Systemic Crisis: The Rise of Machines, Casinos and Illiquidity
London, UK - 16th May 2010, 00:10 GMT
Dear ATCA Open & Philanthropia Friends
[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]
The unprecedented financial markets turmoil on May 6th and the deepening Eurozone debt crisis are together raising issues of systemic risk, not seen since the Lehman Brothers' insolvency in September 2008. At one point on May 6th, the New York stock market plunged as much as 9.2 per cent wiping off $1 trillion in market value. The S&P 500 futures dropped like a stone losing more than 100 points and the Dow Jones Industrial Average (DJIA) managed a near 1,000 point plunge: all in the space of minutes. This is hardly the kind of behaviour which engenders confidence in the banking and financial community.
High Frequency Trading (HFT)
Role of Technology
The sudden sharp downward spike lasting minutes was not caused by traders-in-a-pit shouting at each other. It was, instead, driven by tightly coupled multiple High Frequency Trading (HFT) computers. Today's stock markets are overwhelmingly governed by mathematical algorithms programmed to jump in and out of the markets at lightning speed in a systematic search for casino trades that yield a quick profit. The role of technology in amplifying massive market spikes has now shot to the top of the global agenda for regulators post the near-meltdown of Wall Street earlier this month.
High Frequency Trading (HFT) algorithms provide the illusion of liquidity in today's markets and May 6th is a testimony to how easily that liquidity can evaporate so abruptly. One of the reasons why regulators have indulged questionable High Frequency Trading (HFT) practices is that they believed this would bring greater liquidity into the markets, which saw an astonishing lack of liquidity in the immediate aftermath of the start of The Great Unwind in August 2007 and The Great Reset in September 2008. Today's stock trading computer models include variables based on liquidity. Every high volume trader only has a single exit strategy: sell the stock or some synthetic derivatives version of it! Every one of the computer trading models is based on the notion that the liquidity will be there. What happens if it is not there? What happens if the volume introduced by High Frequency Traders (HFT) disappears altogether, or as some suggest about May 6th, they just decide to stop trading? In that event, Where do the buyers come from? If they don't, the market plunges abruptly!
The stock market ecosystem has changed considerably in the last few years. The interdependencies have deepened just as they have expanded. At present, nearly 60 per cent of the US equity markets involve the use of a form of algorithmic or High Frequency Trading (HFT). That is a huge increase since the 1987 stock market crash, where computerised program trades were blamed for exacerbating falls. Less than 35 per cent of trading in NYSE-listed shares actually takes place on the New York Stock Exchange these days. Trading in equities takes place not only on the main exchanges -- NYSE and NASDAQ -- but on a multiplicity of other platforms, including "dark pools" and proprietary trading systems operated by primary brokers themselves. What does one call it when a significant percentage of volume of an exchange is concentrated in just a few hands? A clique of 'Too Big To Fail' players? Not only do we live in a global economy, we transact on a global network of networks, enmeshed into an elaborate web. These interdependencies have a significant problem: we don't know when a node or trader disconnects until it's too late! When a broker pulls their trading volume, especially when the market expects it to be there, what happens? There can be a lack of buyers, which in turn pushes stock prices lower, quickly and significantly. Which in turn triggers automated selling programs, pushing the market down to circuit breaker levels.
Vital Human Intervention
For most ordinary investors the idea of an exchange is still the physical monument of the New York Stock Exchange (NYSE) on Wall Street. But in reality, most shares change hands in proprietary data centres. The dramatic plunge in US equity markets has focused attention on High Frequency Trading (HFT) computer programs, and whether such technology can be regulated so as to prevent the kind of relentless selling seen recently. Recent events are sure to pile on pressure as the financial regulators consider various kinds of curbs, including mandating a system of "circuit breakers" across all trading venues. Contrary to popular opinion, this may work adversely given the near omnipresence of High Frequency Trading (HFT) platforms and their inherent need for sufficient liquidity. May 6th showed that machines don't panic, they leave that to nervous humans! However, machines can decide not to run their algorithms when certain parameters and thresholds are crossed including lowered liquidity and volume. That may be an entirely logical response but, paradoxically, revival of markets requires non-linear human intervention and emotions to function normally! It was only when the machines were turned off and bottom fishing humans got involved that the free-fall of equities ended on May 6th! If every computer trading model expects a given volume, what happens when that volume falls? We get a massive plunge and deadlock. Without human intervention nothing can restart again!
Fast and Furious
The rise of "High Frequency Traders" using "Algo-trading" is so pervasive that some suspect it may be hard to see how, post May 6th, ordinary investors can be expected to trust market structures in which they have placed their faith for decades. Instead, they may be right to assume that markets serve the interests of short-term traders using state-of-the-art computer technology. The speed of trades is mind-boggling. Last month a US company unveiled a system that can handle a trade in 16 microseconds!
Has technology reached the point where machines pose systemic risks if they go berserk? By and large there are two sets of issues that can arise in High Frequency Trading (HFT) platforms. Either the programs contain bugs, accidental errors introduced by the programmers, or they are not built to cope with changes in their environment: in essence they inaccurately model the real-world so that when it misbehaves so do they. This seems to have been the problem during the Dow's drop on May 6th: the automated trading bots had no concept of a trading time-out and there was no way of stopping them. Most complex computer programs stretch into hundreds of thousands of lines of code. If it is impossible to fully test a program that's fifty lines long, one can begin to understand why it is dangerous to rely 100% on software for anything with hundreds of thousands of real-time participants.
We have long advocated that the dominance of High Frequency Trading (HFT) and diverse types of algorithmic models or "algos" could one day run amok and spark a massive systemic melt-down of the global financial markets, which would be on a scale that is difficult to envisage. The events of May 6th are a wake up clarion call and markets are dangerously unprotected from major misfiring algorithms operating on their own or in tandem with other HFT systems. The accelerating euro crisis could trigger similar event scenarios in the near future. Recent events show the kind of impact on market confidence that software trading bots going off on a tangent or "switching off" can cause: investors simply hate uncertainty and having these unexplained problems happening while everyone's nervous does nothing to calm the global financial markets. Longer term systemic liquidity requires confidence that the playing field can produce winners and losers in a fair way and long term investment skills will be rewarded over short term casino gambling acumen. If traders and investors sense that markets are not only casinos, but ones where a massive software crash can wipe out everyone, they will not want to play within them at all! The rise of machines, casino trading and abrupt illiquidity scenarios is now upon us. What remains to be seen is the regulators' response and our question would be: Can it work?
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