GOLDMAN SACHS: 'Machines have replaced humans' — and their impact on the next financial crisis could be devastating

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The February sell-off in stocks demonstrated the impact of automated trading on markets, according to Charles Himmelberg, Goldman Sachs' cohead of global markets research.
"In this new market structure, machines have replaced humans, and speed has replaced capital," Himmelberg said in a note.
This new ecosystem dominated by machines has dried up the sources of liquidity that would be needed in the next major wave of selling, he said.

As the Dow Jones industrial average plummeted more than 1,000 points last month, many human traders blamed their automated counterparts for massive selling.

That's unlikely to be the last of the finger-pointing or of flash crashes worsened by machines, according to Charles Himmelberg, Goldman Sachs' cohead of global markets research.

"We suspect the Feb. sell-off is symptomatic of a broader risk, namely, the rising 'financial fragility' during the post-crisis period," Himmelberg said in a note on Monday.

"By 'fragility' we mean price volatility that arises not from changes in the fundamental outlook for markets, but rather from markets themselves."

Though the Dow had a record one-day point drop last month, the biggest casualties were exchange-traded notes that had been engineered to profit from lower volatility.As the Cboe Volatility Index, or VIX, had a record one-day spike, machines (and traders) invested in these ETNs were forced to cover their short bets. Two of the biggest ETNs lost 95% of their value that day.

The VIX reflects traders' bets for turbulence on the S&P 500, and it tends to rise when the index falls.

"It felt like the machines took over but we saw (human) investors buying the dip not only in financials but also other sectors," Vincent Kondaveeti, a financials-sector sales specialist at Credit Suisse, said at the time.

"The machines took over" and other flavors of that opinion were shared by several fund managers after the sell-off.

According to Himmelberg, regulations and technologies developed since the latest financial crisis have already put the machines in charge, with dire consequences for trading liquidity.

"In this new market structure, machines have replaced humans, and speed has replaced capital," he said.

"While such changes have greatly reduced the need for equity capital, and are thus efficiency-enhancing, the same was also true about leverage and structured products during the run-up to the financial crisis. While the new ecosystem for providing market liquidity has arguably freed up equity capital for more efficient uses, it has also depleted the pools of capital that will be available for liquidity when the cycle turns."

At a recent Goldman Sachs conference, Himmelberg noted that episodes such as the February sell-off had so far happened against the backdrop of a growing economy. Additionally, investors were always on standby to intervene by buying at lower prices.

But all this has bred complacency among investors, Himmelberg said. And, there could be a steep price to pay when, unlike now, there are more compelling reasons to sell stocks over buying.

"I think eventually the machines and AI will be so smart that your typical machine trader will be better than your typical human trader," Himmelberg said at the conference.

"Having said that, the problem with machines is they're very simple. They don't have any money. So when things get hairy ... the machines shut down."

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