Mysterious Algorithm Was 4% of Trading Activity Last Week

John Melloy, 10 October 2012

A single mysterious computer program that placed orders—and then subsequently canceled them—made up 4 percent of all quote traffic in the U.S. stock market last week, according to the top tracker of high-frequency trading activity. The motive of the algorithm is still unclear.

The program placed orders in 25-millisecond bursts involving about 500 stocks, according to Nanex, a market data firm. The algorithm never executed a single trade, and it abruptly ended at about 10:30 a.m. ET Friday.

“Just goes to show you how just one person can have such an outsized impact on the market,” said Eric Hunsader, head of Nanex and the No. 1 detector of trading anomalies watching Wall Street today. “Exchanges are just not monitoring it.”

Hunsader’s sonar picked up that this was a single high-frequency trader after seeing the program’s pattern (200 fake quotes, then 400, then 1,000) repeated over and over. Also, it was being routed from the same place, the Nasdaq [COMP 3049.41 -2.37 (-0.08%)].

“My guess is that the algo was testing the market, as high-frequency frequently does,” says Jon Najarian, co-founder of TradeMonster.com. “As soon as they add bandwidth, the HFT crowd sees how quickly they can top out to create latency.”

Translation: The ultimate goal of many of these programs is to gum up the system so it slows down the quote feed to others and allows the computer traders (with their co-located servers at the exchanges) to gain a money-making arbitrage opportunity.

The scariest part of this single program was that its millions of quotes accounted for 10 percent of the bandwidth that is allowed for trading on any given day, according to Nanex. (The size of the bandwidth pipe is determined by a group made up of the exchanges called the Consolidated Quote System.)

“This is pretty out there to see this effect this many stocks at the same time,” said Hunsader, adding that high-frequency traders are doing anything to “tip the odds in their favor.”

A Senate panel at the end of September sought answers on high-frequency trading, as investigators look into the best way to stop wealth-destroying events such as the Knight Capital Group computer glitch in August and the market “flash crash” two years ago.

Regulators are trying to see how they can rein in the practice, which accounts for 70 percent of trading each day, without slowing down progress and profits for Wall Street and the U.S. exchanges.

“I feel a tax on order-stuffing is what the markets need at this point,” said David Greenberg of Greenberg Capital. “This will cut down on the number of erroneous bids and offers placed into the market at any given time and should help stabilize the trading environment.”

Hunsader warned that regulators better do something fast, speculating that this single program could have led to something very bad if big news broke, or if a sell-off occurred and one entity was hogging this much of the system.

“The motive of the algorithm is still unclear”—that’s an interesting sentence, the sort of sentence I expect to hear more often.

And we’re not just talking about people who choose to risk their capital by investing in Wall Street, we’re talking about people who were so foolish and intemperate as to take out residential mortgages and student loans, which is where a great deal of the fraud has occurred.

And mathematicians, working in the service of these banks, hedge funds and so on, are compensated in the millions of dollars for aiding and abetting these frauds. At some point there needs to be a serious discussion about scientific ethics, because if there is a backlash, it may not be limited to Wall Street alone.

[1] http://www.democracynow.org/2012/7/5/zero_accountability_glenn_greenwald_on_obamas
[2] http://www.salon.com/2012/08/10/obamas_goldman_sachs_surrender/
[3] http://www.levin.senate.gov/imo/media/doc/supporting/2011/PSI_WallStreetCrisis_041311.pdf
[4] http://www.peakprosperity.com/blog/bill-black-our-system-so-flawed-fraud-mathematically-guaranteed/74785

The occupiers are occupying the wrong place. Whatever one’s moral concerns, if one thinks that people are profiting from immoral earnings, the lawmakers are the ones to address, not those doing legal stuff, however immoral it might be. One really can’t fault people for doing something legal. At least, if one wants to change something, one should work to change the laws.

Also, don’t confuse the stock market with the financial world in general. Stock markets tend to be quite well regulated. Especially with computer-traded stuff, people get paid to keep records, so that bad things can be prosecuted even years later. Many, probably most or even all of the financial products which have wreaked havoc recently (even outside of the financial world; I have no sympathy for someone who comes out of a casino empty-handed) are not traded on exchanges, but are so-called OTC (over-the-counter) products. Stock exchanges would love laws to require them to be traded on exchanges (another source of income for the exchanges), but of course those who profit from them are opposed to this, mainly because the fact that they are not traded on exchanges makes this stuff less transparent.

Yes, some innocent folks might have suffered collateral damage. However, for each one of these there are probably hundreds who invested their savings in Icelandic banks or whatever (something which doesn’t just happen by mistake). Hey, they pay 7%, and my savings account just pays 1%, so I’ll go for the 7%. Why do savings accounts still exist? Because they are more secure. Anyone who can’t figure out that higher interest rates go hand-in-hand with higher risks doesn’t deserve the money he lost when such banks went down.

The real problem is bailing out such banks, and indirectly the people who invested there, due to the same greed one finds elsewhere. Again, this is a problem with the lawmakers. If one doesn’t like such stuff, vote for someone else (at least if one lives in a democracy).

Traders pay money to have their computers in the same room as those of the stock exchange—a few kilometers to their own computing center in the same town is too far.

HFT, algorithmic trading, low-latency trading etc have all been criticized since they are not “real”. However, it’s been a long time since most of the trading on stock exchanges has been what many people still think it is: buy some stocks in a company you believe in and if it does well you can get a dividend and/or sell them at a profit years or decades later. This still exists, of course, but most of the trading is done to make money in some other way, which is everyone’s goal in this game, including that of those who buy stocks and sell them decades later. Things like options and futures were invented to minimize risk of stock purchases, but now they are often bought and sold in their own right, with even higher-order products, e.g. options on futures. This happened before algorithmic trading and even before computers (used as tools of traders) were introduced.

All of this will stop when people are no longer interested in using it as a means to perhaps increase their wealth. Considering that the typical attitude of the traditional stock purchaser is “I have some extra money and it should increase without me having to worry about it”, much of the criticism of the new technology is somewhat hypocritical. Anyone who is worried about his fortune disappearing in microseconds should think about what his fortune actually consists of.

A few weeks ago, I was at one of the best scientific conferences I have ever attended. One of the sponsors was RSJ. At the conference dinner, I happened (purely by chance) to be at the same table as a former colleague, the main conference organizer, one of the highlight speakers, a famous astronomer who got an honorary doctorate during the conference and a chap who went into the computing industry after he had taken up a permanent position at a Max Planck Institute because the pay was so bad (but, as his visit to this rather technical conference attests, still follows the field with interest, rather like myself in this respect). There were two seats free, which I realized later had been reserved. A young man whom I hadn’t seen at the conference came and sat down, together with a strikingly beautiful woman (obviously his wife or girlfriend). I heard someone whisper “he funded all of this” as we enjoyed our conference dinner in the castle. He was a graduate of the university there, a mathematician, and made his own fortune quite quickly. A thoroughly nice chap using his money to fund things like this wonderful conference. He has also set up a foundation which fights corruption, which, though it is worse elsewhere (and not as bad in a few places), is a big problem in the Czech Republic. (As many know, my day job now is also in the financial world (though I’m a non-financial computer person concerned with more traditional tasks, not an algorithms developer or something like that—many physicists and mathematicians work in both of these sectors, of course). I still write the occasional paper and give the occasional talk and attend the occasional conference in my spare time. Interesting that the last conference I attended was made possible by someone with whom I am, albeit indirectly, connected at my paying job.)