"It's Getting Worse & Worse" - JPMorgan's Kolanovic Warns Algos Are Hurting Human Investors

Having shrugged off a collapsing Put-Call ratio as anything but a buying opportunity, and after "quadrupling-down" on his bullish take for risk assets - one which has so far failed to materialize and even following today's latest short squeeze, the S&P remains flat on the year - JPMorgan's quant MD Marko Kolanovic just came clean about some of the real risks in markets.

In an interview with Bloomberg Quint's Joanna Ossinger, the global head of macro quantitative and derivatives research at JPMorgan, recently identified by CNBC in its chyron as “Half-Man, Half-God,” explains that through the 2000s, quantitative trading grew to become a bigger market force than the fundamental investors

And that is just where he sees the potential problems arising...

JO: What bigger-picture market trends are you watching these days?

MK: There’s this fragility in the marketplace that came with the new structure of liquidity, with electronic market-making, computers, and growth in passive. Passive assets and quant assets will grow, and computers and AI will have a bigger role in ­market-making. At some point that’s going to end up badly—most likely when the next recession hits. Some of the problems around computerized liquidity are going to be fully exposed, and it may really deal a blow to investors and markets overall. Not that we are forecasting it with a certain timeline, but more that investors should have it in the back of their minds.

Is there a way to hedge yourself for some type of catastrophic event where liquidity collapses and this whole microstructure potentially fails? Can you design strategies that are going to be resilient to this type of fragility? Can you run some effective hedges that won’t cost you a lot of money? We are thinking about a number of things like timing: market-timing and timing of risk premia. It’s almost a holy grail - can you time these risk premia? So recently we’ve been testing machine-learning algorithms in the context of timing.

JO: So you’re worried about the rise of electronic trading?

MK: There’s more algorithmic trading, where algos are going through headlines or sorting through earnings statements or going through social media in real time and trading. What are the consequences for investors?

We’re seeing reaction time get shorter and shorter for releases, which can also incur costs or take advantage of slower human investors. There are signs of potential abuses with social media posts and headlines. That’s going to get worse and worse and be more of an impediment for human investors to make money. It’s going to cause more confusion in the marketplace.

If you run a certain strategy, how do you insulate yourself against these things? If these algos are taking advantage of you on the liquidity side, maybe they are also taking advantage of you with social media and news headlines. Can you have some sort of countermeasures, if you have a strategy that is vulnerable to that type of thing? What are the limitations? What are the ­regulatory angles as well? If someone is creating fake tweets to hurt your strategy, are you allowed to defend yourself by throwing off that algorithm?

Where’s the limit of market manipulation vs. defense?

Where indeed?

Of course, as long as the algo reactions send stocks higher - not lower - it will remain off the agenda of any and everyone in the asset-gathering, commission-taking world.