‘Fear Index’ trading begins to scare the regulators
Robert Harris’ novel The Fear Index tells the cautionary tale of how algorithmic trading (where computers make split-second financial trading decisions based on a computer programme rather than human judgment calls) can have devastating impacts on the real economy. It’s fiction, of course…
But take a look at the fantastic animated graphic from Nanex (it works on my iPad but not on my PC but that could be user inadequacy) and the commentary from Reuters finance blogger Felix Salmon, who says:
“Back in 2007, I wasn’t a fan of a financial-transactions tax; today, I am. And this chart shows better than anything why my opinion has changed. The stock market is clearly more dangerous than it was in 2007, with much greater tail risk; meanwhile, in return for facing that danger, society as a whole has received precious little utility.”
What the graphic shows is that algorithmic High-Frequency Trading (HFT) by computers (only computers can trade fast enough to be HFT) are sending vast numbers of trades through the financial markets: far, far more than there ever used to be when mere humans had their hands on. Some of the effects are clear from the comments after Felix’s blog, such as human traders being squeezed out of the market which means that decisions about trades are no longer primarily being made on the basis of long-term investment strategies (you can design algorithms for that, of course – we almost all use them at least informally to guide our behaviour – but you don’t need computers to do it). Others are covered in Felix’s blog itself: such as the inability of ‘quants’ at Knight Capital recently to turn off their computers (honestly, just go read Robert’s book if this makes no sense!) which led to the company losing $400m in half an hour. And those who defend HFT on the basis that the more trades are made, the more accurate the price (part of the efficient markets hypothesis) need to beware that what they are seeing is a herd mind making a catastrophic error, rather than the wisdom of crowds.
What’s happening with HFT is that regulators in Europe, Australia and Hong Kong are looking at ways to ‘regulate’ such trading (and here, for once, the wildest-eyed deregulators are right – ‘regulate’ seems to be a metaphor for ‘abolish’!) Meanwhile, over at the Robin Hood Tax campaign, we’re advocating a market mechanism that would have the same effect: a tiny tax on financial transactions that would make the scariest risk-taking unprofitable. But one way or another, it seems that the rise of the machines may be about to come to an abrupt end. Without Arnold Schwarzenegger having to change sides.