The Market as an Evolutionary Microcosm

Natural forces have a way of self-correcting whether in ecosystems, a microcosm or market systems. The energy, creativity and fortitude behind the participants of these systems have often caused wholesale evolutionary change, and in that sense of evolutionary scale, change occurs slowly yet often times with overwhelming force no matter the opposition or the distaste the break with the past inflicts.

In the ongoing debate over high-frequency trading, there are those that continually reference a handful of  detrimental effects, such as the notion that trade volume does not equate to increased liquidity. I suspect on this particular point, there is not much debate really.  No matter, HFT is a powerful force and growing.

The back and forth argument of the pros and cons of HFT, reminds of the debate over genetic engineering of grain crops. The two camps in that debate argument vehemently for their side, neither one budging an inch or conceding to the other.  Seems like a stalemate, but there are natural forces at work here that will push the dispute in favor of the geneticist. It really does not matter if you or I agree; the ecosystems of the world will determine the choice.  Throughout the history of domestication of grain crops which goes back thousands of years, humans have intervened with their genetics. Mutations of all sorts have occurred that favored humans over the grain’s own survival, such as whether the seed pops from its husk and falls to the ground to grow anew in the spring or remains stuck it at the top of the stalk for us to harvest and eat. A seemingly small disruption or perturbation in the natural order of things, yet the ripple effect is long-lasting.  These are the forces at work that bring to bear change within ecosystems.

Like ecosystems, our market system is made up of participants pushing and pulling like opposing forces with a natural order. Trading venues have certain rules for accepting and executing participants’ orders. The behavior of the participants (their desire to place buy/sell orders at a certain time and price) is affected by many external factors as well as by what they see happening in the market place itself. As Leonid Frants, President and Founder of OneMarketData describes: “The whole thing is a Dynamic System with a feedback mechanism. This system has not been consciously designed.” Instead this system has evolved naturally. Hence, it is subject to the same sort of evolutionary cycles caused by behavioral changes and disruptions. High frequency trading, one of the evolving changes in the market has disrupted the old order of things.  Their very existence and the role they play as market makers has made the specialists of yesteryear obsolete.  Steve Wunsch compares the two in his article on market maker obligations.  In his article, Steve talks about the inevitability of HFT, almost like it’s the next evolutionary step in our market system. His warning is don’t over-regulate this natural progression, doing so potentially disrupts their stabilizing effect.

“Laying [regulation-based] stabilization obligations on today’s high-frequency traders — perhaps sweetening them with exemptions for short selling, as has been suggested — would not stabilize markets with anything like the force of the old, [specialist] reputation-based inducements to perform stabilization feats that went far beyond legal requirements. … The small horde of high-frequency traders today is likely to continue to grow rapidly and become a huge horde, eventually solving the stabilization problem on its own…”

 

The next evolutionary stage of our markets by all appearances.

Participants in the market ecosystem provide benefits – they improve liquidity, tighten spreads, and make it cheaper for others to trade. HFT is no exception. Automated trading has over years contributed to trillions of trades executed more tightly, providing liquidity and other benefits even to an average investor. This has to far outweigh the damage caused on a single disruptive day, the perturbation of the Flash Crash.  After the brief 7-minute instability, the markets restored themselves, yet the consequences are still rippling through the system (financial and government).

Regulation looms overhead for our markets and despite Steve’s warning the quoting obligation ruling has taken effect in early December.With that ruling market makers now have the obligation to place buy/sell orders within 8 percent of the national best bid offer (NBBO) for ‘most’ of the trading day (the rules slacken early and late in the trading day), thus eliminating stub quotes.  “They [stub quotes] were an anachronism. This is a good change for the market.”, said Chris Isaacson, COO of Bats Global Markets. The tipping point for enacting this rule has its beginnings in the Flash Crash of May 6th, when liquidity dried up and market orders hit these stub quotes. This is likely the first of many rulings for regulating our financial markets. As many as 300 regulations are to be issued as a result of Dodd-Frank over the next 5 years. A daunting task considering Sarbox had only 16. What Steve Wunsch warns for market makers, likely applies to the financial industry as a whole, we run the risk of seeing the pendulum swing hard and over-regulating.

It’s important to consider the market as a microcosm and like natural systems it is dynamic and subject to an occasional unstable state. These unstable states can happen even when participants behave in a completely normal intended way, and are not trying to abuse the system or engage in disruptive techniques. I’m sure no one believes Waddell & Reed had any intention of causing the instability that ensued on May 6th with 75,000 E-mini contracts. Because such unstable states are highly undesirable for the investor and in the extreme case for economy as a whole, the system has and will continue to evolve to minimize the probability of such events. The introduction of circuit breakers and quoting obligations are examples, but like any evolutionary process the resulting change may have unexpected consequences. That remains to be seen.

We need to understand that such unstable states are inherent to a system which has not been designed holistically, but evolved naturally.  The attention placed on HFT  should clearly consider their contributions to improvements in costs, liquidity and spreads and not just the negative.  Nevertheless, Dynamic Systems are constantly evolving; it is the natural order of things. HFT firms too will have to adapt as regulation’s checks and balances are another evolutionary step in our markets.

Once again thanks for reading.
Louie

For an occasional opinion or commentary on technology in Capital Markets you can follow me on  twitter, here.

About Louis Lovas

Director of Solutions, OneMarketData, with over 20 years of experience in developing cutting edge solutions and a leading voice in technology and trends in the Capital Markets industry.
This entry was posted in Algorithmic Trading, Analytics, Complex Event Processing, Equities, Foreign Exchange, Futures and Options, Tick database. Bookmark the permalink.

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