Saturday, February 11, 2012

 

Ultrafast Trades Trigger Black Swan Events Every Day, Say Econophysicists

Wow, you mean that letting computers make decisions produces the untended result of increased volatility. Well, color me the exact opposite of surprised.

The work also hints at a solution: to somehow reproduce the effect of human oversight at ultrafast scales. How that can be done with regulation alone isn't clear but there is no disputing the urgency with which this matter should be addressed.The markets are clearly changing. The need to outperform competitors is currently driving a multibillion dollar investment in machine trading at rates even faster than milliseconds. In one project, traders are financing the construction of a dedicated transatlantic cable that will shave just 5 milliseconds off the time it takes to trade stocks. Unless it is tackled in the near future, just what kind of behaviour this race-to-the-bottom will generate, is anyone's guess.

There is a concept in chaos theory called the Butterfly effect. That a small change in a non-linear system can lead to huge changes. I look at high frequency trading (HFT) as additional volatility, more shaking of the markets if you will. A vibration that is having effects we still do not understand. As a trader I have personally experienced it as the impossibility of being a market maker or simple spread trader; the computer erases simple market inefficiencies faster than you will even notice them. At this point you might say so what. Does it matter if humans make this decisions or not? Of course there have been crashes without computerized HFT. The difference in that HFT programs would necessarily have vaery similar parameters to make money. If they are trying to do the same thing and if they account for a large share of the volume what prevents them from all driving the market up or down by an inordinate amount. Computers can be turned off but then who picks up the slack when it comes to making markets? The human traders are long gone. In fact, isn't this what took place on May 6th, 2010?


IMHO, this volatility is doing damage to our markets. It has driven out human decision making from trade execution at least on the smallest scales. The vibration added to the markets is not adding to their function of price discovery. But the biggest problem comes when a large exogenous event increases volatility and the HFT programs have to deal with that. How will they? Will their operators turn them off? Then you have an illiquid market at the worst possible moment. It would be better to have tens of thousands of individuals making markets on stocks each with their own time frame and strategies then a couple of dozen algorithms all trying to be in and out of orders in milliseconds not showing a bid and offer that a customer can count on.

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