"Technology - For Good and For Evil"

Sydney M. Williams

Thought of the Day

“Technology – For Good and For Evil”

July 16, 2010

It is probably my age, but I find it offensive when a necessary market is used for purposes that were never intended – especially when the results provide no societal economic benefits other than padding the pockets of a few. I refer, of course, to the stock market and the deployment of quantitative technologies in algorithmic-driven high frequency trading platforms, which generate trading volumes equal to an estimated 70% of a total day’s volume.

The necessity for governments and corporations to raise capital and the subsequent need for investors to be able to sell and to buy provided the impetus that created stock exchanges in the first place. Exchanges date back several centuries, with the earliest operating out of coffee houses and were often only open for an hour or two a day. The Venetians (think Shakespeare and The Merchant of Venice) were among the first, trading debt securities of other governments in the early 1300s. In the first part of the 16th century an exchange was established in Antwerp. London was not far behind. The Buttonwood Agreement, establishing the forerunner of the NYSE, was signed on May 17, 1792. Those exchanges played a critical role in the growth of commerce, the furtherance of global trade and helped raise living standards for millions of people around the world.

That some of those exchanges now serve as little more than casinos, permitting a few thousand people to place bets is antithetical to the original intent of those exchanges. And worse, as we learned on October 19, 1987 and then again on May 6 of this year, quantitative-driven programs increased risks for legitimate investors. The holding periods for many high frequency traders is often measured in seconds. Their claim that they provide liquidity rests on dubious evidence at best. They have, though, enriched a small number of people to an extant virtually beyond measure.

There is no (and there never should be) stopping technological development and, despite my misgivings, there seems little likelihood that any obstruction in the form of regulation (other than circuit breakers) or taxation will be placed in the way of high frequency traders.

It was, therefore, a pleasure to read in Wednesday's Wall Street Journal of a small firm, Rebellion Research, which is using algorithmic equations to design artificial intelligence programs to make investment decisions. At this point, firms utilizing A.I. are small enough to have little market impact, but there are significant differences between those using quantitative approaches to enhance fundamental returns and what HFTs attempt. First, as Spencer Greenberg of Rebellion explains: "What makes Star (as they call their program) intelligent is its ability to adjust its strategy based on shifting dynamics in the market and broader economy." The firm considers more than 30 factors that can affect a stock's performance, from price earnings ratios to interest rates. And, second, the average holding period for Rebellion is four months versus a few seconds for HFTs.

Firms like Rebellion use algorithmic equations to create artificial intelligent platforms in order to make quantitative, but fundamental, bets, while HFTs use similar mathematical models to be able to trade more rapidly, eking out a few pennies per trade, at times arbitraging price discrepancies; for example, ETFs from their underlying stocks, or they may engage in simple old fashion front running. Whether Mr. Greenberg’s firm succeeds or does not – and early reports look promising – he is using technology in a creative and non-destructive way.

Technology, while usually a blessing, can also be a curse. Michael Cembalist, Chief Investment Officer for J.P. Morgan Private Bank and who writes a column, “Eye on the Market”, recently wrote about high frequency trading programs and the temptation to define all forms of innovation as progress: “You do not have to be a Luddite to raise questions about undesired consequences of innovation, particularly when financial services are involved.”