Consider this unsettling sentence from a recent research paper on algorithmic (algo) trading:
As we have seen, HFT algos can easily detect when there is a human in the trading room, and take advantage. [More]The astonishing takeover of all kinds of trading by "black boxes"should be a warning note for farmers who think their markets will not be affected. Quite literally, algo trading changes everything about any public exchange.
A third of all European Union and United States stock trades in 2006 were driven by automatic programs, or algorithms, according to Boston-based financial services industry research and consulting firm Aite Group. As of 2009, HFT firms account for 73% of all US equity trading volume. [More]While the focus of black box trading has been speed which allows High Frequency Trading [HFT], it seems that is now reaching the point of diminishing returns, although it has upped volume magnificently. as for the big benefit - lower costs per trade - that may have bottomed out.
The advantages of the nation’s increasingly high-speed stock market are under the microscope after a number of recent trading malfunctions underscored the risks and instability that have come with the rapid changes. This month, one of Wall Street’s most important trading firms, Knight Capital, lost $440 million in 45 minutes after installing faulty software designed to keep up with an evolving market.As the battle to introduce more sophisticated technology continues, raising the specter of more problems like Knight’s, the diminishing returns flowing back to investors are making even longtime proponents of innovation question whether the competition to make the market faster and more efficient is now doing more harm than good.“They’ve reached the point where the competition is measured in microseconds and there are essentially no benefits to the public at that level,” said Lawrence E. Harris, the former chief economist at the Securities and Exchange Commission, and now a professor at the University of Southern California.High-speed trading firms have thrived in the computerized markets and now account for more than half of all stock trading, up from 26 percent in 2006, according to the Tabb Group, a financial markets research firm. But even many of them acknowledge that they are engaged in an arms race that is delivering diminishing returns.Manoj Narang, the founder of Tradeworx, said that the competition had become “a tax” on computerized trading firms like his. Mr. Narang says he thinks that his competitors are dedicating fewer resources to the race as they see there is little more to be gained. [More]
While reversing this trend doesn't seem to be possible, more than few knowledgeable observers are wondering if we aren't stacking dynamite for a major market demolition.
First, let’s be clear about what these charts are showing. HFT is maybe a bit misnamed, since what we’re seeing here is two separate eras. From 2000 to 2006, trading got faster and cheaper. From 2007 to date, trading itself hasn’t actually risen much, or got faster. the huge spikes are in quotes, rather than trades, and it’s not uncommon for certain stocks to see more than a million quotes over the course of a single day, even when they are only traded a couple of dozen times.But what about our tiny (relatively) commodity markets? Can't we buy a few puts or calls and live to tell the story?
You know the track cycling at the Olympics, where the beginning of the race is entirely tactical, and the trick is not to go fast but to actually position yourself behind the other person? HFT is a bit like that: the algorithms are constantly putting up quotes and then pulling them down again, in the knowledge that there’s very little chance they will be hit and traded on. The quotes aren’t genuine attempts to trade: instead, they’re an attempt to distract the rest of the market while the algo quietly trades elsewhere.
As such, the vast number of quotes in the market is not a genuine sign of liquidity, since there really isn’t money to back them all up. Instead, it’s just noise. But don’t take my word for it. Here’s Larry Tabb, the CEO of Tabb Group, and a man who knows vastly more about HFT than just about anybody else:
Given the events of the past six months, the SEC should think hard about the market structure it has created, and do its utmost to rein it in. While the SEC can’t stop computers from getting faster, there is no reason it can’t reduce price and venue fragmentation, which should slow the market down, reduce message traffic and lower technology burdens.HFT causes stock-market instability, and stock-market instability is a major systemic risk. No one’s benefitting from the fact that the entire market could blow up at any second. So why isn’t anybody putting a stop to it? [More]
Until we can safely manage complex and massive message streams in microseconds, fragmentation is making one of the greatest financial markets of all time about as stable as a McLaren with its RPMs buried in the red.
The big increase in HFT-related trades has been well documented (though exchanges have been reluctant to break out the rising share of HFT trades for fear of inflaming demands for a clampdown). It has contributed to a surge in the number of trades in NYMEX crude from under 1 million in 2005 to almost 42 million in 2011, and in CBOT corn from 133,000 to 10.7 million, as well as a reduction in average trade size.The warning here is clear. Our markets can bumble along in what we consider to be a normal market only to be be overwhelmed by spillover from who-know-what financial exchange and Very Big Money. This will happen between breaths.
It is a truism to say that correlation is not the same as causation. But nothing worthwhile in social science has ever been proved conclusively to this standard. Bicchetti and Maystre do present some convincing arguments for a possible link, though, including the presence of statistical arbitrage programmes operating across multiple markets, and invite further work to establish its extent and the mechanisms.The authors touch on an even more sensitive area when they speculate about whether HFT programmes import non-fundamental influences onto specific commodity prices.The paper points out "(conventional explanations) fail to explain how economic fundamentals or the risk appetite of financial investors changed quickly. Indeed, news frequencies or human investors reaction is certainly not as high as 1-second."Later the authors go on to argue "the strong correlations between different commodities and the S&P 500 at very high frequency are really unlikely to reflect economic fundamentals since these indicators do not vary at such speed."In other words, HFT traders translate volatility from one commodity or financial market to another at timescales from seconds to minutes by arbitraging them very rapidly.In a more serious charge, the authors suggest a lot of HFT programmes have feedback characteristics that tend to be self-reinforcing. "Although individually rational, the overall effect of trend following strategies may destabilise markets". Bicchetti and Maystre cite the "flash crashes" in equities (May 2010) and oil (May 2011) as examples of destabilisation.The potential combination of HFT enforcing tighter correlations, and perhaps also propagating volatility within individual markets through herding behaviour, leads the authors to conclude that "as commodity markets become financialised, they are more prone to external destabilising effects". [More]
My takeaway from this research is this. I want Cargill or Ingredion* between me and HAL. And any banker who funds a commodity trading account is asking for trouble. After all, they can tell I'm merely human.
*Yes - the first major grain buyer with "greedy" in the middle of their name! What committee okayed that one?