Algorithm and blues
Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear
In 1987, Thomas Peterffy, an options trader with a background in software, sliced a cable feeding data to his Nasdaq terminal and hacked it into the back of a computer. The result was a fully automated algorithmic trading system, in which Peterffy’s software received quotes, analysed them and executed trades without any need for human intervention.
Not long after, a senior Nasdaq official dropped by at Peterffy’s office to meet what he assumed must be a large team of traders. The official was alarmed to be shown that the entire operation comprised a Nasdaq terminal sitting alongside a single, silent computer.
From such humble beginnings, computerised trading has become very big business. High-frequency trades take place on timescales measured in microseconds – for comparison, Usain Bolt’s reaction time in the Olympic 100m final was 165,000 microseconds.
There is a variety of motives for high-speed trading. Statistical arbitrageurs look for pricing patterns that seem anomalous, and bet that the anomaly will be short-lived. Algo-sniffers try to figure out when someone is in the process of placing a big order and leap in to profit. (Algo-sniffers are likely to fall prey to algo-sniffer-sniffers, and so on ad infinitum.)
Then there are quote-stuffers, which produce and immediately withdraw offers to trade, perhaps in the hope of provoking other algorithms, or perhaps with the explicit aim of gumming up trading networks and exploiting the confusion. And the algorithmic trading game is constantly evolving.
If this sounds unnerving to you, then you have something in common with Thomas Peterffy, now a billionaire on the back of his electronic brokerage firm. Peterffy told NPR’s Planet Money team that “whether you can shave three milliseconds off the execution of an order has absolutely no social value”. It’s hard to disagree. Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear, and must be set against the risks. Several recent financial “accidents”, including the May 2010 “flash crash” and the implosion of Knight Capital in August last year, attest to the hazards of high-speed trading.
But what is to be done? In a new paper, “Process, Responsibility and Myron’s Law”, the economist Paul Romer argues that we need to start paying attention to the dynamics of how new rules are developed. (“Myron’s Law” is that given enough time, any particular tax code will end up collecting zero revenue, as loopholes are discovered and exploited. Tax codes must therefore adapt. So must many other rules.)
Romer contrasts the box-ticking approach of the Occupational Safety and Health Administration – which has a detailed and somewhat contradictory rule, 1926.1052(c)(3), about the height of stair-rails – with the principles-based approach of the Federal Aviation Administration (FAA), which “simply” requires planes to be airworthy to the satisfaction of its inspectors. Romer argues that financial regulations now resemble the OHSA’s rule 1926.1052(c)(3) more closely than the FAA’s “airworthy” principle – and that this is a problem.
Peterffy’s experience is instructive: the Nasdaq official withdrew, consulted a rulebook and declared that the rules required trades to be entered via a keyboard. Peterffy’s team responded by building a robot typist, and he was allowed to continue. Box-tickers everywhere would be proud, and the actual merits of banning Peterffy did not need to trouble anyone.
The real question here is a question about process – about how new rules are developed, and who takes responsibility for the decisions made. Because as the algorithmic traders are demonstrating, even rules that work today will have to adapt tomorrow.
Also published at ft.com.
4 Comments
Mineracao de Dados says:
Hi Tim!
2nd of February, 2013As a student of HTF and Systemic Risk I don’t think that this algos helps more than hinder the economic ecossystem. This type of activity helps to spread the risk over all financial system; because, whether one algo have some “bug” (it’s absolutely “normal” in programs) it can cause a collapse in all economic system.
s jay says:
It’s stunning that Petterfly, who ran anti-socialism commercials during the recent presidential election campaign, and who made over a billion dollars from the free enterprise system, would invoke the red herring, non-sequitur socialist argument, “no social value”, in evaluating whether 3 milliseconds has any worth. That companies are fighting over 3 milliseconds is certain evidence that competition is driving the profitability of providing HFT to the absolute smallest it can be while still being profitable. It’s evidence that the system is working and that the overwhelming majority of the value being produced by the competitors is flowing to the retail investors. Retail investors are receiving almost all of the benefits of the wondrous technology that is providing them shares to buy or sell, at the touch of a button, anytime they wish, from anywhere they wish, at a cheap price. This is no different than the low prices provided by Target and Walmart, due in part to their excellent technology systems that control inventory, manage just in time delivery, reduce warehouse costs, etc. Because of competition, they have razor thin profit margins too, and that means that all the benefit of the cost savings flows through to the retail buyer. I save much more on the razor blades I buy at Target, relative to the alternative if Target didn’t exist, than Target makes in profit margin on a razor blade. This is business 101. Shame on Mr. Petterfly, who’s swung from penniless immigrant escaping a socialist regime, to entrepreneur, to successful business man, to “I’ve got my billion, now I’m going to apply the old socialist regime principles to those trying to do the same thing I did.” If you halt the competition amongst HFT providers because you think you know better than the free market how to allocate the costs of providing HFT, you will make all retail investors poorer. What’s the social value of that?
2nd of February, 2013ES says:
Well said s jay.
6th of February, 2013fod barnes says:
HFTs as a group must trade with others who are not HFTs for their activity to be economic for them. Hence the relevant question is actually what would happen if the HFTs were not there, or if HFTs did not buy bigger/faster computers or locate closer to the exchanges’ computers. If we are concerned about long term investors, then we need to know what would have happened to them absent HFTs. Would they have executed their trades with other, non-HFT traders? Or with other long term investors. If it would have been the former, then at what price? Better or worse prices than with the HFTs? If with the latter, then as a group the long term investors have avoided paying for these trader intermediaries. If HFTs were causing long term investors to do worse, by either getting a worse price from traders or reducing the times they execute trades with each other, we should be able to pick this up empirically in various measures of transaction “slippage”. However, the rise of HFT does not seem to coincide with any great change in these measures. See, for example, figure 2 in: http://www.oxera.com/Oxera/media/Oxera/downloads/Agenda/High-frequency-trading.pdf?ext=.pdf.
6th of February, 2013Good analysis of what is actually going on (especially in Europe) is surprisingly rare, so evidenced based policy is also unlikely. Which, given the importance of long term investments to the European economy, is not a good sign.