The financial markets on automatic pilot

In a well-ordered economic system, financial markets provide a means for business enterprises to obtain financing and for investors to judge the worth of a business.

Flash Boys, the latest book by Michael Lewis, tells how far the financial markets have gotten away from that purpose.

His subject was high frequency trading, a method of skimming money from other peoples’ financial transactions.  Enormous expense and ingenuity has gone into perfecting high frequency trading.  But from the standpoint of social good, the only question is to what degree it is extremely dangerous, moderately harmful or  merely useless.

High frequency trading is done by computers, because human beings are too slow.  Computer trading accounts for about two-thirds of transactions on U.S. stock exchanges.  There is even a venture capital company that has a computer algorithm on its board of directors.

The science fiction writer Charles Stross wrote about futures in which artificial intelligences incorporate themselves in order to gain legal standing as persons, and in which computers and robots have created a fully functioning society while human beings die out or are sidelined.

I don’t expect this to happen, of course, but it is a good metaphor for what is going on.   Putting such a large part of the financial system on automatic pilot is reckless, especially in an economic recovery that is fragile to begin with.

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Click on Scalpers Inc. for a review of Flash Boys by John Lancaster in the London Review of Books.  Hat tip to Steve Badrich for the link.  I haven’t read the book myself.

High-speed computers put stock markets at risk

An estimated 60 percent or more of trading on world stock exchanges is done not by human beings, but by computers executing, in fractions of a second, orders based on complex algorithms that human traders do not fully understand.

There is a name for this: High Frequency Trading.   Andrew Haldane, executive director for financial stability at the Bank of England, said in a speech quoted by New Scientist magazine, that HFT threatens the stability of world financial markets.

High frequency trading algorithms can execute an order in just a few hundred microseconds, rapidly trading shares back and forth in order to quickly eke out profits from minor differences on the various exchanges.  These trades are so fast that the physical location of the computers executing them becomes vital – even being a few hundred kilometers away from the exchange could mean missing out. 

It’s commerce far removed from any ordinary experience, as Haldane illustrated with an every day example: “If supermarkets ran HFT programs, the average household could complete its shopping for a lifetime in under a second.”

Now it seems this lightning-fast trading could come at a cost.  Haldane blamed HFT for causing the “Flash Crash” which occurred on US markets last year, with the Dow Jones losing $1 trillion in just half an hour.  The event was marked by trading oddities such as management consulting firm Accenture shares falling from $40 to $0.01, while auction house Sotheby’s rose from $34 to $99,999.99 – the lowest and highest values permitted by HFT algorithms.

via One Per Cent.

The computers as such aren’t the problem.  The problem is profits per share in high-frequency trading are tiny, so that traders need to buy and sell huge volumes in order to make it worthwhile, and they need to act with lightning speed to get ahead of other traders.

High frequency trading has become so big a business that it overshadows what the financial markets are supposed to do, which is to allocate capital to companies with the greatest potential to produce good products and services.   Instead of looking for well-managed companies or entrepreneurs with good ideas, the high frequency traders devote all their ingenuity to beating the market—a self-defeating purpose, when they are the market.