Wednesday, May 26, 2010

BW: The Machines that Ate the Market

BusinessWeek has a nice in depth (and balanced) story on high frequency trading that intertwines the history of 'the machines' and how we got here from "there" (there being 15 years ago), with the events of May 6th. Perhaps a Cliff Notes version of Scott Patterson's book on HAL9000. [Feb 12, 2010: [Video] Scott Patterson Tells Us the History of HAL9000 in "The Quants"]

A good read if you have the time - follow link here.
  • Once upon a time, human beings oversaw the trading of stocks. They've been replaced by a complex system of computers that can produce a scary new kind of mechanized panic. An investigation into the crash of May 6th.
  • Clarence Woods was attending a community college near Baltimore in 1982 and playing drums in a wedding band when one day, to his surprise, the financial world beckoned. "They were so desperate for anyone who knew anything about computers," Woods recalls. "If you could spell the word, you had the job." He swiftly moved from the back office at the brokerage Legg Mason (LM) to Equitable Bank, where he installed Quotron stock price machines.
  • On May 6, Woods, now 47, realized how radically his industry has changed. He had just started his own hedge fund after quitting as chief equity trader at MTB Investment Advisors, a $13 billion money manager in Baltimore. He was working at home when the trouble hit.
  • His first thought was that cyber-savvy extremists had infiltrated the fiber-optic network on which automated programs now trade securities tens of thousands of times a second. With no terrorism reports surfacing, Woods shifted his suspicion to the nature of the contemporary market itself: hyper-accelerated, decentralized, and, in important ways, beyond human supervision.
  • "Wall Street is no longer what it was designed to be," Mark Cuban, the tech entrepreneur, veteran investor, and owner of the Dallas Mavericks basketball team, blogged after watching the frantic selloff. "Wall Street is now a huge mathematical game of chess where individual companies are just pawns." (that quote could have been ripped from these blog pages 2-3 years ago)
  • A Bloomberg Businessweek investigation into those harrowing minutes revealed the extent to which the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries. Instead, these former mathematicians and computer scientists see securities as a cascade of abstract data. They direct their mainframes to sift the information flows for minute discrepancies, such as when futures contracts fall out of sync with related underlying stocks. High-frequency traders (HFTs), as they're known, set an astonishing pace. On May 6, 19 billion shares were bought and sold; as recently as 1998, 3 billion shares constituted a very busy day.
  • The HFT wizards argue that all that extra buying and selling provide the liquidity that makes the market more efficient. As long as the machines are humming, electronic bids and offers abound. On May 6, however, we saw what happens when digital networks follow conflicting protocols and some of the mighty computers temporarily power down. Liquidity evaporates. Panic combined with automation leads to much faster panic.
  • As Mary L. Schapiro, chairman of the Securities & Exchange Commission, put it in congressional testimony five days later, some high-frequency firms "withdrew their liquidity after prices declined rapidly."
  • In Washington, the staff at the SEC began reviewing up to 10 terabytes of market data to figure out what happened. Twelve days later, on May 18, the agency conceded that it still couldn't offer a firm answer. That uncertainty in itself suggests the disquieting complexity the stock market now presents.
  • "The world has totally changed in the last 15 years," says Fred Federspiel, who started Pipeline Trading Systems in 2004. Pipeline, based in New York, belongs to yet another new breed: "dark pools" that allow major trades to take place out of public view. Before getting into finance, Federspiel, who holds a doctorate in nuclear physics, worked at Los Alamos National Laboratory in New Mexico, using particle accelerators to determine if subatomic neutrinos help hold the galaxy together. Trading models built by people with this sort of training tend to be based on a view of the market that is data-driven and news-agnostic.

Another topic not breached often in these discussions is the societal harm of the transfer of mind share of the brightest people from hard sciences / industry to instead building a better mouse trap of moving electronic 'paper' around in milliseconds. Obviously brainpower will go where it is best rewarded (most cases financially) so it makes sense from an economic viewpoint... but what is left behind for the betterment of society from these electron transactions in 20, 40, 60 years (i.e. nothing) versus what could be created if these same high end brains were actually inventing new industries for countless Americans to work in?

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