The Lords of Liquidity and Systemic Risk
So what happened on May 6 at 2:45? It is a unique experience–a case of high frequency trading machines (agents) algorithmically self-organizing their selling activities. Those agents that give liquidity are also the agents that can take it away. What the regulators did not anticipate is that a source that collectively provides instantaneous liquidity can deprive the market from that liquidity, not by explicit conspiracy, but by self-organized adaptation of similar strategies to capitalize on observed market signals.
Technology Drives Investing
It used to be that investment capital drove technology forward; however, since the standardization of the state of an order using the Financial Information Exchange (FIX) in 1993, a new market opened up and has evolved in parallel to computers.
With the same curiosity and determination of nanotechnology exploring atomic control at a space scale of 100 billionth of a meter, the quants of the markets were eyeing the order book on the exchanges to orders of a millionth of a second on the micro-time scale. We should not be surprised if we approach “time-nano-trading” very soon. It is also possible that space nano-trading is approachable through sub-divisibility of shares. It is no longer the case that investing drives technology but that technology dictates trading strategies which, given their volume percentages of 60%, effectively determine liquidity.
High Frequency Trading and Regulation
Accommodating short-term traders and long-term investors in the same space and time is tricky given that the two activities are taking place at different time scales and affect each other significantly. These issues were discussed in the Reg NMS 2004 which, in essence, emphasized the 1934 position that “these issues can be handled by simply noting that it makes little sense to refer to someone as “investing” in a company for a few seconds, minutes, or hours.” And therefore, “when the interests of long-term investors and short-term traders conflict in this context, the Commission believes that its clear responsibility is to uphold the interests of long-term investors.”
There is no violation of any rules. While the herd “mentality” of machines may have the de facto privilege of providing liquidity bestowed by them upon the system, it is certainly not an obligation.
The problem with this system is grossly apparent. For example, should they take an unintended self-organized break by canceling orders and flashing others while the system, which has developed an addiction to their life line of liquidity, can choke its way down until the agents decide to resume supplying the fix and power themselves up again–not because they care about the system but because a buy position is triggered by the algorithms. Perhaps it is in this sense that the lords of liquidity have become a systemic risk.
Installing circuit breakers is one answer to this problem but will not be sufficient to hold sellers from selling after the resumption of trade; in fact, it may exasperate a little downturn into a panic.
There are two problems, not addressed by the SEC, at the price-microstructure level by which algorithms may occasionally control the price: one is the ability to post an order and withdraw it without cost and, simultaneously, the automated change in price based on order flow without an execution of an order at that price. The combination of both allows for the positive probability of algorithms “luring” the price down to any level and without executing any order!
Is high frequency trading a systemic risk?
Is high frequency trading by itself a systemic risk or is the erosion of the financial regulatory system itself a systemic risk?
High frequency trading is a natural evolution to algorithmic trading in an environment of competitive strategies, available technology, permitting regulation and generally acceptable economic morality. Agents in financial systems will always test the boundaries of the possible and look in every corner of the systemic architecture, functionalities, and regulation to see if they can gain an edge. I am puzzled by loud, surprised voices which often find comfort in invoking the adage of “the law of unintended consequences” which in reality should be termed “the law of systemic ignorance”. Regulators, who have a difficult job, must step up to the plate and identify the shortcomings of the system and propose long term solutions not quick tactical fixes.
The regulatory system, in dire need of reinvention, should be viewed as a critical component of the overall infrastructure system. Simultaneously and paradoxically we are whipping our technologies and innovations to proceed at an unprecedented speed in history to keep profits up while keeping our infrastructure systems to press forward at a snail’s pace. It seems that we unrealistically view infrastructure systems as part of the detested fixed cost of the business with self-propelling magical powers. This is exasperated by the tension between the political left and right as they ideologically view the role of government from their lenses. The sad reality may be that the problem is not in how much is spent on those infrastructure systems, but in the inability of legacy systems to capture the rapid evolution of systems they are supposed to serve or protect. The proof that this is the case is the inability of current systems to predict where the next problem may be; instead we are surprised that experts in the system, and the system at-large is more surprised than the public, by unfolding events.
We are faced with a dilemma: either we slow down the force of innovation and face relinquishing international leadership or pay more attention to the necessary but unattractive work of upgrading the entire infrastructure system.
The common factor between systemic risks is that by definition the given problem threatens the entire system, is bigger than any one component and must be handled by the systemic keeper of the gate.