Are Markets run by Human Need or Algorithmic Machines ?

Anand Kulkarni — Sat, 15 May 2010 04:24:00 GMT

I recntly watched an interview in Awe and Shock - at www.ft.com in Trading room Video section.It is an interview about growing trend of High Frequency Trading and its growing popularity for Market Making

in Asia and Europe.The interview is Tittled "May 11 :- Does speed Kill ? " - Hirender Misra from Algo Technologies , putting a fight in favour of High frequncy Trading..(.Naturally. )

Here is my take on this.Markets are meant fundementally for buying and selling , It naturally has to be driven by a genuine Need for the underlying that is being Traded.This Genuine needs stems from

Human Need for capital goods and services as much as his own desire to invest and grow his capital.A simple example is if a person who is in need of money in short term wants to sell his securities

he might get a buyer who takes a long term view on the security and is willing to buy the same at Market bid price.Here there is a fundemental and genuine need and they play their small part in The overalll market

price discovery .Now replace this scenario with a Market where most of Trading volume is coming from computer algorithms that are artificially creating huge volume of Buy-Sell simple based on some

algorithms which in turn take decision based on inputs given such as "General Market trend for the Day" , Possible Variance in the prices and Any particular news specific to the security and the Market itself.

These algorithms assign weight factors that eventually come up with a decision to buy/sell the stock based on current Trend.Note here that , No one is looking at fundementals of the security itself , I.e Its

PE Ratio , Price to book value , Dividend history etc etc.If Markets start ignoring fundementals altogether and their sole purpose of Trading becomes that small spread due to volitility then In the long

run we will destory the capability and the fundemental responsibility of Markets i.e providing a platform for price discovery.

High Frequency Trading is largely unethcial although it can not be proven in a court room.below are some key issues that proliferation of of Hig Frequency Trading will create.

Volume Distortion :-

It will distort volume of Trading done on particular security , Index or commodity.In a free Market increasing volume and decreasing volume on Trading indicates real deamand/supply mechanics from

Economic agents involved.It helps figure out any constraints of supply and the supply chain which can be fixed to provide a price stability.For Instance , If some one was trading Mango Futures

in India during summer using High Frequency Trading , It would artificially create more volume of Trading and mislead business to think that there is more demand for Mangoes.This will lead to rise

in Price of Mangoes and Eventually More capital will inflow into Mango Futures for speculation trading which otherwise would not have happened in a free market if only humans were allowed to

Trade.Imagine a Large portion of capital freed from a business undertaking getting diverted into Trading Mango Futures.More capital chasing speculation on Mangoes will drive the prices up

eventually.

Put in simple words We trade for a purpose and Genuine need.High Frequency Trading defies that.Mr Misra says We would be in dark ages with out technological innovation.I completely disagree

with that argument.1000 Years ago people traded Mangoes/Rice/Any commodity for their basic need of food and even today we do that.Some fundemental things in this world don;t change.

A general Level of increase in Volitility in Markets :-

High Frequency Trading will lead to a general level of jump in average volitility of Markets.Weather it is indivisual securities , Commodities or Indexes.This is because algorithms will push

Large volume orders , draw them back or cancell them in flash of seconds creating a Artificial demand/supply in Market that will induce behaviour changes in price.Add to that there

are companies working on Introducing a News Scanner coupled with High Frequency Algos.That will scan / read all news particular to a company and decide what is to be done.

All in a flash of seconds...Imagine a Huge sell order at the beginning of a Market that will drive the price down and same order can be broken into small demand/buy side pieces

to buy the security at lower prices later.

Effect on Market Jumps and Diffusion :-

Let us assume that we have a hypothetical Algorithm that combines news sacanning and Algorithmic techniques to Trade.In the middle of a Trading day on Apple shares.Let us

also assume that Apple is going to announce its quarterly results that day.The quarterly results beat expectations but there is a sudden news that the CEO of Apple has met an

accident and is Serious.Now what decision is Algo going to take ? What is it influenced by ? How much Weightage should it give to company making a profit Vs The accident

which ultimately should have very little affect on the security.If the Algorithm decides to push in a Hugh Margin order of sell , It could easily create a stampede on the stock

and finally turn into a rout on the stock.What if some hrs Later we come to know that the accident was not that serious and actually the CEO is doing good ? Can the algorithm

now do precisely the reverse to bring the price back to a fair level ? No it can;t The market participants would be scared to buy the security because of uncertainity.

Take a sample Example : - Yesterday a spanish newspaper announced that Sarkozy was planning to pull out of Euro.What route could this cause on FX markets if we

have an Algorithmic trading couple with News scanner ? Offcourse EUR is already getting battered.

Make a note that Most investment banks have quantitative models to predict and catch Jumps in Markets.They model it using "Jump diffusion Algorithms" ..This can

lead to a route in Markets as these algorithms will push huge sell orders to benefit from a Falling Market.

The epistemological question of How humans think and Make decisions is beyond the level of Modelling using computers or Statistical Algorithms.It simple is not possible.

And if we replace Genuine human action in Markets by computers it will spell a disater in the Long run.I think regulators should have a curb on High Frequency Trading

to a certain level of volume for Major Market participants.

Unfair game of Machines Vs Humans :

A High frequency Trading also requires DMA i.e a Direct market access via a client API.A normal Trader or investor from the public certainly does not have

access to this kind of facility.He either depends on a broker or does it himself.In either case there is simply no comarison at all.It is very much likely that this

will ultimately lead to a Fight of common Man Vs the Machine. I.e common Man Vs The Hedge funds / Wall ST / High net worth clients.This is simply

unacceptable.

Conclusion :-

High frequency Trading is largely unethical and can have devastating affects on Markets on a bad day if these algorithms go wrong.I am sure they

will.I am a computer programmer myself and i know.No matter how well you write your code there will always be bugs. Look at the latest

example of Misterious DOW collpase over 1000 points.This is just the beginning.The regulators should wake up and understand these

basic issues otherwise there is very strong possibility that people will loose belif in the markets on day.

anand312

Are Markets run by Human Need or Algorithmic Machines ?