high frequency trading

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Have Financial Markets Gone Post-Human?

So, Thomson-Reuters pays the University of Michigan a million dollars a year to provide selected clients with the results of the latest survey of consumer sentiment 5 minutes before the rest of the world sees them — and to provide higher-paying clients with this information in a machine-readable format ready for algorithmic trading 2 seconds before the rest.

This was not first revealed by the issuers of the consumer confidence survey, or by Thomson-Reuters, but rather by Nanex:

On May 28, 2013, about 1/4 second before the expected release of the Consumer Confidence number, trading exploded in SPY, the e Mini and hundreds of other stocks. Even more interesting, activity exploded just 1 millisecond earlier in the futures (traded in Chicago) than stocks (traded in NYC). The speed of light separates information between Chicago and NYC by at least 4 or 5 milliseconds. Which means this was more likely the result of a timed trading in both futures and stocks, rather than a arbitrage reaction between the two.

We found no other instances of early trading in the 11 previous monthly releases of the same Consumer Confidence data.

Nanex’s data:

screen shot 2013-05-28 at 1.55.25 pm

So, is having a two second jump on the market “insider trading”? Well, yes — but it’s legal insider trading with consent, out in the open. And it likely provides a valuable income stream for the University of Michigan. With or without an early information premium, the algorithmic traders would still have the jump on the wider market. A two second delay in the high-frequency world is an eternity. This kind of early information premium is more like a financial tax on high-frequency traders. If we’re going to have high-frequency trading at all, it may be better for publicly-funded information providers to be able to recoup some or all of their costs by charging the high-frequency traders. In fact, while high-frequency trading continues states might want to look at rolling this out across other datasets, and putting the proceeds toward infrastructure spending or some other public good. After all, while banning high-frequency trading makes for attractive rhetoric, it would probably send an even greater amount of financial activity offshore into a jurisdiction that allowed it. That implies that it would probably be about as effective as prohibiting marijuana and alcohol.

And is this financial markets going post-human? These kinds of barriers to entry cannot be healthy for inclusive, open, transparent markets. If there was anything that might drive retail investors out of the markets — retail investors remain significantly under-invested on where they were before the advent of high-frequency trading, for example — it is massive information asymmetries that render the little guy entirely uncompetitive. Of course, retail investors can still be fundamental value investors, buying and holding. But trying to daytrade against the algorithms seems analogous to a human runner competing against a Ferrari. In fact, given the timeframes (microseconds, in some cases) this analogy is many orders of magnitude too small; it’s closer to a human runner competing against an Alcubierre warp drive. Not so much picking up nickels in front of a steamroller as picking up nickels in front of a Borg cube. If this continues, trading is going post-human.

But in the long run — given how badly traders tend to do against the market — perhaps driving daytraders out of daytrading where they tend to lose money against the market, and into holding diversified index funds is a cloud with a silver lining. Let the robots read the tape (i.e. use regression analyses) and do financial battle. Robots are fast, they don’t get bored or discouraged. Just as in other areas where human endeavour is threatened by robots, it is important to note that while robots can do many things, there are many spheres where humans still have a great advantage. Let humans act in the roles in which they have a natural advantage, and in which robots do not have any skill at all — abstract thought, creativity, social interaction. Robots are still largely confined to drudgery; the word itself is rooted in the Czech word for drudgery, after all. In finance, while robots may some day soon do the overwhelming majority of the trading, humans can still devise the trading strategy, still devise the marketing and sales strategies, and still devise the broader macro strategy.

So perhaps the beginning of the end for human traders is just the end of the beginning for global financial markets. Perhaps that is less of a death sentence, and more of a liberation, allowing talented human labour that in recent years has been channelled into unproductive and obscure projects in big finance to move into more productive domains.

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The High Frequency Trading Debate

A Senate panel is looking into the phenomenon of High Frequency Trading.

Here’s the infamous and hypnotic graphic from Nanex showing just how the practice has grown, showing quote volume by the hour every day since 2007 on various exchanges:

It is a relief that the issue is finally being discussed in wider venues, because we are witnessing a stunning exodus from markets as markets mutate into what we see above, a rampaging tempestuous casino of robotic arbitrageurs operating in millisecond timescales.

The conundrum is simple: how can any retail investor trust markets where billions of dollars of securities are bought and sold faster than they can click my mouse and open my browser, or pick up the phone to call their broker?

And the first day of hearings brought some thoughtful testimony.

The Washington Post notes:

David Lauer, who left his job at a high-frequency trading firm in Chicago last year, told a Senate panel that the ultra-fast trades that now dominate the stock market have contributed to frequent market disruptions and alienated retail investors.

“U.S. equity markets are in dire straits,” Lauer said in his written testimony.

One man who I think should be testifying in front of Congress is Charles Hugh Smith, who has made some very interesting recommendations on this topic:

Here are some common-sense rules for such a “new market”:

1. Every offer and bid will be left up for 15 minutes and cannot be withdrawn until 15 minutes has passed.

2. Every security–stock or option–must be held for a minimum of one hour.

3. Every trade must be placed by a human being.

4. No equivalent of the ES/E-Mini contract–the futures contract for the S&P 500 — will be allowed. The E-Mini contract is the favorite tool of the Federal Reserve’s proxies, the Plunge Protection Team and other offically sanctioned manipulators, as a relatively modest sum of money can buy a boatload of contracts that ramp up the market.

5. All bids, offers and trades will be transparently displayed in a form and media freely available to all traders with a standard PC and Internet connection.

6. Any violation of #3 will cause the trader and the firm he/she works for to be banned from trading on the exchange for life–one strike, you’re out.

However, I doubt that any of Smith’s suggestions will even be considered by Congress (let alone by the marketplace which seems likely to continue to gamble rampantly so long as they have a bailout line). Why? Money. Jack Reed, the Democratic Senator chairing the hearings, is funded almost solely by big banks and investment firms:

It seems more than probable that once again Congress will come down on the side of big finance, and leave retail investors out in the cold. Jack Reed opened a recent exchange on Bloomberg with these words:

Well I believe high frequency trading has provided benefits to the marketplace, to retail investors, etcetera.

Yet retail investors do not seem to agree about these supposed benefits.

Retail investors just keep pulling funds:

Reed failed to really answer this question posed by the host:

Senator, US equity markets are supposed to be a level playing field for all kinds of investors; big companies, small companies and even individuals. That said, how is it possible for an individual investor ever to compete with high frequency traders who buy and sell in milliseconds. Aren’t individuals always going to be second in line essentially to robots who can enter these orders faster than any human possibly can?

The reality is that unless regulators and markets can create an environment where individual investors can participate on a level playing field, they will look for alternative venues to put their money. It is in the market’s interest to create an environment where investors can invest on a level playing field. But I think the big banks are largely blinded by the quick and leverage-driven levitation provided by high frequency trading.

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The Real Testosterone Junkies

I especially enjoy reading things that I disagree with, and that challenge my own beliefs. Strong ideas are made stronger, and weak ideas dissolve in the spotlight of scrutiny. People who are unhappy to read criticisms of their own ideas are opening the floodgates to ignorance and dogmatism. Yet sometimes my own open-minded contrarianism leads me to something unbelievably shitty.

According to Noah Smith:

Zero Hedge is a financial news website. The writers all write under the pseudonym of “Tyler Durden”, Brad Pitt’s character from Fight Club. Each post comes with a little black and white icon of Brad Pitt’s head. On Zero Hedge you can read news, rumors, facts, figures, off-the-cuff analysis, and political screeds (usually anti-Obama, anti-government, and pro-hard money). On the sidebars, you can click on ads for online brokerages, gold collectibles, and The Economist.

The site is a big fat hoax. And if you read it for anything other than amusement, you’re almost certainly a big fat sucker.

That’s a bold claim! Why do I make this claim? Well, in one sense, all financial news is a hoax. Financial news, by definition, is public information — if you’ve read it, you can bet that thousands of other people have too. That means that if the market is anywhere close to being efficient, any information in any article you read will already have been incorporated into the price of financial assets. Reading or watching public information should not, in theory, give you any “alpha”.

If the writers of Zero Hedge really knew some information that could allow them to beat the market,why in God’s name would they tell it to you? If they had half a brain, they’d just keep the info to themselves, trade on it, and make a profit! Maybe then, after they had made their profit, they’d release the news to the public (and collect ad revenue), but by then the news would be worthless. Financial news sites, you should realize, are not in the business of giving you insider tips out of the goodness of their hearts.

As you might expect, it’s not hard to look back at Zero Hedge’s predictions and see that a large number of them are junk. For example, here’s a bunch of posts from 2009 predicting imminent hyperinflation. Hope you didn’t make any trades based on that bit of wisdom!

So how does Zero Hedge get away with this hoax? Barber & Odean (2001) give a big hint. Tyler Durden, whose name and image grace every Zero Hedge Post, is a symbol of masculinity. More specifically, he is a nerd’s imagined vision of what a really masculine nerd would be like. In Fight Club, Durden says: “All the ways you wish you could be, that’s me. I look like you wanna look, I fuck like you wanna fuck, I am smart, capable, and most importantly, I am free in all the ways that you are not.”

In other words, you are a young smart (i.e. nerdy) guy sitting at your computer with rivers of testosterone coursing through your veins. And now here comes Tyler Durden, your generation’s Platonic ideal of pure masculinity, telling you that Real Men Take Risks. At the top of the site, there is a Tyler Durden quote: “On a long enough timeline the survival rate for everyone drops to zero.” In other words, gamble. Bet that you’re the smart guy and not the sucker. Because hey, you’re going to die anyway, so there’s no use hedging your bets. Zero hedge, right?

I wouldn’t be surprised if “Tyler Durden” were actually a bunch of behavioral finance grad students, snickering behind their hands at everyone who takes their site seriously.

This is what passes for financial analysis today? Let’s ignore the obvious fact that Zero Hedge has never pretended to offer investment advice. We should take all financial news with a large grain of salt (anyone who has read the latest uber-bailout rumours out of Europe should know that). Anyone who bases their trading activity on blindly following the pronouncements of one site, or one trader deserves to lose their coat. Blindly following a messiah-figure or (even worse) the herd is a surefire recipe for disaster.

But Smith has got his facts wrong. While there has been no hyperinflation, those who traded their hunch and bought gold — pretty much the archetypal Zero Hedge trade — have not done badly. Here’s the price of gold — contrasted against the S&P500 — since Zero Hedge was born in January 2009:

Drawing a meaty profit and significantly outperforming the S&P500 is hardly what you’d expect from a “big fat hoax”. Certainly, you’d have made a loss, not a meaty profit, from betting with Bernanke’s pronouncement that subprime was “contained”.

Smith is spinning loose psychoanalysis spiced with conspiracy theories and schoolboy misunderstandings in order to generate pageviews. He obviously hasn’t read Zero Hedge enough to realise that “on a long enough timeline the survival rate for everyone drops to zero” reflects the reality that calamities and resets happen, and that — given the level of mess, corruption and perversity in finance today — a systemic reset could be just around the corner. And the last thing i would want to do in the face of a systemic reset — or any kind of large-scale financial calamity (a la 2008) — is gamble. The smart thing is to hunker down and robustify, by minimising exposures to all forms of connective risk and financial fragility . Zero Hedge is not about having no hedges and gambling as recklessly as possible; it is about having hedges against the system going to zero. 

Ironically, Smith is accusing entirely the wrong segment of the financial world of wild recklessness. While there are surely many day traders who lose their coats on the pronouncements of analysts (especially the Crameresque stock-picker — something which Zero Hedge has never done), the real danger is surely the testosterone-Red Bull-and-cocaine-fuelled TBTF trader or 21-year old PhD-wielding quant working for a bailed-out bank with an implicit taxpayer backstop on zero-interest government money. The level of moral and financial hazard is simply staggering, and of course this has bred much reckless behaviour; from the evident criminality of manipulating LIBOR, to Corzine’s destruction of MF Global (and theft of customer funds),  to the absurd market-cornering London Whale’s speculation using customer deposits, to the off-balance-sheet activities of Kweku Adoboli, to Goldman’s quote stuffing. And — I am sure, much much more — these are just some of the scams and scandals that are known; there is much more darkness beneath. Zero Hedge has been a powerful journalistic force and clearinghouse in bringing the light-of-day onto these corruptions and criminalities, something that Smith seems entirely ignorant of.

No day trader or goldbug stacking gold eagles has ever blown up the nation’s pension fund, but the protected TBTF banks funded by earth-shattering leverage and taxpayer guarantees have again and again endangered retirement funds, and lost their clients’ fortunes.

It is not unusual on Wall Street to see massively leveraged double or nothing Martingale trading strategies where traders take a position and push leverage and counter-leverage to create a favourable outcome. In theory — with unlimited funds — such an approach always wins, but in reality this approach usually ends in traders running out of counter-parties or running out of leverage, and ending up with a massive loss. It’s picking up nickels in front of a steamroller, and is of course made much easier thanks to the new and manipulable world of high-frequency trading.

It’s ironic (and jaw-dropping) that Smith castigates Zero Hedge as the home of testosterone junkie traders when in fact the vast majority of Zero Hedge writers and readers are angling for better regulation of high-frequency trading to prevent market manipulation, an end to nickels-in-front-of-steamrollers strategies (the best way is to end the taxpayer guarantees so that traders who blow up the system will reap the consequences), and the return of Glass Steagall (or similar) to keep depositors’ funds out of hyper-fragile shadow intermediation chains and the derivative casino.

The financial system is being regulated by clueless schmucks — many of whom would also castigate Zero Hedge as a “big fat hoax”, while ignoring grift and degeneracy within the financial establishment and the TBTF banks. In the face of such grotesque incompetence who can blame market participants for wanting a hedge against zero?

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Why Does Gold Keep Going Up & Up?

Gold, born only in dying moments in the hearts of stars, and blasted out across the universe in supernovae, just keeps going up & up & up, rising today to a meteoric peak of $1684.70:

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