High-frequency trading and the $440m mistake
Published: 11th Aug 2012 00:47:23
Computers and clever maths enable traders to buy and sell in the blink of an eye. But does high-frequency trading make matters worse when things go wrong?
A strange thing happened earlier this month. The New York Stock Exchange launched a new electronic trading platform.
A company called Knight Capital had created a new computer program to link up with the new platform in order to trade shares on it. The stock market opened, and Knight Capital prepared to launch its new software.
"There was some problem with the program," says Felix Salmon, finance blogger for Reuters in New York.
"We don't know exactly what. They switched it on and immediately they started losing literally $10 million [£6.4m] a minute. It looks like they were buying high and selling low many, many times per second, and losing 10 or 15 dollars each time. And this went on for 45 minutes. At the end of it all they wound up having lost $440 million [£281m]."
Oops. This was the latest chapter in the story of something called "high frequency trading". Investors have always valued being the first with the news. Nathan Rothschild, it is said, augmented his fortune after a carrier pigeon brought him the news that Napoleon had been defeated at Waterloo.
But high frequency trading is different. Algorithms - step-by-step mathematical procedures - generate automatic trades, conducted by computers, each one racing to be first. And while some computers do receive news about the outside world in electronic format, many high-frequency trading algorithms are simply responding to the hectic world of the electronic trading floor.
Humans still watch the systems, but the computers move far too quickly for us to react to everything they do - and at Knight Capital, the computer glitch meant the company was making trades it didn't intend to make. That's how to lose almost half a billion dollars in a little over half an hour.
To give you a sense of how fast high-frequency trading can be, in the time it takes Usain Bolt to react to the starting pistol, a high-frequency trading platform could complete about 165,000 separate trades.
Now this isn't quite as insane as it sounds. These computers, all competing with each other, are a lot cheaper and more efficient than human traders trying to match bids to buy and offers to sell. So within reason, automated, high-frequency trading is a good thing. But it's possible to have too much of a good thing.
On 6 May 2010, the UK was preoccupied with a General Election. But on the other side of the Atlantic, a very different story was unfolding.
"We were all sitting around in the middle of the afternoon on a relatively slow news day," says Salmon. "Suddenly the Dow Jones was down 600 points in a matter of five minutes. There was this huge crash for no reason. And then 10 minutes after that it went back up again. And no-one knew what had happened."
What may have happened was that somebody rather clumsily tried to make a very large trade on an electronic exchange called Globex. As the price dropped sharply in the process of trying to find willing buyers, the algorithms of the high-frequency traders plugged into Globex behaved unpredictably.
The "flash crash", as it was called, wasn't just what happened when the algorithms were in a frenzy - it was also what happened when humans pulled the plug on all of these individual algorithms.
"A whole bunch of high-frequency traders saw a bunch of weird stuff going on in the market which didn't make any sense," says Salmon.
Listen to More or Less on BBC Radio 4 and the World Service, or download the free podcast
"And they said 'you know what, we're all just going to hit our off buttons at the same time.'
"And what that did was it meant there was no liquidity in the market. There was no-one buying and selling. You had some crazy trades being done... stocks being sold for literally one penny."
What actually stopped the flash crash was absurdly simple. The exchange itself, Globex, shut down.
Donald Mackenzie, a sociologist at the University of Edinburgh who studies financial markets, says: "Globex has got a program built into it called the 'stop logic functionality.' And in this case it stopped the system trading for just five seconds.
"But that was enough time to halt the downward spiral. It gave human traders the chance to just take a quick glance at the rolling news feeds to discover that nothing catastrophic in the wider world seems to have happened, and to think 'well here, perhaps, is buying opportunity.'"
Mackenzie divides high-frequency trading into five categories.
First, there are algorithms designed not to lose money while executing a trade that's been placed by a human. If you try to buy a large block of shares all at once, for instance, you might find that there aren't enough potential sellers and you'll have to wait for others to show up.
Other computers may see that you've got this large unfilled order and exploit it, perhaps by snapping up shares and selling to you at a profit. To avoid this problem you can ask a computer to slice up your big trade into smaller, more subtle pieces.
Then there are algorithms designed simply to make money by finding buyers and sellers with a little margin between them.
Third, there are algorithms which find statistical relationships between different shares or bonds, and when the statistical relationship fails to hold - even for a moment - they jump in and make a bet that normal service will be resumed. These are called statistical arbitrage algorithms.
So far, so good - it would be hard to find many people in finance who would consider these three types of high-frequency trading to be immoral.
But there are two rather more predatory strategies. One is called algo-sniffing. Here, a super-fast computer tries to find other computers going about their everyday business of buying or selling shares, and figures out what they're going to do and when.
The algo-sniffer can then get ahead of the game and exploit the slower computer. And of course you could have algo-sniffer-sniffers and algo-sniffer-sniffer-sniffers in a high-frequency arms race. No wonder speed can be so important.
And finally, a particular sub-category of the algo-sniffer is the spoofer, which deliberately makes fake offers designed to lure other computers to show their hands, then cancels the offers. Spoofing might be illegal, or at least against the rules of stock exchanges, but it's hard to prove that it's going on.
Andrew Haldane, executive director for financial stability at the Bank of England, is increasingly interested in how high-frequency trading works - and what the future might hold.
"What we have out there now is this complex array of multiple mutating interacting machines, algorithms. It's constantly developing and travelling at ever higher velocities. And it's just difficult to know what will pop out next. And that's not an accident waiting to happen, that's an accident that has been happening with increasing frequency over the last few years.
"We shouldn't wait for the equivalent of the Space Shuttle disaster before remedying the situation. We already have enough light on the dashboard flashing red to want to do something differently."
He says he wants more powerful "circuit breakers" built into the system, designed to pause trading before colliding algorithms send it spinning out of control. He also suggests a sort of "non-transaction" tax to deter traders from clogging the system with trades they then cancel before executing.
But it's not obvious that such measures could successfully be applied to such a rapidly-evolving and global side of the financial system. In the meantime, we will have to wait and see what will "pop out next" - and we have to hope that, whatever it is, the system copes.
Additional reporting by Charlotte McDonald
At 03:49:53 in HeadlinesThe oldest former player with Major League Baseball, Conrado "Connie" Marrero, has died in at home in Havana at the age of 102.
At 03:28:13 in WorldIndians are voting in the sixth phase of a marathon general election in which the governing Congress party is fighting the main opposition BJP.
At 03:13:22 in ScotlandThe last avalanche forecast of the latest Sportscotland Avalanche Information Service (SAIS) season has been published.
At 03:06:05 in ScotlandWhen Nicola Sturgeon joined the SNP, pursuing a career in politics was not her agenda.
At 02:56:02 in ScotlandTwo major curling competitions are under way in Dumfries just a couple of months after Scottish competitors scooped medals at the Winter Olympics.
At 02:54:55 in ScotlandParts of a fast reactor control room at Dounreay in Caithness look set to be dismantled and rebuilt at the Science Museum in London.
At 02:47:22 in ScotlandA new service of flights between Edinburgh and Stavanger has begun operation, it has been announced.
At 02:45:05 in ScotlandMajor restrictions on traffic and parking are to be introduced in Glasgow during the summer Commonwealth Games.
At 02:45:05 in WorldThe number of people who have contracted the Ebola virus in Guinea, according to the World Health Organization, has risen to 208 - and 136 of them have died. About half of these cases have been confirmed in a laboratory - earlier cases were not tested.
At 02:42:42 in ScotlandScottish councils have too little power and are too distant from the communities they serve, according to a report.
Harvard CitationBBC News, 2012. High-frequency trading and the $440m mistake [Online] (Updated 11th Aug 2012)
Available at: http://www.ukwirednews.com/news/1445668/High-frequency-trading-and-the-440m-mistake [Accessed 24th Apr 2014]
News In Other Categories
Cult comic character Frank Sidebottom has inspired a film starring Michael Fassbender, while a documentary and biography are also in the works. Four years after his creator Chris Sievey died, why is Frank's legend growing and who was the man behind the mask?
The Irish education minister has proposed a radical shake-up of the further education sector.
Drones are becoming more common in our skies, performing a variety of tasks, from taking photos to monitoring crops and potentially even delivering broadband.
With the doors to its brand new £1million training centre officially open, one of the UK's leading apprentice training providers, Bristol based S&B Automotive Academy, is showcasing its world-class facilities by launching a series of foreign student exchanges for the first time in its 41-year history. To get a flavour of what life is like as an apprentice in the UK, the Academy hosted 16 apprentice engineers and bus drivers from the G9 Automotive College in Hamburg, Germany, as part of a Europe-wide vocational training initiative called the ‘Leonardo Programme’ with support from the European Social Fund. In a reciprocal arrangement, S&B will be sending nine apprentices to Germany during February 2012 so that they can get an appreciation of life in the automotive industry on the Continent. A further three German exchange groups are being planned for next year. Designed to assist the development of vocational skills and training across Europe, including work placements for trainees, the Leonardo Programme has a budget of €1.75bn, which is helping to encourage UK organisations to work with their counterparts abroad. In what is expected to be another challenging year for employers in the UK automotive sector, S&B’s Chief Executive, Jon Winter, claims that the exchange initiative will bring many benefits to the Academy and its apprentices: “In a world of global automotive brands, it’s important for our learners to understand the international context of the industry they have chosen to make their career. This new exchange programme will enable apprentices and Academy staff alike to achieve a better understanding of the challenges and opportunities within the automotive arena in Europe. With the Academy’s influence also extending to the USA and Asia, there’s every possibility that this initiative could move further afield in the future.” Continued Winter: “The need for skilled technicians across the world is on the increase and we actively encourage our apprentices to look at broader horizons during their training. Many of them have already learned the phrase ‘Vorsprung durch Gelehrtheit’, quite simply, ‘Advancement through learning.” In the 2010/11 academic year, S&B doubled the number of successful Apprenticeships over the previous year with some 350 apprentices graduating from the Academy. At the same time, achievement levels reached an all-time high with an overall success rate of 85%. For those learners on the Advanced Apprenticeship three-year programme, success rates were even higher, at over 98%. PHOTO CAPTION: As part of their exchange visit, S&B Automotive Academy arranged for the German apprentices to visit Hampshire bus operator, Bluestar, at its Barton Park depot. The students are pictured with S&B’s Andy West (3rd right) and Steve Prewett, Bluestar’s Area Engineering Manager (2nd right). Ends http://www.sandbaa.com
The last avalanche forecast of the latest Sportscotland Avalanche Information Service (SAIS) season has been published.
An independent Scotland would have to fund pension costs of an additional £450 per working-age adult each year, the UK government has claimed.