This review was commissioned as part of the UK Government’s Foresight Project, The Future of Computer Trading in Financial Markets. The views expressed do not represent the policy of any Government or organisation.

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Daniel Beunza (London School of Economics), Donald MacKenzie (U. of Edinburgh), Yuval Millo (LSE) and Juan Pablo Pardo-Guerra (LSE)

Introduction

This report identifies impersonal efficiency as a driver of market automation during the past four decades, and speculates about the future problems it might pose. The ideology of impersonal efficiency is rooted in a mistrust of financial intermediaries such as floor brokers and specialists. Impersonal efficiency has guided the development of market automation towards transparency and impersonality, at the expense of human trading floors. The result has been an erosion of the informal norms and human judgment that characterize less anonymous markets. We call impersonal efficiency an ideology because we do not think that impersonal markets are always superior to markets built on social ties. This report traces the historical origins of this ideology, considers the problems it has already created in the recent Flash Crash of 2010, and asks what potential risks it might pose in the future.

Before considering its risks, it is important to point first to the many benefits of automation. The most important advantage has been a notable narrowing of the spreads in the equities market. In addition to lower transaction costs, the structure of the market now has competing centres for order matching, and provides direct access to small investors. Equally important, the audit trail generated by electronic trading has made surveillance more effective.

Automation, however, has also given rise to potential dangers. By favouring algorithms over human discretion and social cues, the ideology of impersonal efficiency has fundamentally altered the functioning of markets and opened the door to problems. Specifically, the risks of impersonal efficiency manifest themselves in three ways. First, the specific form taken by market automation has undermined the social mechanisms of norm enforcement traditionally deployed by human intermediaries. Second, pursuing transparency by enforcing a system of committed, visible quotes on electronic screens that traders cannot back away from can be self-defeating --in that it can deter from participation in the market. And third, it has promoted innovation in a manner that each actor has a very limited view of the entire landscape. As a result, their decisions can easily have unintended consequences and prompt crises

Accordingly, we argue that impersonal efficiency gives rise to three forms of risks. First, the risk of a market characterized by weak norms, where the content of norms and their enforcement are uncertain, leading to opportunism and volatility. Second, the risk of toxic transparency: by reducing trading to a mechanism of information exchange, it has undermined the qualitative role of the price system as a coordinator of the market. And third, impersonal efficiency gives rise to the risk of fragmented innovation, that is, situations where partial knowledge about the technological system leads to misinterpreted cues and market uncertainty. This documents expands on this assessment with a history of market automation in the US and UK, an analysis of the Flash Crash and an assessment of the present.