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Monday, January 3, 2011

Judgment Day

In the "Terminator" movies, computers become sentient and declare war on humanity. Since the machines control all of mankind's weapon systems, including nuclear weapons, their victory is swift.

We fear we may be on the verge of our own sort of "Judgment Day." We don't worry so much about the increasing intelligence of computers as we do about the lack of intelligence--or at least foresight--of their programmers. And we worry less about a nuclear holocaust than we do about a sort of financial armageddon that could have the same civilization-destroying capacity.

If you needed any more proof that the entire financial industry is (ahem) a solipsistic enterprise that ultimately produces nothing other than more grist for its own mills, consider the advent of "High Frequency Trading." In HFT, computer algorithms allow traders to execute trades within millionths of seconds. By taking advantage of the slightest--and we mean slightest--head start, traders can exploit fractional differences in stock prices and make fast profits.

If we understand this phenomenon correctly, it works like this: Computers programmed to scan the markets for--well, for whatever: We don't know what programmers base their algorithms on--identify a stock and execute a "buy" order. Let's say that the price is $100.0001. The computer makes the purchase, and then the stock may "skyrocket" to $100.0002 (perhaps in response to the very purchases the automated trader just made). Other (ever-so-slightly) slower autotraders notice the movement and begin making their own purchases. By now, the stock may have shot up to, oh, $100.0004. So it's time for the first trader to sell! Sure, we're dealing with fractions of a penny, but if you consider the fact that tens of thousands of trades can be executed every minute, the profits can accumulate quickly.

Note that profit and loss seem to have absolutely nothing to do with the inherent worth of any sort of product or business. The only commodity of value in HFT is speed--microseconds of speed. If a programmer sets up an algorithm to make purchases of a company specializing in snail-poop, he can presumably attract the notice of enough other high-frequency traders to turn a tidy profit before these other investors realize they're buying crap. And if autotraders misread market signals, they can provoke a panic that can quickly send the broader market crashing (as happened last spring).

(We realize our explanation is probably extremely simplistic. If anyone can offer a more thorough explanation of HFT--and ideally explain HOW it adds any real value to the world--please feel free to do so in the "Comments.")

What can be done? Probably not much. It does make one wish that these traders--indeed, most of the high-flying financiers who make money for nothing while playing video games with other people's actual savings--could simply be sealed off in their own sector of society. They could then safely play their games and we could watch (or not) while we go about the real business of the world.

Solipsistic References:
"The New Speed of Money, Reshaping Markets"
If you're among the few people on the planet who haven't seen "Terminator 2," you should: It was from James Cameron's pre-"Titanic" days when he just made really cool science-fiction movies.


  1. Not for nothing, but the whole point of the "Terminator" flicks is (spoiler?) THE COMPUTERS DON'T WIN!!!!!
    Anyway, to your real point: The danger is not that power is concentrated in the hands of the wealthy and, um, powerful. The Founding Fathers were wealthy and powerful. The problem is, that with today's technology, it is all too easy to become wealthy and powerful and REMAIN TERMINALLY STUPID!

  2. You did a good job of explaining the unexplainable. I heard about this oh, sometime in the past. The whole point is that micro second of speed and it's almost a game with the companies that are doing it.
    "Money for nothin' and the chicks are free."

  3. A. 98% of stocks don't trade at sub-penny increments so your explanation is not accurate. That's not how HFT firms make fractions of a penny on a trade.

    B. HFT traders often lose the spread on a stock. In your example, you assume buying only. Most HFT provide liquidity on both sides of the market.

    C. If you remove HFT, your spreads will increase dramatically, meaning that you may get much worse enter and exiting prices.

    D. You make vague references to the "flash crash", but your presumptions are not what caused that event. This statement, "if autotraders misread market signals" is exactly what makes it a free market. Anyone misreading signals SHOULD lose money.

  4. @Anonymous (the first one): Suuuuure the computers don't win!

    @Anonymous (the second one): We appreciate your explanation of the ups and downs of HFT--we freely admit to a lack of expertise in this area. We suppose that your point "C" provides some explanation of a "benefit" of HFT. We do, however, stand by our initial thought that HFT--like much of modern finance--is essentially just a game played with (mostly) other people's money: It provides nothing of value to society at large, either through the creation of a useful product or the introduction of a useful service.