HFT and illiquidity – Part 4 (English Language)

The below article continues a series dedicated to High Frequency Trading (HFT) and program trading, from which I derive my trading edge. In previous articles I have briefly explained what HFT and Program Trading are. A few weeks ago I have started a new series focusing on market illiquidity produced by the ever increasing presence of HFT. HFT is really dangerous for markets’ health. Hereunder the list of articles published so far:

Recently I have introduced an new series titled: “HFT and illiquidity” (find here part 1, part 2 and part 3)  focusing specifically on the problem of illiquidity, tightly connected to market crashes, caused by the overwhelming presence of High Frequency Trading (HFT). In the last article of this series below I will briefly report on the social process known as normalization of deviance and how it affects market stability.

‘Some researchers propose the “Flash Crash” event in the US financial markets on 6 May 2010 is in fact an instance of a “normal failure”. Such failures have previously been identified in other complex engineered systems and are major system-level failures that become almost certain as the complexity and interconnectedness of the system increases. Previous examples of normal failures include the accident that crippled the Apollo 13 moon mission, the nuclear-power accidents at Three Mile Island and Chernobyl, and the losses of the two US space-shuttles, Challenger and Columbia.

Researches argue that major systemic failures in the financial markets, at a national or global scale, can be expected in the future, unless appropriate steps are taken. The key factor in this belief is the natural human tendency to engage in a process that is called “normalization of deviance”. How can we easily explain that? Let’s say that some deviant event occurs that was previously thought to be highly likely to lead to a disastrous failure. When this event presents itself and it then happens that actually no disaster occurs, there is a tendency to revise the agreed opinion on the danger posed by the deviant event, assuming that in fact it is normal: so the “deviance” becomes “normalized”.

The fact that no disaster has yet occurred is taken as evidence that no disaster is likely if the same circumstances occur again in future. This line of reasoning is wrong, but it is only broken when a disaster does occur, confirming the original assessment of the threat posed by the deviant event.

As a reaction to the “Flash Crash”, exchanges have tightened the circuit-breaker mechanisms. But these mechanisms in each of the world’s major trading hubs are not harmonized, exposing arbitrage opportunities for exploiting differences. Moreover, computer and telecommunications systems can still fail, or be sabotaged by those who oppose the system, and the systemic effects of those failures may not have been fully thought through.

The new circuit breakers that were introduced will probably help managing adverse events. But there are no guarantees that another event, just as unprecedented, just as severe, and just as fast (or faster) than the Flash Crash cannot happen in future. Normalization of deviance can be a very deep-running, pernicious process. Regulators are not trusted because they were not able to foresee and mitigate the causes of the sub-prime crisis and the next market failure may well have roots in other aspect of the system, maybe a failure of risky technology that, like the Flash Crash, has no clear precedent.

The dangers posed by normalization of deviance and normal failures are if anything heightened in the technology-enabled global financial markets and that is because the globally interconnected network of human and computer traders, or what is known in the academic literature as a socio-technical system-of-systems, i.e., an interconnected mesh of people and adaptive computer systems interacting with one another, where the global system is composed of constituent entities that are themselves entire independent systems, with no single overall management or coordination.

Such systems are so radically different from traditional engineered systems that there is very little established science or engineering teaching that allows us to understand how to manage and control such super-systems. Research thus far provides no direct evidence that high frequency computer based trading has increased volatility. But, in certain specific circumstances, self-reinforcing feedback loops within well-intentioned management and control processes can amplify internal risks and lead to undesired interactions and outcomes. These feedback loops can involve risk-management systems, and can be driven by changes in market volume or volatility, by market news, and by delays in distributing reference data. A second cause of market instability is social: normalisation of deviance, a process recognised as a major threat in the engineering of safety-critical systems such aeroplanes and spacecraft, can also affect the engineering of computer based trading systems.’

The above article appeared on my free Newsletter sent out on Sunday, December the 2nd  along with other information typically including: a weekly review for the Dollar Index, the Euro-Dollar cross, and the S&P500 index, other forex pairs, commodities futures (FibStalker View on Currencies) and stocks, articles on my trading method, market commentaries and HFT/Program Trading articles like the one you have just read. Please, register here to receive the free weekly newsletter.

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Filed under Articles, English language, Newsletter, Program Trading

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