The below article, by Enrico Marro, was published on May 26th, 2013 on Il Sole 24 Ore, the major Italian Financial Newspaper. The article (which can be found here in its original format, in Italian language) discusses part of the content of the presentation I held on Friday May 24th at the Rimini IT Forum, the major Investing & Trading event in Italy.
Humans against Machines in the Markets: how trading robots amplify market collapses, creating systemic risk. Likewise in the 2010 Flash Crash.
“Humas vs machines, and even machines against machines. A huge Flash Crash happened on May 6th, 2010, when simultaneously with the other U.S. indexes the Dow Jones plummeted about one thousand points (over 9%) in a few minutes – traders and market operators staring – only to bounce vertically, recovering losses in a few minutes. But three years later, is also the recent Twitter flash crash, which took place on April 23rd, 2013: a pirate tweet from the Associated Press Twitter account with the phony news of two explosions at the White House, wounding the President Obama, causes a sudden loss of 1% for the Dow Jones, again recovered almost immediately with a “V” movement.
These are just two of the most resounding cases of the power of robots
The reason is in those High Frequency Trading (HFT) systems that have profoundly changed the structure of the market in recent years. Introducing new and unprecedented risks, as also underlined a rich series of Anglo-Saxon studies cited in the excellent Discussion Paper “High frequency trading. Features, effects, questions of policy” recently published by Consob. It’s not just about the risks related to the quality of the markets, but also about systemic risks.
According to the study by Consob, HFT systems can create the conditions for profound and rapid destabilization phenomena in one or more markets. To trigger such events it’s enough a problem to just one single algorithmic trader: e.g. an operational fault (such as a hardware failure) which, in turn, by influencing the strategies of other high frequency traders, may have repercussions on the entire market, and also affect other markets, given the intense cross market operations of market operators. An example: on August 1st 2012 Knight Capital, one of the largest operators on the US market, a HFT system has lost $440 million (equal to about four times the company’s net income) .
At the same time, the FIA EPTA (the Association of the main European traders) reiterated the importance for market participants to work with regulators to minimize the dangers to the stability of the markets (FIA at the time had published a paper with the recommended tests to be performed by trading firms when they change technology).
Faster and intense collapses
Unfortunately the spread of high-frequency trading can lead to amplifying the bearish pressures so much into generating situations of extreme chaos in market exchanges. As in the mentioned Flash Crash on May 6th, 2010, when the “robots” have amplified the fall of indexes, despite the fact HFT not being the triggering cause. A big sell order kicked off the dance. According to the reconstruction of events made by the Sec (Securities and Exchange Commission, american equivalent of Consob), sales orders generated by machines have subsequently triggered more sales of other “robots” by creating a “hot potato” (hot potato trading) whereby trade counter-parties were both HFT systems, that continued to sell. Thus amplifying the bearish spiral.
The instability brought by machines
That High Frequency Trading can be disruptive for the markets is convinced, among others Giuseppe Basile, computer engineer with 10 years of experience as an IT consultant around Europe and project manager at Accenture. Basile (who is also Technical Analyst and trader SIAT member) has devoted – at the recent ITForum of Rimini – a report to the impact of HFT systems on market price dynamics. «It is all about trades placed and removed very quickly, often hundreds or thousands of times a day” – explains – “with a high number of orders cancelled in comparison to filled orders, i.e. trades carried out”. To unleash the robots it does not take a lot: changes in volume or volatility, or market news, or delays in distribution of market data (prices, volumes, or other). «Some systems include listening components that skim the news headlines and immediately act on them, buying or selling on the basis of where prices are in relation to the “correct” estimated value», says Basile. And things in the future, are likely to worsen: “the next generation of programs will be adaptive and will learn from their experiences” — underscored – “and it will be hard to try to predict or control the dynamics of a market populated by a mix of human and algorithmic traders».
Liquidity becomes a ghost
A very common myth that circulates around in the trading environments is that HFT systems have at least a virtue, that is to make the markets more liquid. But it is indeed a myth, a legend that does not match operational reality. On the contrary, Consob explains – backed by Anglo-Saxon studies on the subject – that in specific conditions of market turbulence the HFT can absorb liquidity with major destabilizing effects for the markets. In the trading environment the offer (bid) by HFT systems is called ghost liquidity, to indicate a liquidity only “apparent” because it tends to disappear in the blink of an eye, often in very turbulent market conditions and then just when the traders most need it.
Also in Europe robots are everywhere
Particularly popular in overseas markets, HFT systems have become very popular even in the old continent. In most European countries the share of trading due to robots has grown steadily in recent years and currently fluctuates between about 10% and 40%. Piazza Affari (Milan Exchange) unfortunately is no exception. According to an AFM report, for the first five months of 2010, one order out of five in the Italian Stock Exchange comes from a machine, not a human being. But we are only at the beginning. The instability brought by robots on the market may increase, says Basile, with Flash Crash much worse than that in May 2010.”
Translated and published with the permission of Enrico Marro of Il Sole 24 Ore. © ALL RIGHTS RESERVED.