Program Trading: The Backlash

♠ Posted by Emmanuel in , at 9/18/2007 05:21:00 PM
It is estimated that between 40 to 60% of the trading volume at the New York Stock Exchange is now done via program trading. That is, trading strategies based on algorithms account for nearly a majority or a majority of trading volume. It makes you wonder about the folly of those who closely follow computer-generated stock market gyrations via Bubblevision (CNBC) and the like. Although these media outlets like to generate pseudo-excitement, there is not so much "trading" between humans. In the end, it's more like machines executing predetermined routines for a couple of hours. I never got much thrill watching a computer opponent go up against another computer opponent, so it surprises me that so many do.

Now, it seems that the makers of these machines are reconsidering their reliance on technology as "black box" schemes have gone awry in the wake of the subprime meltdown. Guess what? In times of trouble, maybe there's still room for human judgment after all. Fancy that--maybe it makes sense for people to actually buy and sell shares. Wonders never cease. From Reuters:
The proliferation of so-called algorithmic trading models has prompted many to ponder what role the traditional dealer will play in a future possibly dominated by turbo-charged computer programmes.

Financial and technology experts on Monday said they believe the growing use of "black box trading systems" -- computer models that execute large buy and sell orders in milliseconds and offer users relative anonymity -- will not be able to fully replace the human touch when it comes to managing money.

The current turmoil in financial markets has cast some doubt over the reliability of these high-tech applications as a variety of investors have been hit hard by tight funding conditions and volatility at multi-year highs.

"I'm pretty sure we will see in the area of say, more straight-forward plain vanilla, high liquidity products, less human action there," said Wolfgang Eholzer, head of trading systems design for Eurex, a derivatives exchange, at a financial services round-table discussion.

"There will be plenty of complex products, complex derivatives and pricing, which you don't want to hand over completely to a machine, where innovation is extremely important," he said.

Algorithms, complex mathematical formulas that comb through a vast number of possible trades and execute orders in a split second, are the lifeblood of the statistical arbitrage.

This sort of operation takes advantage of fleeting price differences between securities that usually trade in correlation.

Algorithmic trading, or "Algo-trading" for short, is changing the face of the dealing room. Increasingly banks are on the look-out for physicists, mathematicians and other numbers whizzes that can manage the black boxes.

But dealers are not facing extinction.

"There will be dealers because I don't think that every single person that wants to engage in financial markets will have a tiny little 'bot (robot) on their computer at home keeping an eye on their wealth," said Jon Serocold, a director of the London Investment Banking Association (LIBA).

Nevertheless, the number of human dealers is expected to drop as black box trading becomes more mainstream and the volume of trades handled through a stock exchange picks up.

Part of the rise of algo-trading comes from sweeping regulatory changes coming into force this year.

The introduction in November of Europe's Markets in Financial Instruments Directive (MiFID) will require banks to offer "best execution" on client orders but will allow them to compete head-to-head with exchanges in trading shares.

The new regulations have given rise to a number of new competitors including Project Turquoise, Chi-X and BOAT that can already bypass the exchanges as the European Union strives to create a single financial services market.

"We're clearly on the cusp of some very dramatic changes on the trading landscape," said Eli Lederman, managing director, electronic and agency trading at Morgan Stanley.

"The very definition of what a trader is is changing," he said.

The spike in market volatility stemming from the crisis in the U.S. housing market in August has prompted much soul-searching within the financial community as hedge funds and banks alike have reported losses linked to the credit crunch.

Some of this volatility was exacerbated by the use of black-boxes, Lederman said, adding: "Even in August when (black boxes) were in every headline, when things started to go bad, people noticed and people turned off the black boxes and people decided to turn them back on again, so it's not all as robotic as you might believe."