The recent high frequency trading disaster at Knight Capital brings home the danger of turning key decisions over to computers.
A recent report cites research by Prof Frank Zhang of Yale University and other experts showing that “High-Frequency Trading is positively correlated with stock price volatility and is
1. Stronger during periods of high market uncertainty;
2. Stronger among stocks with high institutional holdings; and
3. Stronger among the top 3,000 stocks in market capitalization.”
In other words, it is not only super fast it also targets exceptionally large sectors of the market. High speed and high volume combine to amplify swings in the market. That makes it particularly dangerous when its goes wrong, when glitches and bugs distort its “choices.”
According to critics, the problem is not just technological. It also distorts markets. By concentrating on small differences and anomalies in share prices, where such amplification can make huge profits, it diverts the attention of investors away from the prospects of long-term growth. If the social utility of markets is that they send money to where it will be useful in underwriting new products and services, HFT undercuts that justification in the service of short-term gains. Developing countries suffer as well as investors now don’t want to wait to get their returns.
But perhaps the most significant danger is that HFT is also amplifying the split between the wealthy and the rest of us. "This is where all the money is getting made," according to William H. Donaldson, former chairman and chief executive of the New York Stock Exchange. "If an individual investor doesn’t have the means to keep up, they're at a huge disadvantage." In effect, we have moved towards a two-tiered global financial marketplace consisting of the high-frequency arbitrage players garnering 'first class' travel access and privileges whilst everyone else has been relegated to 'economy class' status.” (See, “Could Speed-of-Light Trading Trigger The Next Systemic Crisis?”)
The report prepared by The Asymmetric Threats Contingency Alliance in London summarizes the problem: “Investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms. High-Frequency Traders have taken over the wheel in an uncertain period in which there is already too much fear and doubt about future economic prospects and exposure of wealth to the global financial markets.”
In the original story, Dr. Frankenstein’s creation ultimately was destroyed because he suffered from loneliness, an unintended consequence of the fact that his brain inhabited a human body. His basic human need for contact continued to drive his actions, but his approaches frightened the villagers who rose up against him. A story that better fits what happened at Knight Capital is “The Sorcerer’s Apprentice,” in which the apprentice figures out how to get a broom to do his chores but doesn’t know enough to get it to stop. He found a substitute to do his work, but lost control.
The bankers behind HFT also want to minimize human effort and maximize gain. They are not lazy, but they also have not yet figured out a way to shut downa their programs when they run amok.