September 21, 2012

High Frequency Trading, or Not a Double Rainbow

Meet the new trading floor.

While we have been focusing a lot on the Presidential race around here recently - we too get caught up in the sheer volume of reportage of the campaign and equate that with importance - this is a story that is actually relevant to all of us on a daily basis.  All of us that interact with the financial system, that is.  So, unless you are living off-the-grind in a barter based commune in the woods, you might want to pay attention to something called high-frequency trading (hft), or algorithmic trading.

The animated gif below is a daily history of algorithmic trading activity from the past five years provided the analysis firm Nanex.  Take note of how crazy this plot gets starting in about 2010.  We first noticed that something was amiss when we saw articles in the NYT and Reuters back in August [The chart below originally came from this article, but it was taken down.  This article in Technology Review about high frequency trading (HFT) has it archived. -ed.] reporting that Knight Capital Group experienced nearly fatal losses when their high-frequency algorithms went wonky for 30 minutes.

We were reminded of the issues with high-frequency trading this morning when we heard this story on NPR's Morning Edition.  There is apparently some hand-wringing in the halls of Congress over the Knight Capital incident and the glitches that caused a delay in the Facebook IPO.  Like it's a double rainbow we have to ask ourselves about the data and the above chart, "what can it mean?"  If algorithmic trading is an innovation that gives the inventor an creative advantage, then that's what the whole capitalism game is all about.  That's true even if incompetent or unprepared firms make a hash of their algorithms and suffer self-harm, as in the case of Knight, or as presciently imagined by Kurt Vonnegut in his novel Hocus Pocus.  But, if this is little more than a way to game the system and sidestep the letter or intent of SEC regulations, then Congress should absolutely be doing its job to find out and prevent it.

We all know painfully well how the fallout from cavalier regard for risk and volatility on a systematic scale always comes around to bite "normal people".

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