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Financial Algorithmic Trading and Knight Capital Calamity

Stock-Markets / Financial Markets 2012 Aug 08, 2012 - 06:51 AM GMT

By: BATR

Stock-Markets

Best Financial Markets Analysis ArticleOnce all the rage was arbitrage trading. High frequency trading then became the catchphrase. Now the latest scheme to insert financial nanotech - rage against the machine – practices called algorithmic trading created an automated loss of historic proportions. The Knight Capital calamity gave rise to rogue mathematics gone amuck. What a surprise! Removing buy or sell decisions from human hands is the quickest way to destroy a company that took years to build. How the euphemism "TRADING" applies to the upheaval of computerized speculation, could only make sense in the weird world of Wall Street accounting.


When the venerable financial sages over at Forbes warn, Knight Capital's Algorithmic Fiasco Won't Be The Last of its Kind, the world needs to take note.

"Knight is one of the electronic vanguard that has best used automation to become one of the most consequential equity traders in the world. In fact, many at-home traders might be interested to know that Knight likely makes their trades happen. The group makes a bunch of its money by taking the constant stream of trades from places such as TD Ameritrade and ETrade and matching them up with orders from other small traders or those from Knight’s own book. It’s a formula that’s proved lucrative until yesterday, when, in three-quarters of an hour, a set of algorithms may wreck what Knight spent 15 years building."

Knight Capital desperately needed a financial infusion to stay afloat, much to the equity interests of the principals. So how did this long established company get financial food poisoning? Look to Thomas Pascoe for the answer in. How to lose $440m in the time it takes to eat lunch.

"Algorithmic trading is supposed to minimise risk. It relies upon a computer making a very large number of high value trades which aim to benefit from small imperfections in the market mechanism. For instance, let us say that the price of a company and a commodity are very closely linked because the company has cornered the market on the commodity. For whatever reason the price of the commodity drops while the price of the company does not. At this point the computer will step in and start trading on the assumption that the two will shortly recouple – shorting the firm and buying the commodity. When this happens, it locks in a small profit and goes hunting for the next arbitrage opportunity.

While such an arrangement may be successful in minimising the risks attached to each individual trade, it increases systematic risk because it eliminates the role of immediate human oversight. The trading activities of algorithms are watched over by other algorithms. If they start off down the wrong path, then their ability to trade swiftly and with high stakes means that they can do incredible damage before they are brought back under control."

Ever since money became treated as digital entries in a ledger sheet, the calculator used to tally the balance, moved in the direction of automated warp speed. Now that the accuracy of the miracle algorithms are called into question, the catcalls for regulation by way of a speculation tax may seem attractive, but will it really resolve the fundamental nature of machine trades?

Look to advocacy organization, Public Citizen for their take on the problem in, Rogue Algorithmic Trades Intensify Urgency for Financial Speculation Tax.

"Wednesday's computer-driven trading malfunction was a chilling reminder of the May 6, 2010, flash crash and of the persistent dangers that high-frequency trading presents. Knight Capital Group, a Wall Street brokerage firm that specializes in algorithmic trading, placed orders that went "rogue," causing massive fluctuations in the prices of 148 stocks.

High-frequency trading does not lead to productive long-term investment, nor does it allocate resources efficiently. Rather, computer-based algorithmic trading stresses markets and shatters investor confidence in the economy.

It's obvious that human oversight is desperately needed to ensure the stability of our financial markets. Yes, people can make mistakes, but they don't repeat them thousands of times per minute. Computers, on the other hand, operate at lightning speed, and can wreak exponentially more havoc. According to preliminary analysis of the trading debacle, this is precisely what happened. The Knight Capital's computer program made millions of mistaken trades in just 45 minutes."

No doubt, a terminable problem exists with computer servers connected directly to the exchanges that actually make the market that the algorithmic formulas dictate. However, the imposition of H.R. 3313 and S.1787, seeks to impose a financial penalty upon most forms of transactions, some not connected to the abuses of lightning speed frequency algorithmic manipulation.

"Wall Street Trading and Speculators Tax Act") would institute a 0.03% transaction tax. The tax would apply to any share of stock in a corporation; any partnership or beneficial ownership interest in a partnership or trust; any note, bond or debenture; any interest in derivatives on securities; and any derivative on any index."

Leave it to Congress to shoot for over kill. The rudimentary problem with algorithmic programs driving the prices in financial markets is that the integrity of the transactions is slanted in favor of the mega banksters. Investment banking no longer finances "real world" business ventures. The fleecing of the individual investor is the primary endeavor of the computer science used to stack the deck against an honest market.

Banning the interconnect of proprietary programs that amalgamate directly into the systems on the floor of the exchanges is the only way to prevent the integration of systemic collusion among the 1 and 0 computer programs.

The Knight Capital debacle forewarns of a global financial meltdown within the very structure of the way transactions are cleared. If you cannot trust the execution of the trade, at the price of the order, how can the ordinary investor rely on the process that fails to uphold its fiduciary duty to protect your money? In the economic environment of controlled capital, the velocity of interconnection is now the new insider trading violation.

Discuss or comment about this essay on the BATR Forum

http://www.batr.org

"Many seek to become a Syndicated Columnist, while the few strive to be a Vindicated Publisher"

© 2012 Copyright BATR - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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