Will-o’-the-wisp trading | Netherhall House

The recent development of information technology has created a novel phenomenon in the skittish world of finance: electronic trading. Traditional physical contexts of trade where market actors engage in auditory and visual experiences to exchange financial instruments through human interaction have been replaced by numbers on a screen. It was a rapid growth to dominance. Already in 1998 more than half of all trade was conducted electronically, up from 25% just three years earlier. As a consequence of this speedy displacement of face-to-face financial trading with digital interaction, the psychological implications of electronic trading have not been given enough attention. A modest evaluation of electronic communication networks (ECNs), the biggest trading systems of digital interaction, provides plentiful evidence that electronic trading comes with significant disadvantages.

The ECNs are computer-based systems automated to match orders to buy and sell securities at prices specified by multiple market participants. They most commonly take the form of a limit order book, which is when financial traders present bids and offers on a continuous basis and for others to view. Trade occurs when the limit order book automatically matches a bid with an offer of the same price.

On the surface, the ECN is an efficient creation. Market players face lower costs with electronic trading than they do in face-to-face contexts because ECNs bypass human interaction – the human intermediary has been replaced by the computer (and so has his cut of trade profits). Digital trade, as estimated by Terrence Hendershott of University of California at Berkley, is seven to ten times faster than physical exchange. Automated technology enhances the trade execution experience by allowing traders to place orders directly on the network, without having to interact (or share profits with) a broker. The modern market actor needs only a computer mouse to trade his financial instruments.

ECNs are also attractive because they grant traders anonymity. This is particularly important for institutional investors, who tend to prefer their trade to be indistinguishable from that of other players so that their patterns of investment can remain untraced. Another advantage of electronic trading is trade continuity, the inherent feature of ECNs that allows traders to make bids and offers without having to take breaks in-between. Continuity also increases price volatility, the degree of variation of price over time, which in turn enables traders to capture more profits.

It is undeniable that these appealing advantages were the reason why financial trading moved away from face-to-face interaction to digital networks at such rapid speed. But a closer look at the different types of financial markets reveals that some are more likely to adopt electronic trading than others. For example, while foreign exchange markets have moved onto digital platforms before the last millennium ended, electronic trade of US corporate bonds constituted only 10% of all trade in the bond market in 2000. This points to a flaw of ECNs that might otherwise not be apparent, namely that they do not cater for all needs. It seems that some investors do not see it in their interest to replace human interaction with digital technology. This is possibly because an institutional trader wouldn’t be expected to reveal publically their orders for large trade – this is to them an unnecessary proclamation of their activity. Having observed the trends in growth of electronic trade, which has not taken off for the bonds market, it is expected that existing floor-based systems of trade will remain in place until ECNs are developed to a level where complex institutional trade can be conducted to investors’ liking electronically. Traders remain in need of human intermediaries after all.

A particularly interesting disadvantage of ECNs is spoofing, an unscrupulous technique that traders sometimes use to create an illusion of demand for a particular financial instrument so as to manipulate its price, by placing bids and then cancelling them before trade is executed. What makes spoofing an interesting phenomenon is the fact that it is made possible by trader anonymity and trading continuity, two ostensibly advantageous aspects of electronic trading. This poses an evaluative dilemma. Should anonymity and continuity be considered advantages of ECNs, when they enable market manipulation?

It turns out that this dilemma is not so important. Because a deeper examination of the complex subtleties of the psychology of financial trading reveals that no appealing advantage of the system’s operational design could offset its inherent weakness. The inherent problem is subtle but nevertheless major: electronic trading gives traders an illusion of objectivity because of the way it presents data.

By reducing the entire market to a number, of which players monitor for their trading purposes only the last digit, electronic communication networks have unintentionally produced an unfortunate side-effect: they have caused traders to treat on-screen numbers as mere elements of a sequence. Furthermore, in order to reduce the interface to only the bare necessity of information, ENCs represent the entire market as a single numerical value. To traders, this gives the illusion of objectivity because numbers are culturally seen as units of certainty. But these on-screen numbers are in reality far from being factual entities: they are merely a temporary valuation of the monetary condition of the market at a moment in time. The whole perception of informational transparency that is wrongly associated with financial markets is based on the assumption that traders can view on-screen data and make inferences from it that are free from social information that would otherwise cloud their judgment. Financial data can easily be seen as a self-evident set of numbers that renders all human interpretation unnecessary when one needs to use it to make decisions. But this cannot be true. Traders – human beings – view pure data through their framework of social and cultural understanding. Not only do the traders assign their own psychological significance to the numbers before them, but they also interpret it with regards to how they think other players will assign their own psychological significance to it. In this way, self-evident numerical entities take on psychological complexities of large proportions.

All these features of ECNs create a trading environment in which making snap decisions is the driver of success – and in which thoughtful reasoning is a hindrance to reaching desired outcomes. The broader implications of this for the financial industry are vast: ECNs have furthered the decline of the importance of comprehensive understanding within the realm of financial trading. Because the success of traders is dependent on how quickly they can respond to apparent market trends, regardless of whether they understand the reality that underlies observed price movements or what are the actual societal causes of the numerical fluctuations they see on their screen, the digitalization of financial trade brought by the development of ECNs can be said to have eroded the necessity for traders to comprehend in full what they are doing. Electronic trade has simplified market conditions into numerical depictions, and replaced comprehensive understanding of the broader implications of market actions with superficial familiarity of price fluctuation. As a result, traders see patterns where there are none and overreact to events before they even happen. Thinking becomes a disadvantage.

Discussions of the financial industry’s broader significance often do not give enough attention to these psychological issues of electronic trading. Yes, recent technological advances have indeed enhanced the efficiency of market interaction by streamlining the trading process through use of automated systems that bypass human interaction. But the replacement of traditional face-to-face physical interaction with digital trade through electronic communication networks has also caused a shift in economic reasoning employed by market players when interpreting data. Electronic trading, by reducing the whole market to single numerical representations, has given traders the illusion of objectivity and eroded the necessity for them to have a comprehensive understanding of their own actions. Because of this grave detrimental effect of electronic communication networks on the psychological nature of market interaction, electronic trading cannot possibly be considered to have an advantage over traditional physical contexts of financial exchange.