Too Fast for Comfort: Trading Bots Have Unleveled the Playing Field

By Peter Bernstein September 16, 2013

If you get really stressed over things out of your control -- and I limit this to the intended and unintended consequences of the accelerating pace of innovation of communications and computing technology -- here is one to add to the list: trading bots used in high frequency transactions on global stock exchanges. 

If you are an active investor, you are likely aware that algorithmic and High-Frequency Trading (HFT) have contributed to real problems in stock markets around the world. Now accounting for more than 50 percent of U.S. equity trading, HFT’s and other exotic algorithmic capabilities have been fingered as culprits in flash market crashes.

They also have drawn regulatory scrutiny because they undermine the average investor trust that markets are level playing fields. This is especially true as it is clear that HFT trades are not based on fundamentals but basically are used to take advantage of minute -- and possibly millisecond -- arbitrage opportunities. Defenders say that is a good thing for their clients since HFT returns tend to be thousands of times higher in terms of risk/rewards returns than the tried and true method of buying great companies’ stocks and holding them. 

I relate all of this because of an article on by John Timmer, explaining that trading bots create extreme events faster than humans can react. He walks through how faster communications and computing have now made high-speed trading in essence unsafe at any speed but particularly at current ones.

Image courtesy Shutterstock
Timmer points to a new paper by Neil Johnson, Guannan Zhao, Eric Hunsader, Hong Qi, Nicholas Johnson, Jing Meng and Brian Tivnanin in Nature Scientific Reports, which uses an investigation of the stock market to demonstrate how, “far from simply generating faster versions of existing behavior, we show that this speed-up can generate a new behavioral regime as humans lose the ability to intervene in real time.” 

This is the stuff of science fiction movies where the machines are in control. To put it bluntly, this is also serious business to be taken seriously.

How Fast is Fast?

As the authors of the research note, “The strategic advantage to a financial company of having a faster system than its competitors is driving a billion-dollar technological arms race … For example, a new dedicated transatlantic cable18 is being built just to shave 5 milliseconds (5ms) off transatlantic communication times between U.S. and U.K. traders, while a new purpose-built chip iX-eCute is being launched, which prepares trades in 740 nanoseconds19 (One nanosecond is one billionth of a second). In stark contrast, for many areas of human activity, the quickest that someone can notice potential danger and physically react, is approximately 1 second26, 27 (1 s).”

The researchers looked at what they call “ultrafast extreme events (UEEs), looking at historical data from 2006 to the present. What they found were 18,520 crashes and spikes with durations less than 1500 ms. They define a crash or spike as an occurrence of the stock price ticking down (or up) at least ten times before ticking up (or down) and the price change exceeding 0.8 percent of the initial price, i.e. a fractional change of 0.008. In short, there were a lot of them. And, while certain curbs have been put in place which reduced HFT’s as a percentage of total equity trades, as noted above they still represent well north of 50 percent of all trades. There is also a certain irony here that trades involving financial institutions predominate.

What is most troubling about all of this, aside from what on its face is making equities trading even more of a “roll of the dice” than it used to be and giving those who use such tools what appears to be an unfair advantage, is the conclusion that the arms race has caused technology to push humans out of the equation for the most part. The caveat is that HFTs are based on humans making decisions about what strategies to employ. Traders being traders, they follow the herd. This makes a bad matter worse.

What the research also shows is that limiting the number of strategies means that volatility increases. Machines using the same strategies in essence feed on themselves. This is why anomalies that can last less than a second can have profound impacts that cause a halt in trading.

The authors of the research walk through all of their assumptions and how they arrived at their conclusions that faster trading and limited strategies is creating conditions for a big accident to happen, and there is little we can do about it. We seem destined for UEEs that bear no relationship even to company financial reports and have everything to do with taking advantage of trading opportunities where computers call the shots.

That said, the conclusion that resonates came from Timmer who says, “What's not at all clear is what triggers these UEEs, and whether changes in market regulations or trading strategies could eliminate them.” The point is well taken. In fact, it calls into question the advice financial advisors give people about making sure they are properly invested in equities in looking at their long-term financial objectives. When long-term is milliseconds and machines are in control, it should give all of us, including policy makers, pause as to what level of risk we as a society are willing to shoulder in the name of supposed technologic advancements.

Edited by Rory J. Thompson
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