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Physicist, Startup Founder, Blogger, Dad

Tuesday, May 24, 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 :-)

25 comments:

paulyoungUK said...

This says it all:
 
http://www.careerbuilder.com/monk-e-mail/default.aspx?mId=33630934.2&cbRecursionCnt=8&cbsid=63603d68101744c6a6b756ba69e4d332-334773940-RI-414:25:31
 
 

RKU1 said...

Well, all of this is clearly zero-sum, or rather zero-sum under normal conditions but sometimes massively negative-sum.It's unclear to me how society benefits by diverting lots of very smart people into activities which are zero-sum (and sometimes massively negative-sum). The parasites are devouring the host...

KenC said...

How does HFT benefit anything other than exploiting a gap for a small gain multiple times? This is a serious question as I am clueless on this subject. I have traded and invested in stocks for years the old fashioned way but fail to see what benefit (other than enriching a select few) this creates for the whole.



Perhaps that is not the point. I read where systems such as this “create liquidity” whatever that is supposed to mean in this context. Perhaps LY can enlighten us--or me anyway.

David Coughlin said...

 'Creating liquidity' is a red herring.  HFT operators take advantage of price mismatches and the location of information.  They trade prices on different markets against each other.  So, there is, by definition, no demand that is unmet by supply or vice versa that is facilitated by HF traders.  If there is supply for which there is no demand, an HF trader isn't going to get in on it because then they have to defer the liquidation of their position.  They aren't HF any more so the need another strategy at their disposal.

5371 said...

Yes, and even the lowest Tobin tax would presumably eliminate it completely.

LondonYoung said...

I think your question can be folded into a broader one, to wit "does conducting arbitrage create any benefits for anyone but the arbitrageurs?".
And that question, I think, can be folded into a bigger one which is "does any capital transmission activity benefit anyone but those transmitting capital?"
And, finally, does capitalism create any value?

I think a broad sweeping set of intellectuals over time have rejected capitalism in favor of central planning.  However, the results of central planning have been strangely disappointing.  It seems that when individuals restrict themselves to requiring that the actions of others do not harm them, that they do better than to interfere in the actions of others that are neutral to them.  Drawing the line, IMSAO, is what we call "prudent regulation".

Do systems like this "create liquidity"?  I think they transmit liquidity away from large traders to small traders.  So mutual funds get worse fills, but mom and pop on e-trade get better fills.  In theory, our regulators are supposed to favor the latter because the former hold themselves out as experts.  Again, IMSAO, I don't believe the experts outperform, so those who pay them pay the price tag ...

KenC said...

Then one can throw this into the mix and have ones head spinning even more furiously:

http://seekingalpha.com/article/267826-the-forgotten-flash-crash-one-year-later

asdf said...

"So mutual funds get worse fills..."

http://www.sec.gov/comments/s7-02-10/s70210-122.pdf

LondonYoung said...

"OPM"  Other People's Money

KenC said...

And, finally, does capitalism create any value?



Thanks for responding LY. You appear to know about these things so your insight is appreciated.



I would have to say yes to your question even with its imperfections. Capitalism allows and encourages new ideas, technologies, and products to become a reality that are not possible under a command economy. And I would be telling a fib if I were to say I invest stocks and other financial instruments with no intent to profit. So your point is taken.

Perhaps my main problem with HFT is that I don’t understand it nor participate in it so maybe there is a little jealousy that some can make piles of money from a system I can’t fathom. And I have no clue how such an enterprise could be effectively overseen by a regulatory commission that would have enough insight and information keep them on the straight and narrow. 



But my price is 15% annualized. If you can guarantee me that return for the rest of my life I’m on! And I will forget any and all concerns that vex me on these matters....

David Coughlin said...

<snerk>

LondonYoung said...

I can solve one problem for you right away - it is not "piles" of money.  If you look at ROA of vanilla single share market making it is one of the worst businesses on the street.  Basically, HFT has displaced specialists by undercutting them (by a lot) in price.  I can make you a super-tight bid-ask as long as I am so fast that I can yank my prices when any adverse information appears.  But a trained physicist can easily calculate a bound on the total profit potential of an activity based on earning 1/2 a bid/ask spread and then paying BCnE.

David Coughlin said...

 "... as long as I am so fast ..."

Speaking of speed, I am baffled by the number of ads I see for low-latency software developers.

There doesn't look to me to be enough architectural wiggle room to justify the proliferation of HFT operators [and competing with someone doing exactly the same thing as you seems like an instant loser in this thin-margin game].  Maybe they are specializing in specific market arbitrage.  Do you have an opinion on the where the winner line is drawn in the population of HFT operators?

Seth said...

Some interesting academic research on the question from Terry Hendershott:
http://faculty.haas.berkeley.edu/hender/Algo.pdf

His take seems to be that the HFT (or AT as he calls it in the paper) are the "new market makers".  As the world of NYSE floor specialists fades into the twilight and computer-managed auctions and liquidity provision take over, we've got a bunch of interesting problems of governance to work out.  

One of the things I appreciate about Doyne Farmer's work on financial theory is his meticulous study of the double-auction order book (eg. http://tuvalu.santafe.edu/~jdf/papers/RandomOrderPlacement.pdf)  The way trades get negotiated defines the structure of the market, and the word 'structure' here should have certain other resonances (eg http://nobelprize.org/nobel_prizes/economics/laureates/2001/spence-lecture.pdf).  

Economics as a discipline needs to pay more heed to the 'boundary conditions' on their lovely equilibria -- and the rules under which transactions are negotiated are among the boundary conditions.

Seth said...

Sorry, just noticed that there was a peculiar redirect preceding the link I provided to Doyne Farmer's paper(s).  This link should work better:www.santafe.edu/~jdf/papers/doubleauctionfinal.pdf.  Anyone interested in the subject who doesn't already know Farmer's work, should just browse that directory and learn :)   

LondonYoung said...

Most shops think they need to be "flow-monsters", so they do mkt mkg even if they lose money.  To limit the flow of their losses they are trying to hire low latency guys.  At the moment, i think the street loses money in this space, net-net, to the cayman funds.  Once Dodd-Frank rolls out, mkt mkg will no longer be conducted by US regulated entities, and the shadow banking system will become more shadowy...  

MtMoru said...

The UK has a tax on stock trades. I've paid it. Approved market makers are excepted. Doesn't this exclude "high freaks" who aren't approved?

How hard can it be to nullify shares whose owner didn't pay the tax through his broker? No tax means no dividends no resale.

Cayman, unapproved, market makers can be excluded easily.

LondonYoung said...

What about synthetic total return swaps that are executed between two cayman entities?  N
Note also that companies are now starting to noodle about never even listing on regulated exchanges.
Unless you are willing to implement capital controls, these things can be arbed.
However, I do suspect capital controls may be on their way if a solution to the PIIIGS problem is not found ...

David Coughlin said...

There is a deep [for me] question here about emergent structures in markets.  If you'll give me a day, I'll try to formulate it.

KenC said...

I do have a “huge” question LY that has indeed concerned me for a decade or so. Granted this is a political question on a physics board- but never the less I do believe it ties into many ideas discussed in this forum.

 Do you think the US-with it’s currently paralytic, calcified, and dysfunctional government  could ever again be capable of achieving anything great on a national scale?

I refer to the Interstate Highway System, the Apollo space program, nuclear weapons and or power, large scale river damming for irrigation and electrical power, the internet, and GPS systems--for starters.

Or are ‘we’ done in that capacity? And are the only governmental entity’s powerful enough these days ones that have a centralized, insular, powerful command center.  I am thinking of China in this case (imagine that) as they have for now kept the interfering rabble of the masses- for the most part- from “fouling up” those plans. Can that continue?

I refer to the Three Gorges Dam, the proposed many nuclear power plants-which will likely be built even if there is to be a delay due to Japans current woes- and so forth. It seems to me China is on its inexorable path towards wherever it may be going (economic global domination), and little will be able to slow it down on its path towards its goal.

 BTW I don’t view that (assuming its veracity) as necessarily a bad thing--but just a evolutionarily eventuality.

David Coughlin said...

OK, I can't really formulate it.  There is too many things going on here.  A synthetic return swap sounds specifically like collusion.  Might call it, alternately, a limited merger with expiring equity.  The fact that the businesses are in the Caymans is a dark mystery to me.  And when it is all said and done, I don't know how much I care about what people are doing in a secondary market [the market for used businesses], except in that it subtracts capital available for new businesses [and as a side effect affects our social rules, which is another long think that I probably don't have time for].

LondonYoung said...

KenC - Five days late, but better late than never -
IMHO, what we are really discussing here is "US exceptionalism" - something our current president has confessed he doesn't believe in, except to liken us to Greece.  Americans have never accounted for some huge fraction of the world's people nor a huge fraction of its resources.  Yet Americans built the Empire State Building, conducted the Trinity nuclear test, invented the transistor, put a man on the moon - etc ...  But did these accomplishments fall into some narrow time window, say post WWI-1970?  Mebbe.  It sure seems that we have switched from using our resources for public works to using them for personal entitlements.  While the country is still very rich for all those old "immigrant" based reasons, I only see a growing majority of voters lobbying for personal government benefits to be delivered to them over the short term.  So, I suppose yes, I think the U.S. is done until/unless some enormous realigning event comes along to change everything.

In China, they are newly wealthy, and the poor haven't organized to milk the system yet.  I love to tell and re-tell Steve's joke about the major threat to China's new prosperity being a communist revolution.  And I remember the Chinese didn't find it funny ...

high frequency trading said...

High frequency trading is a program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions.

Stock Tips said...

An extremely interesting read, I may possibly not agree completely, but you do make some very valid points.

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