High-frequency trading

Starfox

I find high-frequency trading fascinating. Radiolab recently did a piece on it. I first learned of it as a result of the flash crash, and oh mans, does it sound cool. Writing programs to hunt other programs? That's like 2 steps away from the most dangerous game. Yes please.

Much of the conversation I see about it seems to be of the mindset "What can we do to stop this? It's got to go!" but I'm not sure prima facie that it's a bad thing. It seems to be the natural conclusion of computerization of markets. Also, the fact that these algorithmic trading applications exist doesn't preclude traditional "buy assets and watch them appreciate" investing.

So, FRCF, I ask you: what, if anything, should be done about high-frequency trading? Does anyone (looking at you Rym) have any anecdotes about this crazy world?

Anthony Heman

The people that I hear saying it needs to go are usually regressive in the sense that they think the market should somehow not use the technology readily available. I'm with you in that I think it's a natural progression of technological advancement.

That said, I think it exaggerates the symptoms of the underlying problems with the way our markets function right now. I wouldn't want to be a publicly traded company in this world, and I don't feel like there's a whole lot of inherent value created by these trades.

It's also incredibly technically interesting to me, and I have feelings that any way we go right now some form of this particular problem is always going to crop up in this field and (all the) others.

Walker

The people that I hear saying it needs to go are usually regressive in the sense that they think the market should somehow not use the technology readily available.

In the Radiolab show the industry guy (more or less) said it needs to go because it's created a money sink. The arms race has already resulted in equality in the case of the in-house stock market servers with precisely measured cables. I think it'll end up that way for across the board eventually. If these companies could agree to equal trading speed it'd prevent a lot of pointless waste.

YoshoKatana

This kind of reminds me of a recent novel, Rapture of the Nerds. In it, a Singularity happens, but humans are generally not the recipients of it. They slowly get pushed out of the inner Solar System by intelligent AI that were originally designed to be "smart corporations." I imagine some of those AI started life as high frequency trading programs.

That being said, if I had a spare billion dollars I'd be so into this.

Rym

Maybe we could do a Thursday show on this. Scott can ask me questions, and I can answer them.

Dragonmaster Lou

Maybe we could do a Thursday show on this. Scott can ask me questions, and I can answer them.

I think that could be either a Monday or a Thursday show. Either way, I'd definitely like to listen to it.

Dr. Timo

I found this article. It smells slightly of post-modern misappropriation of vocabulary and is overly dramatic and prosaic, but the core idea, and it's proponent Nicholas Georgescu-Roegen, are, I think, solid and interesting.

TL;DR: You can model trading, and especially HFT, as thermodynamic systems and "prove" that HFT's touted benefits are nugatory if not outright detrimental.

"Phenomena such as flash crashes are the inevitable outputs of a financial ecology that tends towards the non-linear emergence of noise saturation peaks."
...
"Though finance tends towards efficiency and equity it can never achieve these states since it feeds off the noise created by information asymmetries and structural inequality, and aggressively maintains these disparities in order to extract value from the resulting ecological niches."

EDIT: Here (pdf) is a paper by Georgescu-Roegen on the actual theory mentioned in the article. The whole subject of modeling economics with theoretical physics is one I could talk about a lot (we had ourselves a small phyconomics club in the late nineties) at the physics department.

Anthony Heman

This sentence from the article bugs me: "What follows is an account of the concepts of information and noise as they apply to an analysis of high frequency trading according to ‘heterodox economics’."

Heterodox economics is extremely broad being that it's anything outside the mainstream of economics. I haven't read much further yet though, it's just a poor opening statement that bugged me.

Edit: And read it. I don't necessarily disagree with the argument, but I'm surprised a PHD student would phrase some things the way they did there.

Dr. Timo

Like I said "smells of post modern[ism]".

EDIT: also note that said PhD students are not strictly writing an academic paper here, and that they are also not economists but student here.

I really would like to have an argly bargly with an economist about HFT.

SquadronROE

I've had a lot of discussions with my friends about this and we haven't been able to see anything that is redeeming about HFT, as it relates to the economy as a whole. It seems to create a lot of money for people, but not a terribly lot of capital for the publicly traded companies. We are not really all that knowledgeable about the inner workings of the stock market though, so I'd be really interested in Rym's opinion on this.

Rym

If Scott will do it, we'll do this on Thursday. ;^)

I ask you all one thing. This is the most basic piece of equities (stock) trading. It underlies everything else.

Why does a company issue shares?

Anthony Heman

EDIT: also note that said PhD students are not strictly writing an academic paper here, and that they are also not economists but student here.

My hope in my idealized image of the world is that someone with a Masters degree has learned how to research and write at least a basic article, even if it's far outside of their area of specialization. So I am disappoint.

SquadronROE

If Scott will do it, we'll do this on Thursday. ;^)

I ask you all one thing. This is the most basic piece of equities (stock) trading. It underlies everything else.

Why does a company issue shares?

I would always assume to generate a large amount of capital, but that would just be the purpose of an initial public offering. I always assumed that by the time HFT kicks in on your shares, the capital had already been generated by the company and the HFT peeps are basically just making money for themselves, rather than actually investing in a company with the prospect of growing their money (in a classical sense, ie. I give your company $500 with the thought that you'll use that money to grow your company and eventually my $500 worth of shares are worth $600).

In my mind, HFT is akin to gambling rather than investing. Gaming the system to make more money rather than investing in companies.

Am I missing some key pieces here?

Matt

Why does a company issue shares?

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Drunken Butler

Why does a company issue shares?

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Doesn't it also serve to tie the interests of the stock owner to the company granting the company indirect use of the stock-owners non-liquid assets?

For example; a politician who owns a large amount of stock in a company might be inclined to put forth or support favorable legislation.

Also, the offering or stock options to an employee can tie said employee's financial state even more tightly to the company increasing loyalty.

Drunken Butler

Why does a company issue shares?

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Doesn't it also serve to tie the interests of the stock owner to the company granting the company indirect use of the stock-owners non-liquid assets?

For example; a politician who owns a large amount of stock in a company might be inclined to put forth or support favorable legislation.

Also, the offering or stock options to an employee can tie said employee's financial state even more tightly to the company, and thus increase their loyalty.

Dragonmaster Lou

Why does a company issue shares?

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Doesn't it also serve to tie the interests of the stock owner to the company granting the company indirect use of the stock-owners non-liquid assets?

For example; a politician who owns a large amount of stock in a company might be inclined to put forth or support favorable legislation.

Also, the offering or stock options to an employee can tie said employee's financial state even more tightly to the company increasing loyalty.

I think those are secondary goals, but they aren't the primary, original goals of issuing stock. Then again, once upon a time, the reason to buy stock was to get partial ownership of a company and therefore get dividends -- i.e. your share of the profits based on your percentage of the ownership. Nowadays, it's pretty much all speculation, especially since most companies don't pay dividends anyway.

Matt

Not entirely. With the historically low interest rates we're seeing today, companies like Coke/Pepsi, Proctor & Gamble, Johnson & Johnson are actually pretty solid investments if you've got a wad of cash and just want to make ~3% on interest from the dividends. God knows you're not going to get that from a CD.

Dragonmaster Lou

Not entirely. With the historically low interest rates we're seeing today, companies like Coke/Pepsi, Proctor & Gamble, Johnson & Johnson are actually pretty solid investments if you've got a wad of cash and just want to make ~3% on interest from the dividends. God knows you're not going to get that from a CD.

You do have a good point there, but that generally applies to more mature companies such as those and not the ones that people typically get excited about, such as the latest high/biotech companies and whatnot. Generally, only older, more mature companies actually pay dividends.

Also, most investors these days don't buy stock to get dividends. They do it purely based on the notion that the share value will go up, which is definitely more along the lines of speculation.

Dr. Timo

Why does a company issue shares?

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Correct, but you also miss a crucial point. They trade cash for ownership but stocks are not treated that way by the traders anymore (if ever). Few companies pay dividends, and for those that pay the stock price is anything but dictated by that dividend (as it should be if stocks were an investment into a payout).

So what does a company give up if it is not ownership? It gives up control. Not only control over certain financial diligence / accounting matters but also control over the value of their assets. Ultimately they give up control over the value of everything they are.

Look at Apple and what happened to their stock price due to a very, very large (estimated several billions) demand for a share price of $500 on Jan 18th. And even if you don't believe that just look at the basic valuation of Apple vs. Google, Amazon, etc. If Apple were valued as much as Amazon their share price would be $10000.

And that is something that even a company like Apple can do nothing about, if the market decides tomorrow that Apple is worth $10, then that is what Apple will be worth. Well, realistically by that time Apple will try to buy itself back (btw that is my guess on why they are piling up the money mountain).

Neo

I agree with Lou, dividends used to be much more of a big deal which is why, as I understand it, it should matter whether a corporation is growing its revenue or shrinking (or remaining stagnant) as that would forecast future dividend payouts.

These days almost nobody buys stocks for the potential for dividends, they are seen as tools for winning a gamble and getting rich.

Starfox

SquadronROE, you are correct, it's just to generate a ton of cash in one big shot, trading ownership for liquid assets, sometime a necessary move in order for the company to initiate some big growth plans.

Also as a way to make mad bank for the founders/early investors, e.g. Facebook, Zynga, et al.

And that is something that even a company like Apple can do nothing about, if the market decides tomorrow that Apple is worth $10, then that is what Apple will be worth. Well, realistically by that time Apple will try to buy itself back

Also, Apple's worth (money mountain - debts outstanding) at a minimum, so their market cap wouldn't ever realistically go below that.

Someone Falcon Punch me if I'm wrong.

Dr. Timo

Someone Falcon Punch me if I'm wrong.

In principle you are correct but, e.g., Nokia fell below their combined asset worth (not by much but still) without anyone trying to buy them out.

Takeovers cost money in themselves, takeover rumours raise the stock price, and actually splitting up the acquired firm costs money too. I bet Thaed could explain it much better than that.

EDIT: please post adress for delivery of Falcon Punch.

Starfox

Good points Timo. There's always going to be some friction there. I meant more along the lines of "if everyone in the world went crazy and sold me all of AAPL for 10 bucks." Though a billion dollars isn't too useful when you're the only sane person left on Earth.

If Scott will do it, we'll do this on Thursday. ;^)