TCS Daily

Terror, Technology and Financial Markets

By Kevin Hassett - September 10, 2004 12:00 AM

The news that Al Qaeda terrorists have been casing U.S. financial institutions comes as little surprise to economists. The financial sector is widely recognized as the heart of the U.S. economy. Business activity requires enormous flows of cash, and our financial institutions do a remarkable job managing that flow. The terrorists clearly believe that the interruption of that stream could do significant damage to our economy. Indeed, while any terrorist attack might well set off a near-term panic in financial markets, the latest news suggests that terrorists have specifically targeted buildings that house our key financial institutions. If, god forbid, terrorists successfully attacked financial targets, what would happen to the rest of the economy?

It is easy to become complacent toward these risks, given our relatively quick economic recovery from the attacks on the World Trade Center. But the vulnerability of our financial markets has been a key focus of homeland security study since September 11. A recent report by the General Accounting Office suggests that the terrorists may have identified a troubling vulnerability. The September 11th attacks may have been easier to recover from because many individuals who are crucial to the functioning of markets escaped unhurt. While we have ample contingency plans for attacks on buildings and computers, a more serious disruption might occur if the people who make the market work became tragically incapacitated.

As a case in point, consider one of the more visible Al Qaeda targets mentioned in recent reports, the New York Stock Exchange. Under current regulations, almost all trades on the NYSE must occur on the hectic floor of the exchange. If two willing partners try to trade shares in a stock that is listed on the NYSE, they almost always must do so through an intermediary on the floor of the exchange in New York. They are not allowed to use any of the electronic exchanges that dominate trading in stocks listed on other exchanges like NASDAQ.

Once the transaction lands at the NYSE, it is often filled by barking individuals swapping hand-written pieces of paper. This is in marked contrast to the rules that govern most other exchanges around the world, including our own NASDAQ, where computers clear transactions.

The busy floor of the stock exchange is able to manage trading activity because of the countless professionals (called "specialists") who have years of experience dealing with the chaotic complexities of equity trading. The GAO identified that link as a key vulnerability. Davi D'Agostino, the GAO director of Financial Markets and Community Investment recently testified that financial institutions, "faced greater risk of operational disruptions because their business continuity plans did not adequately address how they would recover if large portions of their critical staff were incapacitated."

Imagine, for example, if you were asked suddenly to take on the job of making a market for a stock. Where would you begin? It boggles the mind. The specialists are not easy to replace, at least not with humans.

While heightened security can certainly help manage the risks, the fact remains that concentrated and important targets will inevitably attract terrorists. It is in the interest of economic security to move away from a system that places so much importance on a large group of individuals collected in a small space. A lengthy period of inactivity for equity markets could significantly harm the economy as a whole.

The migration of the NYSE away from current practice has been disappointingly slow. While supporters claim that there are significant benefits associated with floor trading, the academic evidence is weak. A number of studies have found that computers -- like those relied upon by NASDAQ -- seem to do a better job than people at clearing markets. So why is the old-fashioned approach still relied on so heavily? The best explanation is that the specialist system is so profitable. The individuals clearing the trades on the floor of the NYSE can trade on their own accounts, and since they have access to information not available to individuals on the outside, they can make extraordinary profits. For example, one recent study by Brian Becker of Precision Economics, a Washington, D.C. research boutique, observed that specialist firms posted pretax margins of 37% to 61% in 2002.

While those profits buy specialists significant voice in Washington, national security requires that financial markets decentralize. The quickest way to accomplish that would be to move away from current regulations that funnel transactions for stocks listed on the NYSE to the congested trading floor. If computers all around America were simultaneously processing orders, the economic costs of conceivable terrorist disruptions would likely be small.

Kevin Hassett is director of economic policy studies at the American Enterprise Institute.


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