Ban the bots

Anyone who thinks that the stock market is about finding fundamental value so that worthy companies can find they capital they need should read a recent article in the London Review Books.  It is another example of what I call “meta-money”, which is spreading like a virus (the $600 trillion of derivatives being the worst example). This meta money spells a deep threat to capitalism itself. We see this in the loss of a cost of capital evident in developed economies (chronically low interest rates to keep the system going) but that is only a symptom of a much deeper problem. If you are prepared to undermine money itself, then you will eventually have no system. The deification of “rational pricing” and “market forces” is going a long way to destroying the system and agreements on which both depend. The communists failed to defeat capitalism, but the uber capitalists are looking like they could pull it off.

The LRB article describes the problem. The first layer, which speeds up normal transactions, is designed to improve liquidity. That is arguably defensible. But then we get the first layer of meta-money:

No one in the markets contests the legitimacy of electronic market making or statistical arbitrage. Far more controversial are algorithms that effectively prey on other algorithms. Some algorithms, for example, can detect the electronic signature of a big VWAP, a process called ‘algo-sniffing’. This can earn its owner substantial sums: if the VWAP is programmed to buy a particular corporation’s shares, the algo-sniffing program will buy those shares faster than the VWAP, then sell them to it at a profit. Algo-sniffing often makes users of VWAPs and other execution algorithms furious: they condemn it as unfair, and there is a growing business in adding ‘anti-gaming’ features to execution algorithms to make it harder to detect and exploit them.

However, a New York broker I spoke to last October defended algo-sniffing:

I don’t look at it as in any way evil … I don’t think the guy who’s trying to hide the supply-demand imbalance [by using an execution algorithm] is any better a human being than the person trying to discover the true supply-demand. I don’t know why … someone who runs an algo-sniffing strategy is bad … he’s trying to discover the guy who has a million shares [to sell] and the price then should readjust to the fact that there’s a million shares to buy.

And then we get a second layer of meta money, on our way to an infinite regress:

Whatever view one takes on its ethics, algo-sniffing is indisputably legal. More dubious in that respect is a set of strategies that seek deliberately to fool other algorithms. An example is ‘layering’ or ‘spoofing’. A spoofer might, for instance, buy a block of shares and then issue a large number of buy orders for the same shares at prices just fractions below the current market price. Other algorithms and human traders would then see far more orders to buy the shares in question than orders to sell them, and be likely to conclude that their price was going to rise. They might then buy the shares themselves, causing the price to rise. When it did so, the spoofer would cancel its buy orders and sell the shares it held at a profit. It’s very hard to determine just how much of this kind of thing goes on, but it certainly happens. In October 2008, for example, the London Stock Exchange imposed a £35,000 penalty on a firm (its name has not been disclosed) for spoofing.

And then, surprise, surprise, we get an incident in which the system almost collapses:

What needs weighing against this, however, are the implications of one strange and disturbing episode that lasted a mere 20 minutes on the afternoon of 6 May 2010, beginning around 2.40 p.m. The overall prices of US shares, and of the index futures contracts that are bets on those prices, fell by about 6 per cent in around five minutes, a fall of almost unprecedented rapidity (it’s typical for broad market indices to change by a maximum of between 1 and 2 per cent in an entire day). Overall prices then recovered almost as quickly, but gigantic price fluctuations took place in some individual shares. Shares in the global consultancy Accenture, for example, had been trading at around $40.50, but dropped to a single cent. Sotheby’s, which had been trading at around $34, suddenly jumped to $99,999.99. The market was already nervous that day because of the Eurozone debt crisis (in particular the dire situation of Greece), but no ‘new news’ arrived during the critical 20 minutes that could account for the huge sudden drop and recovery, and nothing had been learned about Accenture to explain its shares losing almost all their value.”

This is the folly of finance in the 21st century. The GFC was an obvious instance. It derives from the absurdity of thinking that market forces are an irresistible force of nature that is always, ipso facto, good, that everything can be sorted out if only we have a sound pricing mechanism and that regulation or, perish the thought, government, is alway sub optimal and counter productive. Neo-liberal nonsense, in other words. Which, just by coincidence, happens to benefit the neo-liberals and the business interests they represent. All propped up by the circular arguments and inanities of contemporary economics.

So here’s a thought. If we let these hi-tech barbarians loose by wringing our hands and saying that regulation is impossible, eventually we will have no system. That will even be a problem for the barbarians. because in the end everyone relies on being able to trust what money is. You can’t have serfs if you there is no money with which to pay them.

I suggest the whole article is worth a read. Bearing in mind that more than half the trading in the American stock market is already high speed trading. And a solution? Why don’t we start to ask some basic questions about what equity markets are for? It makes no sense to think that equity capital should change in micro-seconds. What does that have to do with how a company runs and the pricing of same?

Then we should consider governing in order to return them to that function.


  1. On the one hand you state “If you are prepared to undermine money itself, then you will eventually have no system”, on the other, “regulation or, perish the thought, government, is alway sub optimal and counter productive. Neo-liberal nonsense”.

    If you knew your history you would know that it is the government itself that is undermining money. What is considered the ‘risk free’ asset? If it’s not the government bond I’m a monkey’s uncle.

    Money is what EXTINGUISHES debt, government debt cannot extinguish debt. Government debt passed off as money is actually perpetual debt, whose value is uncertain & eventually, worthless. Until you realise this your analysis is flawed.

    And as for your link to the BoE Mr Machina, I call bull****. The BoE has been serially repudiating its obligations for centuries. It is only the strong arm of governments which allow it to continue forcing its irredeemable obligations down the throats of productive people.

    • JMD,

      Although it’s certainly the case that government can undermine money, your view that there is some objective money without rules (which is government) is hypocritical.

      That applies just as much to gold, which only has value within another set of rules (that is again government). Unless you want to argue that they hold gold in the vaults at the Central Bank of Mars.

      There is no money without government.

      • “There is no money without government”

        H & H what exactly is your definition of money ?

        I was of the understanding that money is simply something you exchange your labour (goods, services) for, until such time that you exchange it for someone else’s goods or services, no third party need be involved.

        Where have I gone wrong ?

      • > There is no money without government.

        Only if you mean fiat money. Historically money such as commodity money was more of a social phenomenon and precious metals are still in this category. It can be clearly seen during major upheavals. When governments stop functioning in their usual way the price of gold goes up. Obviously using gold for everyday transactions is impractical since it’s not divisible in the same way as fiat money.

        Obviously governments can confiscate precious metals by this is just theft.

        The problem with fiat money is that it is dependent in an intricate way on all sorts of government regulations and sometimes this dependence is not immediately obvious. Changes to regulations may lead to unintended disastrous consequences. The the repeal of The Glass–Steagall Act in the US is probably the best example.

        Governments are collective political institutions and as such influenced by different views of their members and external interest groups. This makes governments very inflexible.

        Through the fiat money system and web of regulations governments interact with very agile private organisations whose main purpose is profit. Those organisations will always try to find loopholes or influence regulations to their advantage. High frequency trading is a case in point. Since it’s not implicitly prohibited it’s legal and the finance lobby that benefits from it will use every means possible to leave it this way. This will continue until it causes a major financial disaster.

    • “What is considered the ‘riskfree’asset? If it’s not the government bond I’m a monkey’s uncle.”

      Did you deliberately ignore the Who and where part of that question?

      Who considers government bonds to be riskfree – private rating agencies and private bondholders.

      Where are these riskfree assets bought and sold – shock .. horror.. in a “free market” ..the bond market.

    • In the Central Banking system, all “money” is credit (and therefore simultaneously debt).

      A banknote is a number of units of a particular currency owed to the holder by the Central Bank.

      A bank deposit is a number of units of a particular currency owed to the depositor by a bank.

      Each debt can be extinguished by swapping for another form of debt, or by providing goods or services to a creditor.

  2. The whole point of bourses, stock markets etc WAS supposed to be the next step up from entrepreneurs getting funds from banks. These entrepreneurs, now with a tested and formed product or service, need to expand and need venture capital – and go to the marketplace to raise this capital (instead of debt from banks).

    The secondary market allowed for liquidity thereafter, but has spiraled into a speculative quagmire, and has taken over as the primary method of “capital allocation”.

    A possible solution is re-regulating what is and what is not a “stock”.

    I prefer a variation on Steve Keen’s idea of a time-dated stock, treated differently (i.e taxed – either through CGT penalities, or only allowing fully franked (or even tax free) dividends on never traded stocks) if owned from IPO to maturity (i.e never traded) to constant churning/trading.

    The whole point is to encourage the raising of capital through IPO or subsequent raisings and to discourage the flipping and speculating of this capital thereafter.

    Yes, there is a need for liquidity via a secondary market – but if you discourage the constant trading (and all the people who make money from this – including me, I might add, but mainly the brokers, trading houses etc) and encourage a return to fundamental valuations (priced via the intrinsic value of the time limited stock).

    • rational investor

      The problem with that Prince is as pointed out by Ben Graham you don’t have enough information about how a business performs throughout the business cycle if you buy at ipo however for an existing public company you can easily find all the information you need to make a rational investment decision.
      I would also argue that it is far more unlikely to find a sufficient margin of safety at ipo than in the secondary market, due to many more players needing to clip the ticket during the ipo process.

  3. Even before thinking about changes to equity markets we need to think about what the purpose of derivatives is supposed to be: a mechanism for punting or a tool for hedging risk.

    Derivatives are a zero sum game, negative sum game when you take into account transaction costs. This is gambling.

    However if you have an interest in the underlying then derivatives are effective tools for risk management. In insurance you need to have an insurable interest to take out insurance on something. I cannot take out a life insurance policy on SON or insure his house against fire. A lot of the problems with derivatives could be fixed by insuring (no pun intended) that they are used for risk management, rather than punting, by requiring the equivalent of an insurable interest to be able to bet, which in this case would mean some interest direct (producer or end user) or indirect (e.g. part of the supply/value chain for a commodity) in the underlying.

    This of course has been tried before but squashed by vested interests (e.g. L Summers and CDS) who prefer the casino model.

    As an aside, of the big 4 banks how many view their forex desks as a revenue source rather than part of the risk management division?

    On the bots they don’t appear to serve any public good. This problem, if it is a problem, could be fixed (presumably) by fixing a minimum trading time increment that was greater than the time scale at which time series data has memory.

    • In many cases when the derivative is used as insurance on your underlying, the opposite side of the derivative transaction is the punter. You can’t rule out one side.

  4. Rise of the algorithm, via TBP:

    I read recently that the $600 trillion derivatives market is a conservative estimate (no-one really knows) likely to be closer to one quadrillion (don’t even know how to write that!) – could luck to anyone trying to regulate it – not going to happen. Implosion may be the only solution.

  5. Another good topic SON. I find both sides arguing in my head. I am a value investor so on the surface I say down with the gamblers and there robot toys. Ba humbug they stuff everything up. I resonate with a comment last year from of all people, Paul Keating . “We have to find a way to separate the gambling from investment in the stock market”.

    I also think the robots are “unfair”.

    If I am honest with myself I say bull crap, I am no better. I love it when I have picked a “good” company up before others do. I use my training and perception to give me an advantage. How is that different from someone using an algo? If I go to my core I see a greedy son of a bitch that is highly competitive who hides it behind the label “value investor” .

    And then there is another side of me that buy’s GDY (when it was $0.50) because we need the stuff they are trying to do.

    Arrrr, I end up with more questions…thanks a lot SON

  6. I have no problem with anyone betting the house on the derivative market, as long as it is not my (taxpayer’s) house.

    Another thing that puzzles me is why do clients still go to Goldman Sachs and co, when they have been deliberately sold a bill of goods before – there are internal emails showing banksters insulting their clients calling them white elephant, flying pig and unicorn all at once. Either the client fund managers get kickbacks of some sort or they are masochists who enjoy losing their wealth.

  7. BOTS? hahaha the governments are the bots, who do you think has been controlling the markets??? the “bots”?

    no bots and money dumping and its all over, markets meltdown and pensions gone for the boom boom babys along with the housing “values”.

  8. “It makes no sense to think that equity capital should change in micro-seconds.”

    HFT has been happening at nano-second timing as well, so the narrative here is spot on IMO SoN.

    One of the other blogs here stated it’s a traders market now and I have no doubt that this is true.

    The US congress can’t control the FED, and I wonder how much control politically there is of any of the central banks and regulators world wide.

    I’m expecting a market discontinuity soon if progress is not made on the US debt ceiling, and likewise for the EU situation. Nothing I’ve seen make me think that it’s under control. The bond market most likely will provide some guidance for the politicians soon.

    I have one stock left, and I look at how Morgan Stanley hammer it from about six registered parts of their company. I believe they are active as described. I can’t see the timing and just see the buy/sell info in the ASX reports.

  9. Joe Saluzzi of Themis Trading has been keeping tabs on HFT’s for awhile now.

    Karl Denninger at Ticker Forums has a couple of good articles as well. The latest one is on “quote stuffing”

    The Nanex link comes via Tickerforum but first used on ZH “Flash Crash Analysis
    Continuing Developments”

    I see little point in trading when skynet was activated.

    The best cure I found if the urge to trade pops up is to re-watch “Idiocracy”.

  10. Suggestion from electronics. When a system is prone to positive feedback loops, you include a resistor to stabilise it. Taxing transactions should do it.

    • Building on this, isn’t there already a cost of doing business when trading?

      Or do brokers that are directly connected to these electronic brokering systems only have minuscule costs-per-transaction (compared to the $20 per trade they charge the chumps)?

  11. Also remember that your superannuation fund will place large buy orders. Exactly what these Hight Frequency Trading bots sniff for. So that’s a chunk of your super going to Goldman Sachs bank accounts.

  12. I don’t think anything much has changed with the behaviour of the markets. The mechanics by which people trade, yep, that’s always changing.

    Don’t forget, these systems and bots are designed by people, and reflect the same old beliefs and biases that people have been using to trade the markets forever.

    For that reason, it’s no surprise that the same old patterns that have shown up on the charts forever, are all still there.

  13. Guys, let’s face it – the system is rigged. The insiders control the game and only crumbs or misery is fed to investors.

    Ratings agencies are controlled by Wall Street. They deliberately mis-rated CDOs & MBS. Wall Street also calls the shots in Washington. ‘The Presidents Working Group on Financial Markets’ or ‘Plunge Protection Team’ created for ‘market stabilisation’ after the ’89 crash under Reagan has been active manipulating the market along with a number of others – GS, JPM etc. The derivatives contagion created has spread worldwide and resulted in the debts of sovereign nations. Nations with debt are forced to borrow more and implement austerity. Austerity eliminates jobs and reduces government revenue from taxes. As an example, how can Greece with 10 million people pay off $680 billion? Greece will likely default as will other European nations and the Euro will likely collapse. The UK and US are no better off, but the US has the luxury of being the world reserve currency and will gain if and when the Euro disappears. Once QE stops, the US system also collapses.

    This current world financial system has been built around sovereign debt. The GFC was just a speed bump on the way to a major accident.

    Once China’s exports collapse – Australia’s economy, which is currently flat-lining, is toast. The Australian banking system with its 15 trillion dollar exposure to derivatives is bankrupt.

    IMO the only asset class offering any protection is gold and silver. This will never go to zero.

    Will there be a meeting of nations in time to discuss currency devaluations, revaluations and multi-lateral partial or full defaults? Could there be war as a reset for debt? Who knows.

    What I do know is we need to hope for the best – but plan for the worst.

    That’s this weekend’s rant.

  14. Value investing? Guess that’s becoming another useless relic of the 20th century

    Oh where oh where are the stockbrokers yachts
    Today they are fewer, before there were lots
    The baby boom’s over, Gen Y are the tots
    But we’ve all become slaves
    Of the Algos and Bots

    (Ipse dixit)

  15. Automated trading itself is, for the most part, just implementing the rules that human traders would use, but significantly faster. My main issue is with high frequency trading, and the waste of resources (including talented people) that it consumes just to have some liquidity 5 seconds earlier.

    I don’t see that we should regulate against this. It is no different to you using a trading strategy that takes advantage of me being a naive investor.

    If we should want to abolish high frequency trading, there is a much simpler solution than banning or taxing: simply change from continuous transactions on exchanges to discrete-time clearances. If shouts are accepted continuously, but only matched every say, 2 seconds, this would remove any advantage that high frequency traders would have. The bots would be blind to the number of exchanges and the prices until everyone else found them, eliminating most of their advantage.

  16. The thing that really gets my goat about this isn’t that these algorithms are “unfair” it’s that work developing them is work that could be plied to more productive industry.

    There are a lot of incredibly intelligent mathematicians, computer scientists, engineers, etc. that go into finances to make piles of money trading imaginary numbers when they could be working at the LHC or at ITER on things that really would benefit humanity.

    People are free to choose whatever career they want, but the reward system is seriously skewed toward the finance industry.

  17. Simple solution – change to 2 auctions a day and no trading in between.

    Everyone who is involved in buying one minute and selling the next can either find another job or get back to the real use of markets which is determining the right price for the long term.