Paul Wilmott: "High-Frequency Trading May Increasingly Destabilize The Market"

Tyler Durden's picture

Paul Wilmott is a legend in quant circles: his website, which Zero Hedge highly recommends to all readers for an in depth analysis on all things that are below the surface of the market, is one of the most popular resources dealing with the constantly changing topology of our increasingly more complex equity capital markets. Simply said, his opinion on matters in program and high-frequency trading is second to none.

Which is why we read his latest Op-Ed in the New York Times today, Hurrying Into The Next Panic, very carefully. His piece is a stunner - in summary, and in agreement with what Hedge discussed at length many months ago (we suggest readers familiarize themselves with this ZH piece as it is the one that started it all, and also explains partially our fascination with VWAP), Paul sees HFT as a force that is tantamount to what index arb and "dynamic portfolio insurance" was in the crash of 1987.

Thus the problem with the sudden popularity of high-frequency trading
is that it may increasingly destabilize the market. Hedge funds won’t
necessarily care whether the increased volatility causes stocks to rise
or fall, as long as they can get in and out quickly with a profit. But
the rest of the economy will care.

This argument goes to the real heart of the problem with HFT - the monopolization of liquidity provisioning, and the complicit nature of both exchanges and specific broker/dealers who are willing to usurp this "liquidity=volume" fallacy in exchange for perpetuating the $20+ billion revenue stream spread among a minute number of market participants. As such, Zero Hedge increasingly believes that what Goldman does on the NYSE (for example) is not so much an SEC issue (ignore the fact that the SEC is about 10 years behind the curve on this topic) but is in actuality an anti-trust concern.

Here is Zero Hedge's 2 cents: Christine Varney, forget about Google for one day and instead focus on what is easily the scariest, stealthiest, and potentially most expensive anti-trust issue in American society (and history) - that of HFT's increasingly monopolizing capital markets.

All this other talk about Flash frontrunning is for all intents and purposes merely window dressing (and not the best approach at that) - banning Flash, and leaving the other components of HFT untouched, would in fact be a big step back as it would merely enhance the strength of the New York Stock Exchange, and its symbiotic-parasitic partner Goldman Sachs would benefit even more if ECNs utilizing Flash and its variants such as Direct Edge and BATS are terminated: end result - concentrating even more power into a very limited number of players. 

Back to the Wilmott Op-Ed:

So, is trading faster than any human can react truly worrisome? The answers that come back from high-frequency
proponents, also rather too quickly, are “No, we are adding liquidity
to the market” or “It’s perfectly safe and it speeds up price
discovery.” In other words, the traders say, the practice makes it
easier for stocks to be bought and sold quickly across exchanges, and it more efficiently sets the value of shares.

responses disturb me. Whenever the reply to a complex question is a
stock and unconsidered one, it makes me worry all the more.
aside the question of whether or not liquidity is necessarily a great
idea (perhaps not being able to get out of a trade might make people
think twice before entering it
), or whether there is such a thing as a
price that must be discovered (just watch the price of unpopular goods
fall in your local supermarket — that’s plenty fast enough for me), l
want to address the question of whether high-frequency algorithm
trading will distort the underlying markets and perhaps the economy.

It has been said that the October 1987 stock market crash was caused in
part by something called dynamic portfolio insurance, another approach
based on algorithms. Dynamic portfolio insurance is a way of protecting
your portfolio of shares so that if the market falls you can limit your
losses to an amount you stipulate in advance. As the market falls, you
sell some shares. By the time the market falls by a certain amount, you
will have closed all your positions so that you can lose no more money.

By 1987, however, the problem was the sheer number of people
following the strategy and the market share that they collectively
If a fall in the market leads to people selling according
to some formula, and if there are enough of these people following the
same algorithm, then it will lead to a further fall in the market, and
a further wave of selling, and so on — until the Standard & Poor’s
500 index loses over 20 percent of its value in single day: Oct. 19,
Black Monday
. Dynamic portfolio insurance caused the very thing it was
designed to protect against.

This is the sort of feedback that
occurs between a popular strategy and the underlying market, with a
long-lasting effect on the broader economy
. A rise in price begets a
rise. (Think bubbles.) And a fall begets a fall. (Think crashes.)
Volatility rises and the market is destabilized. All that’s needed is
for a large number of people to be following the same type of strategy.

And if we’ve learned only one lesson from the recent financial crisis
it is that people do like to copy each other when they see a profitable

Zero Hedge could not agree more and we implore to carefully read the whole piece and consider all its implications. This is truly a topic that is critical to capital markets - if and when we have another 20% fall in the capital markets (especially now that people's faith in the system is on the edge every day), will likely turn away those few remaining retail players who still hope to make a living from speculating. The sad thing is that long-term buy and hold investors have already departed the market, as they have realized the traditional methods of approaching stock valuation such as fundamental and technical analysis have gone out of the window and been replaced by such arcane concepts as quant factors. 

As for those curious to investigate more of Wilmott's thoughts on the matter, we would like to point them to this specific entry in Paul's Blog "This is no longer funny." As this was written on March 10, 2008, it was eerily prophetic - I summarize several of Paul's key forward looking points here:

THERE WILL BE MORE ROGUE TRADERS: While people are compensated as they
are, while management look the other way to let the ‘talent’ do
whatever they like, while people mistake luck for ability, there will
be people of weak character who take advantage of the system. The bar
is currently at €5billion. There will be many happy to stay under that
bar, it gives them some degree of anonymity when things go wrong. But
that record will be broken.

regulatory bodies or governments do we are all a pushover for the slick

CONVEXITY WILL BE MISSED: One of the more common reasons for losing
money is assuming something to be known when it isn’t. Option theory
tells us that convexity plus randomness equals value.

with more than one underlying, including CDOs. Stop trading these
contracts in quantity this very minute. These contracts are lethal. If
you must trade correlation then do it small and with a big margin for
error. If you ignore this then I hope you don’t hurt anyone but
yourself. (I am sometimes asked to do expert-witness work. If you blow
up and hurt others, I am very happy to be against you in court.)

RISK MANAGEMENT WILL FAIL: Risk managers have no incentive to limit
risk. If the traders don’t take risks and make money, the risk managers
won’t make money.

Banks and hedge funds are in control of a ridiculous amount of the
world’s wealth. They also trade irresponsibly large quantities of
complex derivatives. They slavishly and unimaginatively copy each
other, all holding similar positions. These contracts are then
dynamically hedged by buying and selling shares according to
mathematical formulae. This can and does exacerbate the volatility of
the underlying. So from time to time expect to see wild market
fluctuations for no economic reason other than people are blindly
obeying some formula.

house in the neighbourhood, and today not tomorrow, you can only do it
by betting OPM (other people’s money) big and undiversified. There are
no incentives for spreading the money around responsibly.

MORE HEDGE FUNDS WILL COLLAPSE: You can always start a new one. Hell, start two at the same time, one buys, the other sells!

want to earn £50k p.a. working for the public sector, or £500k p.a.
working for Goldman Sachs? Governments, who are supposed to set the
rules, do not even know what the game is. They do not have the
slightest clue about what happens in banks and hedge funds. Possibly,
for the same reason, London will lose out to New York as a world
financial centre.

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Anonymous's picture

Wilmott's issue is not the same issue you've had with HFT...Wilmott does not purport any wrongdoing with HFT, simply that it adds volatility.

In fact, his issue really isn't even so much with HFT, but that of different trading styles (providing vs. taking liquidity).

Always interesting to hear Wilmott's take, but this article lacks substance imo.

somethingisrotten's picture

Man, I would love to see behind the mask, err I mean bag, of these GS employees.

erich's picture

Amen!  When clueless, revert to mention of GS!  Case CLOSED!

somethingisrotten's picture

It appears from the market trading since light was shone on this disgusting topic that non-HFT traders have voted - they consider it illegal by all standard definitions..

Anonymous's picture

And clearly they are the smartest people in the room.

anthurium's picture

Not a chance, unless I get 100 to 1 odds. These HFT geniuses are going to cause another  flash crash at some point. I just hope I'm out of the market when it happens. anthurium

Anonymous's picture

Willmott's issue with HFT is very different from Joe and Themis Trading (and until reading your conclusion I believed ZH position). He does not claim flash orders are illegal or front running. He does raise the systemic risk inherent in HFT which is vital to discuss. Unfortunately, this issue has been completely missed by most people discussing HFT. Instead most have focus on the simple and populous issues of fairness, order types, and front running. Thank you for bring his editorial to our attention.

KidDynamite's picture

BINGO. this is the key.

Anonymous's picture

I heart fairness. IOC orders should be active for at least 1 second, and frontrunning in all it's forms should be illegal and apparently is not.

Those droids are the ones I'm looking for, capiche?

zeropointfield's picture
zeropointfield (not verified) Jul 29, 2009 9:23 AM

So crashing the market is a good thing?
Thanks for sharing your worldview and letting us know what motivates you in life.

Anonymous's picture

Please show where any of us state that crashing the market was a good thing? My point was that we should discuss the systemic risks associated with HFT and not if an order type most dont understand, is front running. Thank you for adding zero value to this discussion.

dark pools of soros's picture

all this running up on no real merit is what causes that drastic crashes - that is what ZH et all is trying to prevent


why is BAC shooting up while everyone else is bleeding today??


bots are firing!

Anonymous's picture

You say the run up has no merit. I'm pretty confident I can find a number of people who control very large sums of money that will disagree with you. If as you say, it has no merit, wouldn't that present an awesome opportunity for you to take the other side?

Anonymous's picture

Not if they are manipulating the market, squidboy. You're too easy.

Hondo's picture

Wilmott doesn’t purport there isn’t any wrong doing either.  He assume all information is publically available.  Well, news…. flashes aren’t publically available. 

When everyone is doing the same thing (remember the HF’s in the summer of 2007 ) then things will get nasty very quickly when sentiment changes (and it always does).  When 70% of the volume in the market is from one strategy (that proclaims to be adding liquidity but isn’t and won’t when the sentiment changes) then big moves in the market are destine to happen and there is no way to get out of the way when it does.  These kinds of moves are very destabilizing to the economy as a whole due to their effect on wealth, consumption and investment (to say little of the effect of government deficits to try and bring back balance to the overall economy.

Anonymous's picture

> "flashes aren’t publically available. "

Yes they are. You simply sign up for the right account, pay a fee and sign up for them.

Is news in the WSJ not publicly available because you have to buy a subscription?

Anonymous's picture

Umm, just so you know, HFT consists of HUNDREDS of different strategies.

SampsonHelix's picture

Everything that too excessive are not good. It's also apply for trading.

Tyler Durden's picture

Unfortunately you seem to have missed both the gist of Wilmott's piece, as well as my original contention from the original linked article. Happy to provide the conclusion from that piece:

"So what happens in a world where the very core of the capital markets
system is gradually deleveraging to a point where maintaining a liquid
and orderly market becomes impossible: large swings on low volume,
massive bid-offer spreads, huge trading costs, inability to clear and
numerous failed trades. When the quant deleveraging finally catches up
with the market, the consequences will likely be unprecedented, with
dramatic dislocations leading the market both higher and lower on
record volatility

Anonymous's picture

I had a longer response typed up which didn't post, but basically my point is Wilmott doesn't take issue with HFT per se but with everyone following the same strategy. HFT happens to be the strategy, it could've been anything else. HFT is the scapegoat here, unless any illegal wrongdoing is brought into the mix.

He implies no illegal activity in HFT, which is another argument altogether.

I think we're on the same page in terms of whether HFT does actually provide liquidity or not and whether the concentration of power is a good thing or not....I just see Wilmott's article as taking a slightly less aggressive stance on HFT than what's been put forth on ZH in the past.

erich's picture

ZH makes numerous conspiracy sightings each day, so one has to be careful when stating ZH has not made the same claim as Wilmott.

I think it is clear that the notion volume = liquidity is a mistake, and both ZH and Wilmott agree on that.  It also seems clear to me that for exchanges to rent out special access server space is unfair and should be stopped.  I would like to know if Wilmott and others agree with that.

Anonymous's picture

Agree with you on most points- but anyone can co-locate. If it adds value to your business you will co-locate. Its like saying its not fair one business purchases better, more expensive real estate for their store. No one rents special access servers- they rent an office closer to the line so they get data a bit faster than someone who rents an office further away.

Anonymous's picture

To which the golden boys respond, if you take away our license to steal it will be your fault when the market crashes.

Goldman Sachs Group Inc., the fifth- biggest U.S. bank by assets, said attempts to curb speculation may be “disruptive” to markets.

Anonymous's picture

HFT is not illegal but HFT does allow power to be concentrated into the hands of a few. I appreciate the comment that Goldman Sachs has a monopoly on the capital markets both in information and trade execution. This is purely an antitrust issue and should be pursued by the Government---channeling the Trust Busting of Teddy R.

The above comment that GS will destroy this market if they don't get their way has already been proven in Fall of 2008.

Anonymous's picture

HFT is not illegal but HFT does allow power to be concentrated into the hands of a few. I appreciate the comment that Goldman Sachs has a monopoly on the capital markets both in information and trade execution. This is purely an antitrust issue and should be pursued by the Government---channeling the Trust Busting of Teddy R.

The above comment that GS will destroy this market if they don't get their way has already been proven in Fall of 2008.

Anonymous's picture

"...Goldman Sachs has a monopoly on the capital markets both in information and trade execution"

A monopoly in trading volume, maybe, but I don't think they have a monopoly in trading execution. Maybe, just maybe, they are a few micro seconds faster than the other big banks, but I don't think that qualifies as a monopoly.

ShankyS's picture

BINGO! Ring the bell we have a winner here. GS has come to our government at a time of need as the white knight. Lo and behold to our leaders surprise GS became so entrenched that they can not be removed from the system without causing systemic collapse at a time when government power teeters on the brink and we can least afford it. They are dammed if they do and damned if they don't. They want power and control, so guess which way they decide?

Problem that TD is pointing out is that the white knight's system will eventually fail as power coils and condenses at the top. Then it crumbles. In the mean time to protect against this future event they remove shorting possibilities which will further exacerbate the fall when it occurs. We're fucked one way of the other.

I am pleased that this is being addressed, but GS's power base is so well entrenched and they are making so much money that the worse of the two scenarios will happen first. Flash will be done away with as "regulatory reform" occurs while not addressing the larger problem (similar to CDS issues). They sew up the wound but don't perform the required surgery to fix the problem. 

dark pools of soros's picture

just like the english boys did in that 20's crash and also what they did to Jackson when he got the US out of debt


they play the games and the sheep are their army

Miles Kendig's picture

The increased dynamics of these topics in various areas of society is the desired natural progression of the work that has been applied to this point.  I am sure that TD and many of the much more informed that I am among the participants here have carefully considered how those that oppose our efforts will attempt to deflect and alter the discussion and potential outcomes.  In this careful consideration and enhancement of the flows of information and consideration of specific reactions to stimuli will be most instructive.

Keep up the pressure.  The dynamics of the deep strike continue to apply.  Best wishes.

DebtorShredder's picture

MORE HEDGE FUNDS WILL COLLAPSE: You can always start a new one. Hell, start two at the same time, one buys, the other sells!

Auditting the FED may yield.

SWRichmond's picture

comment moved to new relevant thread

Anonymous's picture

Trader on Bloomberg says markets are manipulated and volumes 'ficticious'.

Anonymous's picture

We used to have flowing waves of amber. Now it's flowing waves of cesspool provided by Goldman and JP.

Anonymous's picture

Gee, that sure changed from the article I read this morning!

It was also, curiously, one where the 'positive' main page headline was drastically different from the actual article. I suspect that data has been so massaged since this morning that it's now out having a cigarette.

Anonymous's picture

The problem with Brownian dispersions is that eventually everything turns to sh*t. That is no assumption but reality.

amarshall's picture

Great, we didn't need the NYSE anyway

Anonymous's picture

I think there was nothing new learned in the op-ed that some people already know which is if everybody is perfectly hedged then nobody is. The point is that everyone seems to think there is more liquidity and hence their stop losses or what not would be good enough, except when that liquidity suddenly disappears. You could apply the same thing to the US bond market, which everyone thinks is most liquid. Some day it won't be so. In a zero sum game everyone cannot win that's why complacency precedes a crash.

Anonymous's picture

HFTs are just another reason why no average joe retail should participate in the stock market. It's a total sham with the market heavyweights trying to take your money away. Wall street needs retails in the market to take your money.. no retails means they canibalize each other

Anonymous's picture

Wilmott is brilliant. Most commentors here are clueless -- HFT is a tiny portion of GS revenues.

Anonymous's picture

OK anon 18213, show us our ignorance. Show us your brilliance.

BorisTheBlade's picture

Joe Saluzi is on the Bloomberg today talking about Flash trading:


Anonymous's picture

Anything that constitutes 70% of all trading will destabilize the market when the sh*t hits the fan

Anonymous's picture

Bubble markets and irrationally depressed markets have always existed, as have intense periods of volatility.

There were no computers buying tulips in Amsterdam, railroad stocks in London or crashing the US markets in the 30s.

Nor were there computers selling stock to irrationally low values compared to expecter income streams in the 60s and 70s.

Humans as a group are far less rational than computers when it comes to trading... and the volatility and boom/bust cycles are primarily of human making.

If you lost money in 2008 and are blaming it on the HF traders, I suggest a quick peek in the mirror followed by a re-read of Benjamin Grahams 'The Intelligent Investor'.

Prices took a beating not because computers ran them up and then down, but because human speculators ran them up, and there was finally no greater fool to sell to.

> Anything that constitutes 70% of all trading will destabilize the market when the sh*t hits the fan

I disagree. The computers will still be there looking for things to buy on the cheap when the markets are falling, whereas human nature is to run for the hills compounding steep market moves downward.