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Monday, May 23, 2011

MacKenzie on high frequency trading

Donald MacKenzie writes on high frequency trading in the London Review of Books.

Earlier posts: MacKenzie on the credit crisis , two book reviews

LRB: ... No one in the markets contests the legitimacy of electronic market making or statistical arbitrage. Far more controversial are algorithms that effectively prey on other algorithms. Some algorithms, for example, can detect the electronic signature of a big VWAP, a process called ‘algo-sniffing’. This can earn its owner substantial sums: if the VWAP is programmed to buy a particular corporation’s shares, the algo-sniffing program will buy those shares faster than the VWAP, then sell them to it at a profit. Algo-sniffing often makes users of VWAPs and other execution algorithms furious: they condemn it as unfair, and there is a growing business in adding ‘anti-gaming’ features to execution algorithms to make it harder to detect and exploit them. However, a New York broker I spoke to last October defended algo-sniffing:

"I don’t look at it as in any way evil … I don’t think the guy who’s trying to hide the supply-demand imbalance [by using an execution algorithm] is any better a human being than the person trying to discover the true supply-demand. I don’t know why … someone who runs an algo-sniffing strategy is bad … he’s trying to discover the guy who has a million shares [to sell] and the price then should readjust to the fact that there’s a million shares to buy."

Whatever view one takes on its ethics, algo-sniffing is indisputably legal. More dubious in that respect is a set of strategies that seek deliberately to fool other algorithms. An example is ‘layering’ or ‘spoofing’. A spoofer might, for instance, buy a block of shares and then issue a large number of buy orders for the same shares at prices just fractions below the current market price. Other algorithms and human traders would then see far more orders to buy the shares in question than orders to sell them, and be likely to conclude that their price was going to rise. They might then buy the shares themselves, causing the price to rise. When it did so, the spoofer would cancel its buy orders and sell the shares it held at a profit. It’s very hard to determine just how much of this kind of thing goes on, but it certainly happens. In October 2008, for example, the London Stock Exchange imposed a £35,000 penalty on a firm (its name has not been disclosed) for spoofing.

... As Steve Wunsch, one of the pioneers of electronic exchanges, put it in another TABB forum discussion, US share trading ‘is now so complex as a system that no one can predict what will happen when something new is added to it, no matter how much vetting is done.’ If Wunsch is correct, there is a risk that attempts to make the system safer – by trying to find mechanisms that would prevent a repetition of last May’s events, for example – may have unforeseen and unintended consequences.

Systems that are both tightly coupled and highly complex, Perrow argues in Normal Accidents (1984), are inherently dangerous. Crudely put, high complexity in a system means that if something goes wrong it takes time to work out what has happened and to act appropriately. Tight coupling means that one doesn’t have that time. Moreover, he suggests, a tightly coupled system needs centralised management, but a highly complex system can’t be managed effectively in a centralised way because we simply don’t understand it well enough ...

This is the funniest thing I've seen in a long time, if you can understand what the chimp is saying :-)

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