By Guest Author
If there are any human traders still out there that happen to be reading
this, the UK Foresight project team has some news for you : don’t expect to be
trading for much longer. Here is what the report had to say: Read
Paper Here
“It is reasonable to speculate that the number of human traders involved
in the financial markets could fall dramatically over the next ten years. While
unlikely, it is not impossible that human traders will simply no longer
be required at all in some market roles. The simple fact is that we
humans are made from hardware that is just too bandwidth-limited, and too slow,
to compete with coming waves of computer technology.”
The UK Foresight project is a group of academics from over 20 countries who
decided to get together and study the effects of computer based trading. Lots of
familiar academics names appear in the report including the pro-HFT academic
crowd of Brogaard, Angel and Hendershott. And lots of the same old, tired
defenses of HFT appear in the report: no evidence that HFT increase volatility,
liquidity has improved and transaction costs have been lowered. No doubt this
report will be picked up by the HFT lobby and their friendly media contacts and
waved around telling people that all is well in the stock market.
But the report does raise some major concerns. Two of which
are feedback loops and market manipulation.
Six different types of feedback loops are identified: Risk, Volume,
Shallowness, News, Delay and Index loops. You can read more about these on page
14 of the report but the bottom line is that many HFT systems are very similar
and tend to react to each other when unexpected events occur. The report
says:
“The direct link between market outcomes and the fundamental events that
ought to act as anchors for valuation has been severed and replaced by a complex
web of iterated and nested beliefs.”
“A liquidity shock on one venue that might have gone unnoticed if there
was one large centralised exchange can now affect prices on that venue. In
normal times, the aberrant price would quickly disappear as cross-trading-venue
HFTs buy low and sell high. But in stressed times, the capital of HFTs may be
limited, or the HFTs themselves may start to doubt the prices (as happened
during the Flash Crash) and refrain from arbitraging. Real-money investors then
start to mistrust valuations across the board, and the resulting pressures mean
that HFTs no longer contribute to liquidity provision, which makes price
divergence across trading venues worse still. And so the shock is
transmitted through the network, and its effects are reinforced by positive
feedback. Trades and transactions will happen at socially inefficient
prices, and mark-to-market valuations can only be done to multiple and illiquid
marks. Understanding how to avoid such situations, and to contain them when they
do occur, is a topic for further research.”
They must be kidding? They just described how flash crashes happen and then
leave it by saying they need further research on how to contain them. We will
save you the trouble and all the hours of research with one simple word:
Fragmentation. Without fragmented markets and multiple liquidity pools, the
situation that is described above does not occur.
There is much more in the Foresight report but we just wanted to touch on one
more subject they brought up: market manipulation.
“Negative effects on efficiency can arise if HF traders pursue market
manipulation strategies. Strategies such as front running, quote
stuffing (placing and then immediately cancelling orders), and
layering (using hidden orders on one side and visible orders on the
other) can be used to manipulate prices. For example,
deterministic algorithmic trading such as VWAP (volume weighted average price)
strategies can be front-run by other algorithms programmed to recognise such
trading. Momentum ignition strategies, which essentially induce algorithms to
compete with other algorithms, can push prices away from fundamental
values.”
So, be gone human trader. You are no longer needed as now we have a system in
place which has the potential to crash at any time due to feedback loops and
where market manipulation “strategies” run rampant. And, luddite, don’t you dare
complain or raise objections because technology is always good and always
increases efficiency. Right?
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