INTRODUCTION
Ian Huntley now acts as a consultant to Morningstar having sold Huntley’s Investment newsletter to them some years ago. He is well known to our editor and both he and Morningstar have given permission for Ecinya to reproduce a recent article on ‘Dark Pools/ High Frequency Trading written by him on 1 November 2012. This is a topic that we are interested in, and interested in developing further views in the future. Ecinya is always concerned when markets adopt American practices that lack transparency and too often result in fears and tears for the retail investor, and indeed the market as a whole. We regard Ian Huntley as an earnest, experienced and honest commentator and observer of markets and take his views seriously.
Warning on Dark Pools, High Frequency Trading: Terrifying! – Review by Ian Huntley
The conclusion of Scott Patterson’s brilliant book Dark Pools is really all you need to know about the myriad algorithmic trading systems now running amok in our electronic stock exchanges, even worse now that Chi-X has joined the scrum using the most advanced electronic exchange techniques
Patterson describes one electronic advance: "In late 2011, for instance, NASDAQ rolled out a platform called Burstream that gave clients the ability to get data in six hundred nano seconds – six hundred-billionths of a second…In the options market nearly nine million orders flowed through the system each second, overwhelming computer programs and making a hash of trading information.
"That entire turnover was having a real-world impact on stocks. At the end of World War II, the average holding period for a stock was four years. By 2000, it was eight months. By 2008, it was two months. And by 2011 it was 22 seconds, at least according to one professor’s estimates." One prominent high frequency trader claimed a holding period of 11 seconds!
Patterson describes how these high frequency traders competed with each other for speed to the market, installing better connections, fighting to install their robots as close to the exchanges as possible – moves the exchanges aided and abetted in their lust for turnover.
Sub-titled, The rise of A.I. trading machines and the looming threat to Wall St, the concluding sentences are brilliant. A.I. is the label for artificial intelligence used to drive programmed robotic trading machines. Patterson quotes Spencer Greenberg addressing a high powered tech savvy conference saying that few were more knowledgeable about using A.I. to invest than Greenberg – the reason he was keynote speaker that day.
Greenberg warned: "Machine learning can be disastrous in the hands of people who don’t know what they are doing." And illustrated: "A terrifying example of this comes from a poorly planned military project that a computer scientist once told me about. A group of military technicians were attempting to rig an algorithm to distinguish between photos of a forest without tanks and a forest full of tanks. After training the system, they found it achieved remarkably good accuracy.
"But when the researchers attempted to duplicate the experiment, it failed. They then realised, late in the game, that in the original situation they had taken the photo of the forest without tanks on a cloudy day, while the photo of the forest with tanks had been taken on a sunny day. The A.I. was simply accomplishing the mundane task of noticing the difference between a sunny forest and a cloudy forest – it had nothing to do with the tanks at all.
"The horrific results of such a flawed system being activated in the field could only be imagined."
One can only conclude all these high frequency robotic trading systems should be banned and all stock exchanges should be required to shut off all links to them. And ALL orders in Australia, institutional and retail, should be routed through the one exchange. Send Chi-X off, complete with its ultra-smart electronic exchange tooling, so much in demand for HFT and all the rest of it.
The operations of HFT and dark pools have turned electronic exchanges into yet another alphabetic derivative style soup, akin to the concoctions that brought on the GFC. **
** Bold highlights in the last two paras are by Ecinya for emphasis