Saturday, October 8, 2011

How computers and scientists are driving world finance

The Daily Mail published a very interesting article on the subject. Here's an excerpt.

Computers have become so powerful in the world of financial trading that the human involvement has been reduced to that of the 'quants' [quantitative analysts] and their obsessive statistical analyses. But computer programmes based on statistics, however brilliantly analysed, do not allow for common sense.

Computers predicted the U.S. property market would rise for ever because statistics showed the country’s house prices had never fallen in history — and every financial institution worldwide piled into the American’s mortgage market. We all know what happened next: the housing market crashed, U.S. mortgages were worthless and the so-called sub-prime loan crisis sent the world’s financial markets into meltdown.

Most of us in Britain remember May 6 last year as the date of the General Election. But about two and a half hours before the polls closed in the UK, at around 2:30 pm on the American East Coast, the U.S. financial markets experienced what came to be known as ‘the Flash Crash’.

The events of those few minutes provide a terrifying snapshot of what the modern markets have become. First, there is their sheer scale: 19.4 billion shares were traded on that day, more than were traded in the entirety of the Sixties.

But the figure is misleading: hundreds of millions of these shares were never actually sold, but merely held for a few thousandths of a second as computerised high-frequency traders tested the waters in the market.

They ‘sniped’ and ‘sniffed’ (in the jargon of the industry), making bogus offers to buy or sell shares so that they could find out the price, but the traders never went through with the sale.

The trouble is that the computers registered these bogus offers as real sales, and so much of this activity took place that the online trading section of the New York Stock Exchange temporarily froze. It was unable to cope — all the ‘sniping’ and ‘sniffing’ had made the amount of shares traded seem ten times larger than it actually was.

In the ensuing panic, the Dow Jones Industrial index dropped by roughly 700 points in the space of 20 minutes, wiping out nearly $1 trillion of investors’ money. This, then, is the financial world which we now live in: a world of extreme volatility, with lurches of 3 or 4 per cent a day on the markets no longer uncommon.

A world of terrifyingly complicated financial instruments designed to spread risk but which have, instead, spread a contagious lack of confidence; a world of instant communications, in which tremors of panic spread across the whole globe in the time it takes ripples to spread across a lake; a world in which thousands of the most brilliant minds on the planet are no longer paid to pursue scientific progress, but to devise financial strategies that are mostly non-productive and sometimes potentially highly dangerous.

. . .

How many of us, for example, have the least idea of what the latest financial instrument — an exchange-traded fund — actually is? Yet the quants are now busy turning exchange-traded funds into a trillion-dollar industry, up 40 per cent in Europe alone in the past year. And like all these computer-devised financial derivatives that preceded them, they are cloaked in mystery and are risk damaging the financial system.

. . .

As the current sense of sleepwalking towards calamity continues, my worry therefore is not so much the obviously imminent Greek default, or even the strains in the Eurozone, or the U.S. budget deficit, or the long-term intentions of the Chinese.

It is that the financial system itself has somehow slipped all human control — that it has become the preserve of a profoundly anti-democratic, super-rich elite, and that it girdles the planet like some alien entity from an H. G. Wells novel.

The digitised financial machine does not work for us: we work for the machine. And I do not believe that our political leaders have the faintest idea how to bring it under control.

There's much more at the link. Thought-provoking reading, to put it mildly! Highly recommended.



trailbee said...

And we can't turn the computers off anymore! Scary.

deadcenter said...

"Computers predicted the U.S. property market would rise for ever because statistics showed the country’s house prices had never fallen in history — and every financial institution worldwide piled into the American’s mortgage market."

Sorry, but wrong. Wrong, wrong, wrong!. Computers models as programmed by human beings that have no concept on how to model that which they have not encountered, predicted ever increasing prices on houses. Any human being that has read, and grokked, an Economics text book would not have been ignorant enough to write the quoted sentence. Garbage in, garbage out, plain and simple and if you have no data indicating when housing prices fall during various economic up turns and down turns, then you cannot program a model that will predict when supply will out strip demand and cause prices to fall.

Epic fail.

Noons said...

High speed computerized trading must be stopped.

The stock market is supposed to be a place where people can trade options, shares, etc.

The keyword here is "people". Not computer programs.

Of course: one can use computers to effect the trading and settlement, that is where they are useful.

But to allow computer programs to make the decisions on trading is not only against the purpose of the stock market, it is against people in general.

The stock market is supposed to be open to everyone. What do you fancy are the chances of a person trading against these high speed programs?

None whatsoever!

What is happenning - and has been for nearly 15 years now - is that a small number of companies with access to immense computing power and high speed communications, have essentially subverted the entire stock market and transformed it into a mockery of what it was supposed to be.

As usual: at the expense of small and medium private investors.

There is no moral, civil or political justification for this state of affairs to continue other than unmitigated, pure corporate greed.