The debate is to what extent that has beneficial or negative effects on volatility, market movements, herd mentality - and rational behavior any different from the old days of human domination since the computers are run by humans and the algorithms they employ are designed by humans. JL
Steven Pearlstein reports in the Washington Post:
A small fraction of the trades on stock markets these days — maybe 10% — are made by real-life humans. An additional 40% reflect decisions to invest in the entire stock market, or an industry, or a class of companies — index funds, exchange-traded funds (ETFs) or other kinds of passive investments. That leaves half the trading done by computers that focus on changes in market prices or indexes caused by the trading done by other computers.
It has been comical to watch the parade of guests on the business news channels this week try to explain to viewers, and to one another, why our hyper-efficient financial markets — the ones that are supposed to be so brilliant at pricing the value of everything — have been bouncing around like a squash ball on an overheated court.
Pay no attention to the volatility, these financial wizards assure us. It’s just a little technical correction, a bit of froth being taken off the top of a market that had gotten a little ahead of itself. The fundamentals of our otherwise sound economy will soon reassert themselves.
Why is it that when the market is climbing by improbable leaps and bounds month after month we are supposed to take that as a genuine reflection of the fundamentals, but when the market is in a free fall, we are supposed to write that off as momentary fits of
The truth is that the market is just as irrational and divorced from fundamentals on the way up as it is on the way down. It is in the nature of markets more so today than ever, as a result of the computerized high-frequency trading strategies of the Wall Street wise guys. What we’ve watched this week is herd behavior on steroids.
It’s important to remember that a small fraction of the trades on stock markets these days — maybe 10 percent — are made by real-life humans deciding to buy or sell shares in one company or another. An additional 40 percent or so reflect decisions to invest in the entire stock market, or an entire industry, or an entire class of companies — index funds, exchange-traded funds (ETFs) or other kinds of passive investments.
That leaves half the trading that is done automatically by computers, according to complex algorithms that focus on changes in market prices or indexes caused by the trading done by other computers. In this kind of robots vs. robots trading with its circular logic, fundamentals are irrelevant, the volumes are enormous and the holding periods are often a matter of minutes, or even seconds. More often than not, a “trade” is likely to be a combination of trades — buying this stock, shorting that ETF while selling a call option on some derivative instrument. And almost all of it is done with borrowed money.
One theory about Monday’s 1,000-point plunge in the Dow Jones industrial average had something to do with a trade that shorted an ETF tied to a volatility index, which forced the sponsor of the ETF, Credit Suisse, to buy some huge number of futures contracts to balance out its exposure.
The instrument goes by the name of Velocity Shares Daily Inverse VIX Short-Term Exchange-Traded Note, or XIV for short. In all honesty, I can’t explain what any of that means, but it apparently created a vicious cycle in which selling begat more selling and wound up wiping out nearly $3 billion in valuation for investors. Credit Suisse has now announced it would soon stop trading in the instrument, which in hindsight seems like the only sporting thing to do.
“In my wildest imagination, I don’t know why these products exist,” Devesh Shah, the financial whiz who invented the VIX, told Bloomberg News this week. “Who do they benefit? No one except if someone wants to gamble.”
Aside from the gambling aspect, the rationale put forward for these ridiculously complex instruments and trading strategies is that they reduce price volatility and increase market liquidity, which is true except when it is not, which is precisely at those moments of market panic. Instead of hedging risk, which is often the reason people buy these instruments, they wind up increasing risks for those who own them and the market in general.
This is particularly true in a market such as this one, where the amount of trading done with borrowed money is higher than it has ever been, as a result of the low interest-rate policies of the major central banks that allow hedge funds to borrow $4 or $5 for every one of their own they put at risk. When prices start to fall rapidly, the funds are forced to sell their positions to pay back the banks and brokerage houses, driving down the price even further. Selling begets yet more selling. Investors rushing to cover short positions, or to sell underwater options before they expire, run into a similar dynamic.
And, of course, what happens with one asset class can affect what happens in all the others. A bubble in bitcoin, for example, can stir what John Maynard Keynes called the market’s “animal spirits,” encouraging investors to take risks and bid up the price of stocks or real estate or fine art. And it works in reverse when fear replaces greed. There’s no rational reason the collapse in bitcoin prices, from $19,500 to $7,500, has any rational connection to stock prices, but as Keynes understood, investors and markets are not rational.
In truth, there is no reason a financial system has to be this complex and so volatile. There is no reason it has to divert so much of the country’s talent and capital, and to siphon off so much for traders and bankers and hedge fund managers. With a bit of intelligent regulation, we could have a financial system that is simpler, less risky, less expensive and less susceptible to manipulation.
There is a cost to the kind of financial “innovation” that produces instruments such as the Velocity Shares Daily Inverse VIX Short-Term Exchange-Traded Note. And my guess is that those costs now greatly exceed the benefits.
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