Can Humans Wrest Control of Financial Markets Back From Computers?

Awesome news! Algorithmic trading systems have the digital equivalent of ADHD - presumably mimicking many of their inventors. JL

Gillian Tett comments in the Financial Times:

If the trading system is like the spaceship in ‘2001: A Space Odyssey’, it is Hal at the helm.The crucial point is that these automated trading programs — like Hal — lack human judgment. When a crisis erupts and prices churn, computers do not wait for common sense to return; instead they tend to accelerate trading, fuelling those flash crash swings.
Investors have had plenty of reasons to worry about oil prices this year. Now there is another: Timothy Massad, chairman of the US Commodity Futures Trading Commission, revealed on Wednesday that there have been 35 bizarre “flash crashes” in American oil markets this year.Yes, you read that right: according to CFTC researchers, on three dozen occasions prices for West Texas Intermediate crude have gyrated so dramatically that they have been defined as flash crashes. This means prices swung 200 basis points in less than an hour, before recovering at least 75 basis points.

Even if the definition is a little arbitrary, these swings are clearly becoming far more frequent — and not just in oil markets. Investors were shocked this year when a flash crash in US equities caused the price of some exchange traded funds to plummet for a brief period. Almost exactly a year ago, similar convulsions erupted in the Treasuries market.

However, the CFTC research shows the problem extends well beyond these eye-catching episodes: flash crashes are now affecting even hitherto dull commodities sectors, such as corn.
Why? Ask a banker, and they will be tempted to blame regulation. The argument is that reforms introduced after the 2008 crisis have made banks so risk averse that they are reluctant to act as market makers, standing ready to buy or sell when investors want to trade — which means liquidity vanishes in a crisis, making prices swing.

But Mr Massad points to another culprit: algorithms such as those used by high-frequency traders. This is the vital piece of the puzzle. In the past few years, use of automated computer programs has expanded so fast that the CFTC says they are now involved in 50 per cent of all trades for metals and energy futures, and 67 per cent of Treasury futures. If the markets were like the spaceship in the movie, 2001: A Space Odyssey, it would be Hal, the craft’s wilful computer, at the controls.

The crucial point is that these automated trading programs — like Hal — lack human judgment. When a crisis erupts and prices churn, computers do not simply “take a long coffee break”, as Mr Massad says, and wait for common sense to return; instead they tend to accelerate trading, fuelling those flash crash swings.

This not only creates a headache for mainstream investors; it also poses a political challenge for regulators, not least because figures such as Hillary Clinton, the Democratic presidential candidate, are increasingly focused on the issue. And the problem for policymakers is that curbing the phenomenon looks extremely hard.

In theory there are three broad paths they could take. First, they might try to switch off those automated computers or slow them down (say, by taxing trades or capping trading speeds). Second, they could encourage banks to resume their role as market makers. Or, third, they could accept that gyrations are inevitable and try to curb their impact — by imposing long trading breaks on the entire market, for example, or trying to spot when computers are about to go haywire.
In practice, the CFTC appears to be focused on the third path. Mr Massad revealed plans this week for his agency to scrutinise traders’ algorithms and curb those that seem likely to behave erratically when liquidity disappears. The agency also wants greater oversight of high-frequency traders and moves to reinforce circuit breakers that can halt trading in a crunch.

These measures are sensible but unlikely to stop flash crashes unless stronger measures are used too. The asset management industry is setting out objections to turning the computers off or slowing them in a way that would make it more costly for investors to trade in normal times.

And there is no desire among regulators to roll back the post-crisis reforms and encourage banks to take up market making once more. In any case, algorithmic trading has become so dominant in the past five years that, even in the unlikely event of regulatory change, it is far from clear that the banks themselves would wish to resume the market-making role.
So the CFTC and others are stuck. They can keep diligently counting those flash crashes. But they cannot truly prevent them.
The only silver (or gold, oil and cotton) lining is that, the more flash crashes occur, the greater the chance that mainstream investors will learn to shrug them off. And, of course, some ultra-canny financiers will get better at exploiting these periodic price swings — by keeping their human wits about them.