Are PCs to blame for the financial mess we're in?

How algorithmic trading has reshaped the stock market

There is little doubt that algorithmic trading isn't for the faint of heart - if your algorithm isn't up to date, or you have applied it the wrong way or to the wrong market, it's possible to lose a lot of money very quickly. Human error can quickly become very costly in the world of automated high frequency trading.

As the Bank of England's Andy Haldane pointed out: "In 2003, a US trading firm became insolvent in 16 seconds when an employee inadvertently turned an algorithm on. It took the company 47 minutes to realise it had gone bust."

This, of course, is an extreme example, but it does highlight that by putting themselves at one remove from the actual trading, dealers may quickly lose the understanding of what is going on in the markets, and even feel disconnected from the sums of money they are playing with.

Despite all this doom and gloom surrounding high frequency algorithmic trading, many people are embracing this type of new technology with open arms. After all, electronic trading isn't a new thing in the financial markets - the first electronic exchange (NASDAQ) is over 40 years old.

One such proponent of algorithmic trading is Brian R Brown, author of Chasing the Same Signals: How Black-box Trading Influences Stock Markets from Wall Street to Shanghai. Although he agrees that caution should always be used, he thinks the new technology should be viewed as a positive thing.

"Certainly there are mixed opinions on the financial crisis," he says, "but the overwhelming evidence of cause was bad lending practices and aggressive risk taking, which computerised trading cannot be blamed for.

"Having said that, the speed and pace of today's market, as a consequence of black box strategies, definitely have eroded the common person's perspective of the economy, and that needs to be addressed by regulators and the industry. In light of the Flash Crash, our industry needs a more granular view of market activity to better audit and regulate systematic risk; that is, we have historically audited large shareholders, but now we need to audit the high-frequency participants, who may not be in the league tables of shareholders, but certainly have an influence on the stability of share prices."

Forecasting models

But should we be laying the blame for the Flash Crash on computers? Could this form of trading ever have been possible before their existence?

"The usage of mathematical models for stock price forecasting has a history as long as the financial markets," explains Brown, "but the game changed with the advancements of technology that allowed strategies to be fully automated. The industry is very different than it was just five years ago, let alone a decade ago."

So does he see algorithmic trading as bad for the market? "There are mixed views on the impact of black-box strategies to the markets. Many strategies are widely viewed to have a stabilising effect on the market by buying out of favour stocks, or selling over-valued stocks, effectively dampening volatility. Having said that, evidence suggests that the 'tail' events are greater than ever, which is a consequence of today's complexity of our markets."

So would he put recent volatility in the market, such as the flash crash, at the door of computer-led trading? "Certainly the instances of rapid share price movements have been increasing in most global markets," explains Brown. "However, the post-mortem of the flash-crash indicated that human error was the root catalyst for the rapid impact in the S&P futures. What's most concerning is that an event in one market, ripples through to global markets, raising volatility to historical levels. We certainly have new types of 'systematic' risks that weren't in the markets a decade ago."

It's clear that Brown is aware of the risks, but he is still optimistic about the future: "Despite differing views, the recent advancements in trading technology have overwhelmingly improved market efficiency, reduced costs to investors, opened up market access and improved execution quality for investment managers. There is a teething process at times, but active investors should recognise the benefits. A retail investor in Chichester can now trade the Brazilian market just as easily as a professional institution."

Of course, computers play a much bigger role in the financial world than just high frequency trading. One person who is keen to lose the automation and bring people back into the finance markets while still using computers to do so is Jonathan Assia, CEO of Etoro.

Etoro is the world's largest investment network, with over 1.5 million users in over 130 countries.

Social trading

Etoro has been championing social trading, which lets every investor see, follow and copy the actions of other investors in real time. It is Etoro's mission to open the financial markets to every individual and make them accessible through a simple, transparent and more enjoyable way to trade currencies, commodities and indices online.

We contacted Assia to ask him whether social trading using computers has opened up the financial markets to people in a way that didn't exist before.

Johnathon assia

"At the heart of social trading is a large community of investors from all walks of life and from every region of the world. The rich diversity of people who invest their money creates the largest knowledge base of free investment advice that every one can instantly tap into. It lets people drill down into each traders profile and see their performance record, risk appetite and investment strategy.

"Furthermore, people can now apply social indicators to determine a trader's performance, which is reflected by the number of followers and the number of people actively copying the investment decision and actions of any given trader. Another indicator is the rate of responsiveness and the level of a trader's/investor's interaction with the community, and the circle of direct followers that provide further information about a trader's personality, performance and investment strategy. It's this collective wisdom, often described as the wisdom of crowds, that provides novices, trader and pros with valuable information to form a conscious investment decision."

Transparency for all

Assia is certain that this form of sharing trading expertise is the future, but he wonders how quickly this transparency will spread.

"The question is whether traditional financial institutions are ready to open their doors and grant users full transparency into their financial structure," he says. "Surely they would find themselves in a very challenging position as they are not ready yet for this type of information revolution that could disclose performance inconsistencies, resulting in unwanted questions. It would put them in competition with every consumer turned trader in a world where performance is the defining factor for consumers choosing their (indirect) money manager.

"Many financial markets are regulated to provide consumers with a sense of security to invest their funds. However, many of these regulations were enforced because financial institutions and financiers were finding ways to use information, not available to the general public, to generate tremendous profits for themselves and their organisations.

"But what if 'inside' information becomes available to everyone for free? Is it then still considered to be inside information? Social investment networks like Etoro provide free information and full transparency on every executed trade in their network. This valuable information is available to everyone instantly and easily.

"Furthermore, the ground-breaking difference in most cases is that consumers copying a specific trader know upfront that the trader is investing his or her own funds. Therefore, if they do well, every CopyTrader will do well. This interlinked trader-investor relationship is one of the most important trust building blocks that is currently not available in tradition financial channels - the majority of consumer funds are invested by fund managers and traders who are not known to the investor, and who themselves have often not invested with their own money, which constitutes a much looser trader-investor relationship."

Man vs machine

So what does Assia think about automatic trading compared to social trading? "Whenever we leave all decisions to automated computer systems then we shouldn't be surprised if at some point an unexpected event topples everything we have learned so far or were able to anticipate," he says.

"Recent events have proven again and again that financial stability is at risk when confronted with unexpected events. Technology, just like in every other industry, was invented to provide competitive advantages. Algorithmic trading is already very entrenched in the financial investment community, it surely has its advantages in certain (predictable) situations - faster execution, no emotions, macro trend identification, a high amount of data processing and more. However, the human factor has some additional features to offer that a computer can't match - sensibility, intuition, experience, courage, creativity and most of all the ability to assess complex situations by filtering out the noise and to focus on the bare essentials. All of these human attributes are inherently connected to social networks, and coupled with the 'wisdom of crowds', they provide a powerful information network to allow clever investment decisions.

"Furthermore," Assia adds, "algorithms are also a reflection of a programmer or inventor's investment personality, and as such they are imperfect by nature."

Risks of algorithms

Does Assia feel that algorithmic trading could be damaging to the financial markets? "Algorithmic trading can influence the markets if the financial institutions using them are carrying with every trade decision large amounts of funds.

"Many of the algorithms use similar base functions to execute upon current market conditions and influencing events, which could trigger an avalanche of trading activity that might lead to an unfavourable outcome.

"Leaving investment decisions in the hands of computer generated programs can be dangerous if the markets become unpredictable. In these situations human intelligence would supersede any artificial intelligence as it incorporates a lifetime of experiences and a macro-economic view of global events to help form decisions."

What about algorithmic trading that responds automatically to buzz words that appear in news feeds? "There is a risk that many of the algorithms would generate similar investment decisions as they all incorporate the same news data set," says Assia.

"Possibly the best solution would be to use a hybrid (human/computer) approach to make use of each entity's best traits. However, we should always consider human judgement superior because it incorporates intangible attributes that no computer program can duplicate."

Despite these worries about automatic trading, Assia still sees some crossover between his company's social trading and algorithmic trading:

"Social investment networks apply a people-based trading algorithm. Investors can create a portfolio consisting of traders with different asset classes, risk appetite and investment strategies. They can then decide to automatically copy every trade, but with the advantage of ultimately diversifying their investments by incorporating every human and technical parameter with every indirectly executed trade.

"It's a similar yet very different approach to algorithmic trading. However, at some point someone will come along and try to create an algorithm that effectively picks the right people instead of financial instruments to create the winning investment strategy."

Computers in charge

eToro

If automated financial technologies can be trusted, does Assia see a future where computers are in charge of entire economies?

"Orwell would say 'I told you so'. Leaving the economy at the mercy of computer programs is just irresponsible and dangerous. No computer can incorporate the human elements that have built economies. Intuition, experience, compassion, courage and humanity cannot be coded into a program and all of these attributes are at the heart of every functioning economy.

"How many times have decisions been made in favour of the people that a computergenerated decision would have ignored? Macro economy is on the opposite side of what the computer is all about. The idiom clearly states (to miss the forest for the trees) so what if you could crunch all the available market data but still miss the really important things that define us as human beings?"

Computer-free trading

What if we were to do away with computers completely, then? If we didn't have computers we wouldn't be able to deal in such mind-bendingly large numbers, preventing us from the boom and bust economies we so often see? Does Assia agree that computers have allowed us to hide from the size of the figures involved?

"Possibly not. The minute we have detached ourselves from the physical currency and moved to a virtual state of money exchange, the human touch is lost. This is possibly the most dangerous aspect because it triggers riskier investment decisions - often the traded volumes are much more than the regular consumer could comprehend, and it is in our human nature to lose the conscious connection to the tools of our daily trade. How do investment managers cope with the fact that they are risking billions of dollars? They simply rationalise it to stay sane. Using computers to make investment decisions further releases the acting trader from their responsibilities to apply their best human judgment to every investment decision they make.

"Without computers people would have to communicate more and the impact of their decisions would be felt. It would place them at the centre of every decision and it would be their name signing off on every executed trade. I'm convinced that if we would have to hand-carry suitcases filled with money or valuables to every trade we would make more careful investment decision and we would reduce the amount we are willing to put down for a specific trade."

Does this mean that computers have made us poor, or is it just that another bubble has burst? "The financial market might be the greatest bubble of all time, but instead of accepting the fact that there is something wrong at its base, we find ways to create more virtual liquidity in order to compensate for the underlying problem. The question is, when will virtual wealth outweigh the actual wealth of goods and what will trigger [a meltdown]?

"History is full of events that have wiped out virtual wealth and have returned humans to the real world, where goods are the actual currency," Assia explains. "An apple becomes the most expensive good when you are hungry and even a million dollars in virtual currency cannot pay for it. Humans have experienced these conditions in the aftermath of wars, where a collapsed economy regenerated itself based on real goods and a more reasonable approach to measure the value of knowledge, skill and physical labour.

"Computers have brought about an incomprehensible improvement in our productivity, and in the ability to let our imagination run wild and create tremendous achievements in every field. In most fields, computers have helped us to improve human value - whether in medicine, science or education - but when it comes to finance, computers have detached us from the reality of how much a buck is actually worth.

Computers are responsible for our debt, and for allowing us to take uncalculated risks with our hard earned income. It's time to let the human touch back into the financial world."

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First published in PC Plus Issue 312. Read PC Plus on PC, Mac and iPad

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