Ted Kaufman - United States Senator for Delaware

Look Out Below: The Quants Control The Markets and May Cause Another Crash in Stock Prices

Source: Forbes

By Robert Lenzner

August 26, 2010

“WATCH OUT FOR THE QUANTS,” a column I wrote in February, 2008, warned that computer driven buy and sell orders were dangerously fragmenting the marketplace for stocks. Dan Mathisson, Credit Suisse head of advanced execution services, told me then; “More and more of the world’s trading is done by spraying dark orders across multiple destinations by using deliberately complicated patterns and algorithmic models that can’t be discovered or duplicated. No one knows who’s doing what to whom anymore.”

The market went into a death spiral over a 20 minute period in the early afternoon due to massive sell orders by professional traders that were a multiple at times hundreds or thousands of orders for each transaction executed. Some of the computers trying to deal with the massive data at peak times at least 3 million messages per second overwhelmed the available liquidity and caused several high frequency trading firms to shut down completely.

That’s 180 million messages every minute when the market is open. Or 900 million messages communicated to computers in the 5 minute period when the market had its most sickening collapse. Larry Tabb, founder of TABB Group, the expert research firm on quant activity, explains that “the machines had to sift through all this data to get the trades executed, and they just couldn’t keep up. The data was overwhelming, because it ranged from orders in stocks to options on stocks, indexes, and most problematic, the EWTFS that dealt in these stocks. This is the reason the drop in ETF prices was so sickening.”

Chaos ensued because no one could make sense of sellers trying to sell 100 shares by offering 1000 or 10,000. In the face of this avalanche of selling orders many “systems shut down automatically,” says “Drowning in Data,” a report by BMO Capital Markets in Montreal warns that this primitive method of trading stocks “has placed a growing stress on market systems that makes a crash more likely.”

No wonder that many old line investment advisers with billions of other peoples money under management believe that the ability to properly evaluate buy and sell decisions for clients has been smashed by the volatile movement of stock prices caused by computer driven trading strategies. How do you invest for the long run in the era when massive intraday buying and selling dominates the marketplace? Is quant dominance making the markets more dysfunctional?

Today, the quants, High Frequency Traders (HFTs) like Getco, Allston, Citadel and RGM, quant hedge funds like D.E Shaw and Renaissance, as well as the high tech trading desks at Credit Suisse, Goldman Sachs and others also dominate trading in options, futures, sovereign debt (US Treasuries) No doubt computer driven mathematical formulas will soon rule credit default swaps and other complicated derivative instruments.

Wall Street will never be the same. High Frequency Traders alone are responsible for 56% of stock trading volume according to Larry Tabb, founder of TABB Group, widely considered the research authority on computer trading. Tabb describes the quant role as a war of the robots, HFT robots against hedge fund robots. Sen. Edward KAUFMAN, Dem., Delaware, who is asking the SEC for major reforms, calls it a “micro arms race.” It is no longer the activity of Fidelity, T. Rowe Price or J.P Morgan that dominate the intraday market action. It is the HFTs buying and selling, buying and selling‹and trying to get flat‹ie no long positions by the markets close.

Regulation and oversight of the war of the robots has failed to keep pace with their suddenly vastly more dominant role.

Some HFTs have achieved an unequal technological superiority by paying exchanges to place their servers in a location close to the market to achieve price discovery earlier than competitors. Some exchanges practice “pay for play” by offering rebates on orders for competitive advantage.

Today more than 50 trading venues and 200 brokers can execute buy and sell orders internally without other parties knowing the details. In fact, there are 40 so-called “dark pools the largest being owned by Goldman Sachs and Credit Suisse that close off their bids and offerings to the HFTs so that these operators can’t detect price action on some 10% of all trading.

As Wall Street waits for the SEC to act, Sen. Edward KAUFMAN wrote SEC Chairman Mary Shapiro on August 5, warning that “several areas of current market structure lead me to be concerned about the performance of the markets for investors and companies seeking to raise capital. The proliferation of exchanges and other market centers has increased fragmentation., the substantial rise in volume executed internally by broker-dealers or in dark pools, excessive messaging traffic, the dissemination of proprietary market data catering to high frequency traders, and order-routing inducements all may be combining in ways that cast doubts on the depth of liquidity, stability, transparency and fairness of our equity markets.” KAUFMAN will not be in the Senate to fight for reform as he has only 90 days left in the Senate.

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