Knight Capital: Algo trading’s ‘millisecond battlefield’ risks extreme market behaviour

3rd August 2012

On Wednesday Knight Capital suffered trading losses of $440 million after what Chief Executive Tom Joyce called a "fairly major" flaw in new software the firm had installed the previous day. Yet much of the debate over the risks of High Frequency Trading (HFT) algorithms has focused on short-term losses rather than looking at longer term consequences for buy and hold investors.

Commenting on the trading error, the Asymmetric Threats Contingency Alliance (ATCA) 5000 said although the case of Knight Capital will increase investors' concerns over HFT models, the real damage wrought is that "[it] will only further serve to diminish trust in the stock market in general".

DK Matai, chairman of ATCA 5000, has been following the story for a number of years and has released serveral papers, including this one from 2010, on the subject warning of both the systemic and confidence risks that HFT poses.

"As far as markets are concerned events like Knight Capital are exacerbating collapsing confidence. People are increasingly feeling that the markets are stacked against them," Matai says. "It was fundamentally a penny hoovering operation, which is all about the speed of trades. In this type of environment trading has become a millisecond battlefield."

With competition focussed on the speed of trades, the aim of algorithm design has been to reduce the time it takes to place a buy or sell order to take advantage of small price anomalies. Such are the stakes that firms will often need a constant stream of new, faster algorithms to keep up to prevent another firm swooping in.

As a consequence testing these algorithms has to be done quickly and can be far from exhaustive. While a small flaw can often be identified before it causes any significant disruption, they can also cause market chaos as seen in May 2010 during the so-called "flash crash". The problem financial markets face is that these shock events are becoming ever more frequent.

Part of this reflects the fact that high-frequency trading has helped to bully many buy-and-hold investors out of the market. In part this is due to a lack of confidence in the liquidity supposedly provided by HFTs.

"Value investing is increasingly being made obsolete by the fact that markets are operating in very different ways. Retail investors have been abandoning the market in droves in recent years, and the volume of trades has thinned significantly as a consequence," Matai says.

Replacing retail investors with algorithmic trading poses a problem for financial firms. The price anomalies many of these trading strategies exist to exploit are caused in part by the innate irrationality of human participants. The more machines are forced to butt up against each other the narrower the margins are likely to become – and the greater the risk of extreme market behaviour.

The case for the defence is that these HFTs provide the basis for market liquidity. Without them, the argument goes, it would become significantly more difficult for people to trade in and out of their positions in a timely, efficient manner.

Felix Salmon, blogging editor for Reuters, is among those who have cast doubt on this logic in the wake of the Knight Capital crash. He writes:

"I frankly find it very hard to believe that all this trading is creating real value, as opposed to simply creating ever-larger tail risk. Bid-offer spreads are low, and there's a lot of liquidity available on a day-to-day basis, but it's very hard to put a dollar value on that liquidity."

One of the potential solutions proposed by Salmon is a financial-transaction tax that would have the effect of reducing the benefit of this quest for speed. His contention finds support from Matai, who says that these types of trades only provide the semblance of liquidity, which is therefore prone to evaporating.

"Unless a distinction is made between the people who buy and hold and those who trade multiple times in a given second then we will continue to see these types of events. One option is to put a tax on these penny-hoovering transactions but the lobby groups in America have been very vocal in resisting this."

If financial markets are supposed to be about the productive allocation of capital then investing should be prioritised ahead of HFT-type trading. It is only by going down this route that financial firms will be able to restore confidence among retail investors that they are participants and not victims.

 

More on Mindful Money:

The sins of high frequency trading

The rise of the machines

The Kay Review: How to change the City

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