BUSINESS
11/06/2012 01:44 pm ET

Wall Street Reformers Unwittingly Turn Derivates Market Over To Robots

We've seen how well robots handle stock trading, why not give them the keys to the credit-derivatives market, too?

There may not be much choice: As an unintended consequence of making derivatives safer, we might be opening the door to high-speed-trading robots that don't have the best track record of safety themselves.

But then maybe we're just letting ourselves get hung up on a few instances of robot-trading unpleasantness, like the Flash Crash and the Facebook IPO and the Knight Capital trading debacle, etc. The majority of stock trades are now performed by high-frequency algorithms, and the vast majority of those trades do not end in harrowing market collapses.

So maybe it will be totally fine that the trading of bonds and other credit securities, including derivatives such as credit-default swaps, should also move increasingly toward algorithms, which is already happening faster than you can say "Open the pod bay doors, HAL," as Bloomberg points out.

One by one, big credit-trading banks such as Credit Suisse and Goldman Sachs are letting go of their high-paid derivatives traders, who make an average of $2 million a year, and replacing them with robots that have a startup cost of just six figures and only occasionally refuse to open pod-bay doors. UBS last week became the latest bank to join the trend, Bloomberg reports, firing top credit-default-swap index trader David Gallers and replacing him with computer algorithms.

As you know, this is happening because of onerous, burdensome financial regulations. Just because credit derivatives helped wreck the global economy one time, reforms such as the Dodd-Frank law are forcing banks to move derivatives trades out into the open, onto exchanges, where everybody can see them. This means high-priced bankers won't have nearly the leeway to vigorously shave muppets, also known as clients, with every opaque derivative trade they make, The New York Times pointed out back in July.

That means less profit for Wall Street, as revenue from credit and derivatives trading has already been cut nearly in half since 2009 and will probably never recover, as the NYT notes. Yet Wall Street has cut maybe a third of the jobs it needs to cut to match that revenue loss, the NYT suggested, citing one analyst's research.

This is bad for Wall Street, but possibly good for Main Street. Moving derivatives onto open exchanges is one way to help keep the derivatives market from getting out of control again -- though human traders will still be able to make big, dumb derivatives bets, such as the London Whale trades that cost JPMorgan Chase $6 billion or so earlier this year.

The potentially scarier prospect is that we may also need to prepare for the occasional flash crash in derivatives, as high-frequency traders rush in to take advantage of the greater market transparency and liquidity afforded by exchange trading.

"Dodd-Frank is the Trojan horse for high-frequency trading," a hedge-fund high frequency trader told Risk magazine last month.

As we have seen with the stock market, with high-speed trading come high-speed blowups. And the derivatives market, with hundreds of trillions of dollars in notional value, is magnitudes larger than the stock market.

There are features of derivatives trading that could make the trading robots leery, including a greater level of complexity and possibly higher barriers to trading. But if there's money to be made, you can bet their human overlords will be working on ways to make it.

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