Sunday, July 19, 2009

The Dangers Of High Frequency Trading... As Predicted By Lawrence H. Summers

When discussing high-frequency trading, Zero Hedge recently asked "As Goldman is becoming the primary conduit of trading (whether principal or agency) in virtually all markets, the risk of a
massive liquidity drain becomes exponentially larger, and the risk of an exogenous event approaches LTCM and Lehman levels. It is this key risk driver that regulators should be focusing on, instead of chasing and attempting to punish the perpetrators of the most recent market crash (we are not saying they should not, but they should prioritize and now should focus on what is most critical to maintaining a functioning market topology). " It seems we were wrong about authoritarian figures never predicting the implicit risk of this subset of program trading - ironically, it was well over 20 years ago and none other than the future Chairman of the Federal Reserve Larry Summers who had some prophetic words of caution. In a paper titled "Commentary on 'Policies to Curb Stock Market Volatility" in which Larry was discussing the cause and effect of Black Monday (about which he is quite wrong that nobody had seen coming), he lays out some oddly forward looking observations about program trading, or positive-feedback trading as high frequency trading was yet to become a staple market diet.

"In any event, positive-feedback trading is likely to increase volatility substantially. If one wants to design regulatory interventions that will decrease volatility, one must think about measures that will discourage positive-feedback trading rather than negative-feedback trading. Positive-feedback trading is substantially discouraged when traders using that strategy suffer massive losses, which is what one observed after the crash. Everyone who had been pursuing positive-feedback strategies bought more and more as the market went higher and higher, thinking that their portfolio insurance would enable them to get out. They were wrong. It's clear that the crash reduced volatility by reducing the attractiveness of positive-feedback trading."

And some very peculiar observations on margin requirements by Larry, which may have much to do with why it has become so difficult to borrow any heretofore presumed liquid stock:

"More generally, the case for margin requirements raises a question. Instead of asking why the market fell 500 points in one day, it might be more important to know why the market reached 2700 in the first place. Low margin requirements, by encouraging positive feedback trading, may well have encouraged the market increase, setting the stage for the crash."

Could it be that Larry is attempting to negate the positive feedback implications of program trading and other + feedback trading patterns by enacting higher margin requirements? That would be quite a departure, as it would mean that Goldman Sachs is in fact taking advantage of Larry's policies as they impact traditional market mechanisms (the stock loan houses State Street and BoNY in particular), by taking the other side of the positive feedback trade. Consider this in the context of the elimination of market diversity that Zero Hedge discussed in the above referenced article.

A highly insightful paper, definitely worth your read, written by a much younger and much less conflicted Larry Summers (notable phrase: "I conclude that it may be noise rather than news that is driving the market." Zero Hedge agrees wholeheartedly that the N in CNBC stands for noise).

And to conclude, a phenomenal Yale/London School of Economics paper discussing the explicit risk of High Frequency Trading. The authors argue that you can get a liquidity hole due to leveraged short-term traders (e.g., HFTs) driving prices far above what risk-averse long-term investors will buy them at. If the market falls due to an exogenous event, herding behavior, and loss limits, then prices may need to fall a long way until they hit the residual demand curve at which risk-averse long-term value investors will buy. Perhaps Larry should have read this paper when he was considering Black Monday - both the one in 1987 and the upcoming one, compliments of HFT and its #1 purveyor.

Hat Tip Richard

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