11.15.11

Quantitative Trading (II)

Posted in Blog at 12:45 pm by Andrew Clearfield

In the middle of a spirited online debate on the pros and cons of High-Frequency Trading, and whether those traders working exclusively from mathematical algorithms were aiding the cause of price discovery or causing causing unnecessary fear in markets, someone asked: “so why the excessive volatility[?]”  I could not resist responding.  The following is an expanded version of my comments:

We have excessive volatility because it is the interest of trading firms to encourage it, that’s why. And since all of today’s banks have huge trading operations, which generate a large share of their profits in good years, whenever they talk to clients or to the news media, they all encourage volatility. With low volatility, they would soon be out of a job. And before that, their bonuses would evaporate. Again, the question must be asked, is all this volatility helping or hurting the fundamental function of markets (which, contrary to widely held belief, is NOT to make a relatively few traders rich)? If the volatility is harmless—hey, why not? But if it is harmful, if it makes it more difficult for the economy to expand because economic producers cannot raise capital in the markets at fair prices, or savers are afraid to commit their money to economically productive enterprises because of the terrifying lurches in the market, then it should be curbed.

One can argue that the markets ought to be volatile due to the uncertainties of the present economic situation. But the present economic situation has been pretty static for quite a while: there is news flow, but no real change in the outlook, which remains somewhere between very sluggish growth and a modest (but discouraging) further contraction. What real news should induce investors to be 3% more optimistic one day, and 4% less optimistic the next?  The largest part of the market volume is algorithmically driven (HFT alone is  56% according to TABB, an association of quantitative traders, and this does not include the huge volume in other quant strategies involving ETFs and other non-economic market correlations); there are no fundamental convictions involved, nor any view of the markets lasting beyond tomorrow. So what useful function is all this volume serving aside from providing an income to traders? Worse, since many of these quant strategies are zero-sum games, there is no net gain to the economy.

Has anyone done any comprehensive studies of whether all these new forms of trading add to or subtract from the original function of markets? I haven’t seen one; academics just assume that liquidity equals efficiency. Nor have they ever conceded that markets can be hyper-efficient (i.e., over-react), which anyone who has ever been a portfolio manager knows to be a common phenomenon. And everyone loves to forget the great market crash of 1987, which presaged nothing, and where most of the liquidity was provided by computers trying to sell enough options to make up for the gaps down in share prices. (They never could catch up. If the market had been open another hour, it probably would have fallen another 20%.) This form of portfolio insurance is now remembered as a ‘success’ by its academic inventors, but it was a dismal failure for anyone who put any money into it.

One would know none of this from reading the public statements of senior bankers against restrictions on their proprietary trading or any other fundamental changes in the structure of our capital markets. In response to ex-Fed Chairman Volcker’s call for ring-fencing and reduction of these activities, the Administration has been waffling, while the bankers say, ‘Over our dead bodies.’  Many of these same bankers were members of the blue-ribbon Council on Jobs and Competitiveness which recently called for severe curbs on Sarbanes-Oxley’s auditing requirements, and which received President Obama’s unqualified endorsement; this despite the horrendous accounting scandals we have had which defrauded millions of investors of billions of dollars, and precipitated at least one major market decline, as well as making the Great Crash of 2008 possible.  How likely is reform of our markets when both major parties seem to share this Panglossian view that we have the best of all possible capital markets in this best of all possible financial worlds?

11.06.11

Against Quantitative Trading

Posted in Blog at 5:24 pm by Andrew Clearfield

  • I wrote this in response to a thread on LinkedIn, on which Mark Rome raised the question, “Is it Time for a Market That Prohibits High-Frequency Trading?”  regarding ETFs and all sorts of quantitative techniques, as well as HFT itself, on 5 November 2011:

I’m afraid that most of this discussion loses sight of the real issues. Liquidity is not an end in itself. Cheap execution is not an end in itself. And I’m afraid that huge bonuses are not the goal of capital markets, either, although they are wonderful to bring home for the trader him/herself. In fact, much of the money made from trading is merely a form of rent extraction, which means it is raising costs for everyone else, there is no net gain, and probably a net loss.

Capital markets exist to bring together natural lenders of money with those providers of goods and services who by their very nature have a constant need for capital. All the rest of our market activity is derivative of this basic function. Savers (investors) have long believed that they can get an excess return on their investments if they invest their money intelligently, and this has given birth to a huge industry in search of these excess returns. Unfortunately, not every technique works consistently, and none works over every time period, so there is a constant search for new techniques. It is in the interest of the general economy that markets allocate money to those investment opportunities which will lead to the greatest amount of net economic gain for their owners, and therefore the highest returns for investors. This is the real meaning of efficiency.

Quantitative techniques are a way of gaming the system so that one tries to get a positive return no matter what is going on in the real world of the economy, by looking at correlative market events having little or nothing to do with the general economy. They are at best, a sideshow to the main event. Unfortunately, because such gains are inherently minuscule (if they exist at all) on any one transaction, they must be multiplied by vast volumes of trading, or by using huge amounts of leverage, to make them worth anyone’s while. This often leads to excess volatility, especially at times when the market lacks clear direction. If there are hidden risks, which were not properly accounted for in the trader’s algorithm, they can cause enormous losses, and perhaps even start panics.

There are always going to be people who are looking for a way to get a free lunch, including those who believe, despite all the principles of science, that there is such a thing as a perpetual motion machine, that it is possible to turn lead into gold, that one can find a chemical or physical reaction which results in a net gain of both mass and energy with no entropy loss, and that it is possible to make money on the stock market without doing one’s homework, and finding something truly undervalued. Historically, in the grand scheme of things, such people were relatively harmless—perhaps they defrauded a few investors, but that was all. Unfortunately, with the vast amounts of leverage now commanded by some traders through the magic of derivatives, this quest for the the gimmick that gives one a free lunch can become very expensive indeed.

Portfolio insurance was a fraud, which directly led to the market crash of 1987. Long-Term Capital Management had run out of gimmicks, so they started gambling on naked risk arbitrages with huge leverage, and caused a market panic in 1997. Collateralized Debt Obligations were a fraud which caused the great credit crisis of 2007, multiplied by the leverage offered by CDS, which accelerated the crisis. All of these quantitative strategies were supposed to make markets more efficient; in the end, they all led them astray. I think that regulators need to stop giving all arguments for increased liquidity a free pass. There is such a thing as excess liquidity, and just as seawater sloshing back and forth on the deck of a Roll-On-Roll-Off auto ferry caused it to sink, excess liquidity careening back and forth within markets causes frightening volatility, scares off investors and borrowers alike and can cause crashes. It needs to be brought back within rational limits.