Tuesday, July 30, 2013

HFT and the Flash Crash

Boyle and McDougall’s hedge fund doesn’t do high frequency trades, so to find out more I meet Simon Jones, who was running the quants desk at a major bank up until a few months ago. He is 36 years old.

“The guys and women who worked with me were the best of the best. They came from all over the world: from India, Russia and China.” The job was intense and highly competitive. “Let’s say I have noticed that the moment the Dow goes up the FTSE goes up,” says Jones. “The first person to notice that and make a trade can make money but to do that means getting the data from New York to London and then getting my trading decision across the Atlantic and me buying my FTSE before anyone else does.”

In this game speed is critical and that has led to what has been dubbed an arms race between firms. It has got to a point where firms have actually started moving their servers nearer to an exchange to speed up connection times.

In 2010, a company called Spread Networks laid a new direct cable between New York and Chicago, going straight through the Allegheny mountains, which shaved a little bit more than 1,000th of a second off the transmission time between stock exchanges.

For the opportunity to use a similarly fast tube between New York and London, Jones’s old bank was asked to pay $50 million. “It would have given us an advantage over others of about a six thousandths of one second,” says Jones.

This focus on the shortest of short-term gains has vastly increased volatility. “Warren Buffett owns shares in Coca-Cola and when they go down he says 'I’m holding on to them because I think they will go back up’,” says Jones. “But the HFT guy, all he cares about is the next millisecond. And when too many people start panicking about the next millisecond that’s when you have a crash.”

The perfect example of such a crash took place on May 6 2010. So many shares were traded that day that the online trading section of the New York Stock Exchange temporarily froze and between 2.30pm and 3pm the Dow Jones lost and then regained nearly $1 trillion. In what became known as the “Flash Crash”, shares in the management consultancy firm Accenture plummeted to a fraction above zero . Apple shares went up to $100,000.

“None of us knew what to do or what would happen next,” says Dave Lauer, a quant who was working on a HFT desk that day. “It was terrifying.”

For Lauer, the Flash Crash was a wake-up call. “I started to see how the race to be fastest had left things in a very fragile state,” he tells me. The following year his wife revealed she was pregnant which prompted him to make a big decision. “I remember thinking, 'How will I explain to my future child what I do for a living?’” Lauer quit his job and last year told the Senate Banking committee that High Frequency Trading had brought the market to crisis point.

The Flash Crash was partly caused by the HFT strategy of “spoofing”; making bogus offers to buy or sell shares to flush out the intentions of rivals. On the day, an astonishing 19.4 billion shares were traded, more than were traded in the entirety of the Sixties, but hundreds of millions of them were never actually sold; they were merely held for a few thousandths of a second as traders tested the waters.

Isn’t there something wrong with a system that promotes so much volatility to the benefit of no one except a handful of hedge funds? Can it be a meaningful investment of time and technology? Warren Buffett’s business partner, Charlie Munger, has described High Frequency Trading as “basically evil”. “I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short-term people trying to get information one millionth of a nanosecond ahead of somebody else,” he said earlier this year. “It’s legalised front-running.” HFT is certainly of no clear benefit to everyday investors - savers in pension funds and life policies.

The quants I meet don’t believe what they do is necessarily dangerous but they do voice some doubts.

“Some of the guys who come from pure science and maths backgrounds are used to solving a problem and it works,” Patrick Boyle says. “They think they can find a formula that will perfectly describe how the market moves. That is the philosopher’s stone – it is utterly impossible.”

[via ScaleNet]

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