are the systemic risks even if everything seems to be functioning well.

  15. WallaWalla says:

    kek says, “What is the evidence that the US has a crumbling electrical grid? A 100 year old oak taking down a neighborhood doesn’t count.”

    The Minneapolis I-35W collapse is a good example. The immediate closure of the Crown Point Bridge between Vermont and New York is another. It’s a fact that there is a huge backlog of structurally deficient bridges, decreasing funding for refurbishment, and increasing state reliance upon federal funds.. See this report on the state of the nation’s bridges:
    The Fix We’re In For: The State of Our Nation’s Bridges

    Broadband capacity in the country isn’t doing much better:
    Hey America! We’re Ranked #16 in Broadband!

    National electrical systems show high vulnerability to cascading events such as the 2003 Northeast blackout.

    Check out http://www.infrastructurereportcard.org/report-cards for even more information on potential shortcomings of infrastructure.

  16. rd says:

    The financial sector could learn major lessons from the saftey culture that has been developed over the past 20 years in much of industrial America.

    A cornerstone of good safety programs is rigorous self-reporting of near-misses and learning from them. The OSHA defintion of a near-miss is:

    NEAR MISS – Near misses describe incidents where no property was damaged and no personal injury sustained, but where, given a slight shift in time or position, damage and/or injury easily could have occurred.

    Companies that do a good job learning from near-misses have seen their accident rates plummet with major savings to their bottom lines. There is little OSHA regulation requiring near miss reporting but it has been found to be highly effective so many companies have adopted it because it works, not because it is regulated.

    However, unlike the financial sector, when industrial America has an accident with injuries or property damage, OSHA crawls all over the place handing out citations and fines. The personal injury lawyers also circle over head.

    The financial sector usually just gets a bail-out. Things may be improving Knight was forced to dilute its existing shareholders substantially over the weekend to get new financial backing after the SEC refused to give them a do-over on botched trades (I assume that Knight would have wanted to only jettison the losing trades but keep the winning ones). The shareholders should stop bleating about it since it was the management that they voted for and invested in that blew the place up. This is the way capitalsim is supposed to work!

  17. denim says:

    In answer to willid3. ok. Economics is the analysis, study, and design of economies. The economy is the system. It has at least one input and at least one output. That is all it takes to be a system. Systems engineers existed before computers…like this Russian systems engineer executed in 1929:

    “Graham, Loren R.,

    The Ghost of the Executed Engineer:

    Technology and the Fall of the Soviet Union,

    Harvard University Press, Cambridge, 1993.

    One of the first Systems Engineers was an early twentieth century Russian named Peter Palchinsky. He resolutely advocated that engineers be responsible for the big picture. Contrary to the Russian engineers’ traditional role of solving the technical problems presented to them by higher authorities, Palchinsky wrote in 1926 that engineers should provide active economic and industrial planning, suggesting where economic development should occur and what form it should take. For example, he thought that engineers asked to design a large hydroelectric dam on a certain river should ask:

    Is the purpose to obtain electricity?
    Is that the best river to dam?
    Is a dam the best way to obtain electricity?
    What are the trade-offs among the alternative generating techniques?
    Is coal available locally?
    If so, might a thermoelectric plant be a better choice?

    Answering such questions depends on analyzing local factors and evaluating the economic, social and environmental effects of each.
    In 1929 Peter Palchinsky was executed for his views on engineering. Afterwards, the education of Russian engineers became very narrow.”

  18. kek says:

    RW, your power grid response is primarily based on future demand, while in reality, the power grid is performing fine for what it was designed to do, work with vertically integrated regulated utilities. The problem comes with deregulation, and the resulting loading levels, wheeling power, etc., stuff it was never designed for. To say that the grid is crumbling due to a lack of maintenance is just not accurate.

  19. SteveC says:

    Buying and selling of stock has never been easier or cheaper. Let’s not roll back the clock to the marketmakers of 15 years ago, when trades were $300, and spreads were wide. I used to get terrible fills back then. Let’s not go back.

  20. [...] into the market.This cost the firm $440 million dollars — all in less than an hour. Barry Ritholtz helps put this in perspective:The snafu with Knight Trading as they were testing new algo trading [...]

  21. [...] week, alluded to the recent Bill Gross criticism on the Death of the Cult of Equities (See this and this). Several references to Stocks for the Long Run have been made, including the “Siegel [...]