Paul Wilmott on High Frequency Trading: 'It May Increasingly Destabilize the Market'

| About: Goldman Sachs (GS)

Paul Wilmott is a legend in quant circles: his website Wilmott.com, which Zero Hedge highly recommends to all readers for an in depth analysis on all things that are below the surface of the market, is one of the most popular resources dealing with the constantly changing topology of our increasingly more complex equity capital markets. Simply said, his opinion on matters in program and high-frequency trading is second to none.

Which is why we read his latest Op-Ed in the New York Times today, Hurrying Into The Next Panic, very carefully. His piece is a stunner - in summary, and in agreement with what Hedge discussed at length many months ago (we suggest readers familiarize themselves with this ZH piece as it is the one that started it all, and also explains partially our fascination with VWAP), Paul sees HFT as a force that is tantamount to what index arb and "dynamic portfolio insurance" was in the crash of 1987.

Thus the problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market. Hedge funds won’t necessarily care whether the increased volatility causes stocks to rise or fall, as long as they can get in and out quickly with a profit. But the rest of the economy will care.

This argument goes to the real heart of the problem with HFT - the monopolization of liquidity provisioning, and the complicit nature of both exchanges and specific broker/dealers who are willing to usurp this "liquidity=volume" fallacy in exchange for perpetuating the $20+ billion revenue stream spread among a minute number of market participants. As such, Zero Hedge increasingly believes that what Goldman Sachs (NYSE:GS) does on the NYSE (for example) is not so much an SEC issue (ignore the fact that the SEC is about 10 years behind the curve on this topic) but is in actuality an anti-trust concern.

Here is Zero Hedge's 2 cents: Christine Varney, forget about Google (NASDAQ:GOOG) for one day and instead focus on what is easily the scariest, stealthiest, and potentially most expensive anti-trust issue in American society (and history) - that of HFT's increasingly monopolizing capital markets.

All this other talk about Flash frontrunning is for all intents and purposes merely window dressing (and not the best approach at that) - banning Flash, and leaving the other components of HFT untouched, would in fact be a big step back as it would merely enhance the strength of the New York Stock Exchange, and its symbiotic-parasitic partner Goldman Sachs would benefit even more if ECNs utilizing Flash and its variants such as Direct Edge and BATS are terminated: end result - concentrating even more power into a very limited number of players.

Back to the Wilmott Op-Ed:

So, is trading faster than any human can react truly worrisome? The answers that come back from high-frequency proponents, also rather too quickly, are “No, we are adding liquidity to the market” or “It’s perfectly safe and it speeds up price discovery.” In other words, the traders say, the practice makes it easier for stocks to be bought and sold quickly across exchanges, and it more efficiently sets the value of shares.

Those responses disturb me. Whenever the reply to a complex question is a stock and unconsidered one, it makes me worry all the more. Leaving aside the question of whether or not liquidity is necessarily a great idea (perhaps not being able to get out of a trade might make people think twice before entering it), or whether there is such a thing as a price that must be discovered (just watch the price of unpopular goods fall in your local supermarket — that’s plenty fast enough for me), l want to address the question of whether high-frequency algorithm trading will distort the underlying markets and perhaps the economy.

It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms. Dynamic portfolio insurance is a way of protecting your portfolio of shares so that if the market falls you can limit your losses to an amount you stipulate in advance. As the market falls, you sell some shares. By the time the market falls by a certain amount, you will have closed all your positions so that you can lose no more money.

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday. Dynamic portfolio insurance caused the very thing it was designed to protect against.

This is the sort of feedback that occurs between a popular strategy and the underlying market, with a long-lasting effect on the broader economy. A rise in price begets a rise. (Think bubbles.) And a fall begets a fall. (Think crashes.) Volatility rises and the market is destabilized. All that’s needed is for a large number of people to be following the same type of strategy. And if we’ve learned only one lesson from the recent financial crisis it is that people do like to copy each other when they see a profitable idea.

Zero Hedge could not agree more and we implore you to carefully read the whole piece and consider all its implications. This is truly a topic that is critical to capital markets - if and when we have another 20% fall in the capital markets (especially now that people's faith in the system is on the edge every day), will likely turn away those few remaining retail players who still hope to make a living from speculating. The sad thing is that long-term buy and hold investors have already departed the market, as they have realized the traditional methods of approaching stock valuation such as fundamental and technical analysis have gone out of the window and been replaced by such arcane concepts as quant factors.

As for those curious to investigate more of Wilmott's thoughts on the matter, we would like to point them to this specific entry in Paul's Blog "This is no longer funny." As this was written on March 10, 2008, it was eerily prophetic - I summarize several of Paul's key forward looking points here:

THERE WILL BE MORE ROGUE TRADERS: While people are compensated as they are, while management look the other way to let the ‘talent’ do whatever they like, while people mistake luck for ability, there will be people of weak character who take advantage of the system. The bar is currently at €5billion. There will be many happy to stay under that bar, it gives them some degree of anonymity when things go wrong. But that record will be broken.

GOOD SALESMEN WILL HOODWINK SMART PEOPLE: No matter what you or regulatory bodies or governments do we are all a pushover for the slick salesman.

CONVEXITY WILL BE MISSED: One of the more common reasons for losing money is assuming something to be known when it isn’t. Option theory tells us that convexity plus randomness equals value.

CORRELATION PRODUCTS WILL BLOW UP DRAMATICALLY: This means anything with more than one underlying, including CDOs. Stop trading these contracts in quantity this very minute. These contracts are lethal. If you must trade correlation then do it small and with a big margin for error. If you ignore this then I hope you don’t hurt anyone but yourself. (I am sometimes asked to do expert-witness work. If you blow up and hurt others, I am very happy to be against you in court.)

RISK MANAGEMENT WILL FAIL: Risk managers have no incentive to limit risk. If the traders don’t take risks and make money, the risk managers won’t make money.

VOLATILITY WILL INCREASE ENORMOUSLY AT TIMES FOR NO ECONOMIC REASON: Banks and hedge funds are in control of a ridiculous amount of the world’s wealth. They also trade irresponsibly large quantities of complex derivatives. They slavishly and unimaginatively copy each other, all holding similar positions. These contracts are then dynamically hedged by buying and selling shares according to mathematical formulae. This can and does exacerbate the volatility of the underlying. So from time to time expect to see wild market fluctuations for no economic reason other than people are blindly obeying some formula.

TOO MUCH MONEY WILL GO INTO TOO FEW PRODUCTS: If you want the biggest house in the neighbourhood, and today not tomorrow, you can only do it by betting OPM (other people’s money) big and undiversified. There are no incentives for spreading the money around responsibly.

MORE HEDGE FUNDS WILL COLLAPSE: You can always start a new one. Hell, start two at the same time, one buys, the other sells!

POLITICIANS AND GOVERNMENTS WILL REMAIN COMPLETELY IN THE DARK: Do you want to earn £50k p.a. working for the public sector, or £500k p.a. working for Goldman Sachs? Governments, who are supposed to set the rules, do not even know what the game is. They do not have the slightest clue about what happens in banks and hedge funds. Possibly, for the same reason, London will lose out to New York as a world financial centre.