Will Technology Continue to Drive Changes in the Stock Market Model?

Published: September 30, 2009 in Knowledge@Emory

Technological developments and a broad move to strike down political barriers to commerce have helped lead to an explosion in the pace and scope of investment trading. For example, from the inception of the New York Stock Exchange, more than 100 years passed before Big Board trading volume topped the 2 billion share mark in January 2001, yet by September 2008 it peaked at 9.3 billion shares.

Even in today’s depressed market, share volume frequently surpasses the 5 billion mark.

But while technology has sped up market trades and made the process more accessible to a wider audience of investors, it has also led to disruptions, say faculty from Emory University’s Goizueta Business School.

To explore the possibilities and pitfalls of the changing market, Knowledge@Emory spoke with Benn Konsynski, a chaired professor of business administration for information systems and operations management, and with Ramnath Chellappa, an associate professor of information systems and operations management.

Knowledge@Emory: We’re hearing that technological, social and other developments are driving creative disruptions in the stock-trading model. Would you agree?

Konsynski: Without a doubt. We’re seeing an evolution and a migration in the markets. At one level, the changes are as basic, though dramatic, as ending the New York Stock Exchange’s position as the dominant exchange for blue-ribbon companies. Microsoft, for example, is still on the NASDAQ, as is Google.

But the changes go beyond that, as the reasons for the existence of the major markets themselves are diminishing. We’re seeing the rise of virtual activity, where it’s easier for buyers and sellers to meet, and for both to tap multiple sources of information. This activity is known as neo-intermediation.

Chellappa: We’re also seeing changes in the way that the trading firms themselves execute their activity. As market volumes rise and the trading activity itself accelerates, more trading firms are utilizing risk management programs that pull information from a variety of sources—similar to data mining techniques used by consumer research and other organizations—and alert the firms about certain conditions, such as whether they may be over-concentrated in a particular security or a sector. The software itself is of course still being developed, but many domestic and off-shore firms (such as Infosys and Tata Consultancy Services) appear to be making some impressive advances.

Knowledge@Emory: What does the development of neo-intermediation, or neo-intermediaries, mean for investors and for companies? What other kinds of developments can we expect?

Konsynski: More competition and more choices when it comes to information. Neo-intermediation involves unbundling services, and the transformation of products and services. It also drives a change in the categories of securities that can be traded. With the increase in information flow, investors can bid on indices, portfolios, electronically traded funds and other asset classes and instruments with greater confidence. With the advent of neo-intermediaries, investors are able to access information from a wider range of sources, rather than relying on a limited number of gatekeepers. Under this new model, the traditional broker structure is no longer as useful as it once was. Instead, a self-structured model now has the opportunity to take on an enhanced role.

We’ve already seen the emergence of many new facilitators, including information resources like bloggers and websites such as thestreet.com and seekingalpha.com, that offer commentary and analysis.

Chellappa: The technology-driven advances in trading are also resulting in the development of new, more-powerful computing models. This is likely to accelerate the move to cloud computing [an emerging model of computing today that was originally defined in the 1990s by Chellappa as a condition where most applications and activity reside on and take place in cyberspace], since it would be inefficient and prohibitively expensive to do the computing at local workstations as quantitative models become more complex and as data become increasingly voluminous.

A traditional computer is likely to be used as a front end for traders, but the heavy-duty work will be done in the cloud.

As more companies embrace cloud computing and the computing models it enables, more trading firms will develop proprietary methods that may enable them to better evaluate the risk issues in their portfolios. But to be effective, the capabilities must be made available to appropriate employees across departments and information sources. The risk monitoring systems will essentially function as back-end operations that will help traders make decisions about risk across a broad range of areas.

Knowledge@Emory: Technological and other advances may bring unintended consequences. The factories and automobiles that increased the world’s productivity, for example, also gave rise to pollution. The development and use of antibiotics may also be accelerating the development of resistant diseases. Is it likely that neo-intermediation, the resulting boost to the use of cloud computing, and other developments will also lead to unintended consequences?

Chellappa: Undoubtedly. For one thing, much of the development and external cloud hosting is likely to take place in India and other off-shore destinations. As sensitive data is exchanged across borders, privacy and security issues may arise, particularly if U.S. privacy laws are more stringent than the laws in some of these other locations.

Konsynski: We’re also likely to see more volatility in markets, since an increase in the variety of instruments traded and data available can create a kind of information overload. When there are so many sources of information, how can investors tell the trustworthy ones from the ones that are not valid? How can you assess reputation when fragmentation quickly increases?

In 1929, 1987, and most recently in 2008, we saw how unintended consequences and a lack of regulatory control helped to break down the market. Short-selling, derivatives and other behavior and instruments need to be monitored to see if they’re creating unacceptable risk.

Knowledge@Emory: Some observers would argue that excessive regulation hinders the market instead of helping it.

Konsynski: I agree that a balance must be struck, but the fact is that the broad community suffers when financial and trading instruments get out of hand. Some regulation is necessary to govern financial instruments, but we also need an assessment of risk, and a clear chain of responsibility for trading activities.

But we shouldn’t stifle innovation. Instead we need to assess risk and other implications and maintain accountability.

Perhaps the increased regulation could include systems and procedures to monitor activity and provide an alert if there’s an overly broad market risk. So the idea would not be to control or constrain, but rather to amplify weak signals that indicate when action needs to taken.

Chellappa: While there is some truth to that, much of the compliance-type regulations will result in greater need and investment in technology, since these rules are likely to be embedded in systems.

Knowledge@Emory: What other kinds of changes do you see coming about as a result of the new trading technology?

Konsynski: I think people will realize that the growing global trading platform means it’s unnecessary to separate trading markets by region. Instead we need to recognize that global markets will influence each other, and that there are no regional immunities in a global market. Retreating to protectionist policies of the 19th and 20th centuries is not an option, but regulators will have to settle on appropriate global risk and other controls.

The power of technology lies in creating engines that tolerate more complexity and offer more trading opportunities, especially as more advances are made in cloud computing.

In fact the market meltdown we’ve just experienced may offer a unique opportunity to restructure our trading environment with new patterns that offer, for example, a more robust trail of accountability, and that enable buyers and sellers to better deal with new kinds of financial instruments, with the continued unbundling of services, and with the introduction of new intermediaries.

A few months ago I was on the floor of the New York Stock Exchange and I saw parts of the facility that have remained unchanged from the last century. In years to come, however, I expect to see very little resemblance to today’s facility or trading model.

Chellappa: I believe we will see the required skill sets become even more interdisciplinary, combining elements of quantitative studies and domain knowledge from finance and technology. We should never forget that successful firms have a holistic view of people, process, and technology. These are complementary, and one cannot simply substitute for another.

Smaller financial institutions may find it difficult to meet the costly tech requirements that may come with these advances, just as we’re seeing smaller publicly listed firms complaining about the cost of complying with Sarbanes-Oxley [financial reporting and other] requirements. In fact, there is evidence that the steep costs associated with Sarbanes-Oxley compliance has driven some public firms to delist.

Invariably some combination of off-the-shelf products and outsourcing/offshoring will emerge to help smaller firms.

Technology advances can help with the decision-making process, but their use can also be controversial because of the possibility of unintended consequences. Consider security and privacy issues in general or “flash trading” in the financial industry. This has always been the nature of technological innovations. Initially, you think about automating some process and it leads to a host of other benefits and challenges.


Photo: Professors Ram Chellappa, left, and Benn Konsynski stand next to an "old school"  trading post once used at the NYSE and donated to Goizueta. The two innovative thinkers foresee more change.


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