Build a system that even a fool can use, and only a fool will want to use it.
George Bernard Shaw, 1856-1950, Irish-born British Dramatist
The initial trigger for the drop in the Dow was probably due to fears that the Greek crisis was going to spread. One could credit this for 300 or maybe even a 400 point drop in the Dow; however, a 1000 point drop is quite another matter.
At 2.20Pm, the Dow was at 10,460 and then suddenly in 7 minutes it shed another 600 points. Humans could never move that fast. There are rumours that a trader entered billion instead of million and this triggered the massive sell off. Whatever the cause, the primary wave of selling was initiated by computers.
A simplified look at quant model
A Quant (Quantitative) programme is a computer model which determines which investment strategy is going to yield a superior rate of return; to simplify matters let’s assume the application decides when to go long or short. It is assumed that because computers have no emotions, they should be better at trading as they can move in and out of the markets extremely rapidly. The scary part is that the computer renders the final decision. There is one problem, these computers are programmed by humans and one glitch in the programme can cause havoc. Let’s not forget the old saying junk in junk out. Today’s wild action is indicative of what can go wrong when computers take over.
These quant programs now make the vital function of market marker almost obsolete and this is a very dangerous situation if left unchecked. Today Treasuries, SP500 and other indices were moving so fast it was hard to manually follow them. Computers took over the markets for a few minutes and in that time, they wrecked total havoc. What happens if the glitch is not spotted immediately, then a cascade of sell orders could be triggered pushing the Dow down until the circuit breakers kick in. However, if the glitch were not found then computers would resume selling after the markets opened again. Let’s not forget that big firms can still sell via Dark pools. They are electronic networks that allow big firms to sell stocks without tipping their hand; in other words, they can sell these stocks anonymously without the public ever knowing. This is a separate topic, and we will try to cover it another day. Two examples of firms offering such services are Liquid Net Inc., Pipeline.
Quant strategies are becoming extremely popular. They are now accepted in the investment community and even mutual funds are now using these models. These models are also known as alpha generators, or alpha gens. These programs are often set up in advance so that the computer can react instantaneously to moves in the market. For example, if the Dow drops below a certain level, the programme can unleash a massive sum of sell orders and in doing so trigger other quant programs. This could potentially trigger a market meltdown as was experienced today. Indeed, by some counts computers are responsible for as much as 70% of daily trading volume.
These models are now a real threat to the health of the financial markets and should be eliminated or closely monitored and regulated. Exchanges should not cater to firms that are using these programs and openly allow computers to place orders for millions and or billions of dollars. Exchanges should place a dollar limit on trades that can be initiated by such programs. One can only imagine what would happen if the computer mistakenly places a trillion dollar sell order. Today’s action is a warning, next time things could be infinitely worse. At one point ACN fell from 42.30 to 4 cents, that is 4 cents; it ended the day at 41.08 down $1.08. PG shed $23 in a heartbeat but closed the day down only $1.41. In between someone could have had a heart attack. Imagine you had 1 million dollars in ACN, and then suddenly watched your portfolio shrivel right in front of your eyes as ACN fell to 4 cents from 42 dollars.
One of our first warnings came from Long-term capital (LTC). LTC founded in 1994 was one of the most famous Quant based funds and it was run by two noble prize winning economists: The Quant model did not foresee the Russian government defaulting on its own debt and this triggered a series of events that destroyed LTC. In less than four months in 1998 LTC lost 4.6 billion dollars. If the Feds had not stepped in, things could have really turned ugly.
These quant trading programs need to be regulated and not allowed to freely take over the markets; they are destroying the vital role market makers play to maintain financial stability in the markets. Today’s action should serve as a wake-up call for those who have turned a blind eye to risks these programs pose to the markets. Next time round we might not be so lucky.
The key to the age may be this, or that, or the other, as the young orators describe; the key to all ages is — Imbecility; imbecility in the vast majority of men, at all times, and, even in heroes, in all but certain eminent moments; victims of gravity, custom, and fear.
Ralph Waldo Emerson, 1803-1882, American Poet, Essayist
Other articles you might be interested in
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Gold, Silver, Palladium: True Bull Market (April 28)
Bonds nowhere to go but Down (April 21)
Dollar, Gold and Silver (April 20)
The dangers of Quant Trading models