Guest Post: Market Ecology

Rajiv Sethi

The erudite and very readable RT Leuchtkafer has posted yet another comment for the Securities and Exchange Commission to digest. This one was prompted by a paper by Andrei Kirilenko, Albert Kyle, Mehrdad Samadi and Tugkan Tuzun that provides a fascinating glimpse into the kinds of trading strategies that are common in asset markets today and the manner in which they interact to determine the dynamics of asset prices.

As I have argued on a couple of earlier occasions, the stability of a market depends on the composition of trading strategies, which in turn evolves over time under pressure of differential performance. Since performance itself depends on market stability, and destabilizing strategies prosper most when they are rare, this process can give rise to switching regimes: the market alternates between periods of stability and instability, giving rise to empirical patterns such as fat tails and clustered volatility in asset returns.

But the underlying strategies that are at the heart of this evolutionary process are generally unobservable. Since traders have no incentive to reveal successful strategies, these can only be inferred if individual orders can be traced to specific accounts.

This is what Kirilenko and his co-authors have been able to do, on the basis of “audit-trail, transaction-level data for all regular transactions in the June 2010 E-mini S&P 500 futures contract (E-mini) during May 3-6, 2010 between 8:30 a.m. CT and 3:15 p.m. CT.” While their primary concern is with the flash crash that materialized on the afternoon of the 6th, their analysis also sheds light on the composition and behavior of strategies over the period that led up to this event. Their analysis accordingly provides broader insight into the ecology of financial markets.

The authors classify accounts into six categories based on patterns exhibited in their trading behavior, such as horizon length, order size, and the willingness to accumulate significant net positions.  The categories are High Frequency Traders (HFTs), Intermediaries, Fundamental Buyers, Fundamental Sellers, Opportunistic Traders and Small Traders:

[Different] categories of traders occupy quite distinct, albeit overlapping, positions in the “ecosystem” of a liquid, fully electronic market. HFTs, while very small in number, account for a large share of total transactions and trading volume. Intermediaries leave a market footprint qualitatively similar, but smaller to that of HFTs. Opportunistic Traders at times act like Intermediaries (buying a selling around a given inventory target) and at other times act like Fundamental Traders (accumulating a directional position). Some Fundamental Traders accumulate directional positions by executing many small-size orders, while others execute a few larger-size orders. Fundamental Traders which accumulate net positions by executing just a few orders look like Small Traders, while Fundamental Traders who trade a lot resemble Opportunistic Traders. In fact, it is quite possible that in order not to be taken advantage of by the market, some Fundamental Traders deliberately pursue execution strategies that make them appear as though they are Small or Opportunistic Traders. In contrast, HFTs appear to play a very distinct role in the market and do not disguise their market activity.

Based on this taxonomy, the authors examine the manner in which the strategies vary with respect to trading volume, liquidity provision, directional exposure, and profitability. Although high-frequency traders constitute a minuscule proportion (about one-tenth of one percent) of total accounts, they are responsible for more than a third of aggregate trading volume in this market. They have extremely short trading horizons and maintain low levels of directional exposure. Under normal market conditions they are net providers of liquidity but their desire to avoid significant exposure means that they can become liquidity takers very quickly and on a large scale.

The extent to which different trading strategies provide liquidity to the market is assessed by the authors on the basis of a measure of order aggression. An order is said to be aggressive if it is marketable against a resting order in the limit order book (and is therefore executed immediately.) The resting order with which it is matched is said to be passive:

From a liquidity standpoint, a passive order (either to buy or to sell) has provided visible liquidity to the market and an aggressive order has taken liquidity from the market. Aggressiveness ratio is the ratio of aggressive trade executions to total trade executions… weighted either by the number of transactions or trading volume… HFTs and Intermediaries have aggressiveness ratios of 45.68% and 41.62%, respectively. In contrast, Fundamental Buyers and Sellers have aggressiveness ratios of 64.09% and 61.13%, respectively.

This is consistent with a view that HFTs and Intermediaries generally provide liquidity while Fundamental Traders generally take liquidity. The aggressiveness ratio of High Frequency Traders, however, is higher than what a conventional definition of passive liquidity provision would predict.

Moreover, the aggressiveness ratio of HFTs is not stable over time and can spike in times of market stress as they compete for liquidity with other market participants:

During the Flash Crash, the trading behavior of HFTs, appears to have exacerbated the downward move in prices. High Frequency Traders who initially bought contracts from Fundamental Sellers, proceeded to sell contracts and compete for liquidity with Fundamental Sellers. In addition, HFTs appeared to rapidly buy and [sell] contracts from one another many times, generating a “hot potato” effect before Opportunistic or Fundamental Buyers were attracted by the rapidly falling prices to step in and take these contracts off the market.

To my mind, the most revealing findings in the paper pertain to the profitability of the various strategies, and the ability of some traders to anticipate price movements over very short horizons (emphasis added):

High Frequency Traders effectively predict and react to price changes… [they] are consistently profitable although they never accumulate a large net position. This does not change on May 6 as they appear to have been even more successful despite the market volatility observed on that day… Intermediaries appear to be relatively less profitable than HFTs. During the Flash Crash, Intermediaries also appeared to have incurred significant losses… consistent with the notion that the relatively slower Intermediaries were unable to liquidate their position immediately, and were subsequently run over by the decrease in price…

HFTs appear to trade in the same direction as the contemporaneous price and prices of the past five seconds. In other words, they buy… if the immediate prices are rising. However, after about ten seconds, they appear to reverse the direction of their trading… possibly due to their speed advantage or superior ability to predict price changes, HFTs are able to buy right as the prices are about to increase… In marked contrast… Intermediaries buy when the prices are already falling and sell when the prices are already rising…

We consider Intermediaries and HFTs to be very short term investors. They do not hold positions over long periods of time and revert to their target inventory level quickly… HFTs very quickly reduce their inventories by submitting marketable orders. They also aggressively trade when prices are about to change. Over slightly longer time horizons, however, HFTs sometimes act as providers of liquidity. In contrast… unlike HFTs, Intermediaries provide liquidity over very short horizons and rebalance their portfolios over longer horizons.

What appears to have happened during the crash is that the fastest moving market makers with the most effective algorithms for short run price prediction were able to trade ahead of their slower and less effective brethren, imposing significant losses on the latter. In Leuchtkafer’s colorful language, this was a case of interdealer panic and marker maker fratricide.

But regardless of how the gains or losses were distributed in this instance, the fact remains that an overwhelming share of trading activity is based short-run price forecasts rather than fundamental research. Under these conditions, how can one expect prices to track changes in the fundamental values of the income streams to which the assets give title?

Markets have always been based on a shifting balance between information augmenting and information extracting strategies, but a computational arms race coupled with changes in institutions and regulation seem to have shifted the balance markedly towards the latter. Unless the structure of incentives is altered to favor longer holding periods, I suspect that we shall continue to see major market disruptions and spikes in volatility.

This is not just a matter of academic interest. To the extent that changes in the perceived volatility of stocks gives rise to changes in asset allocations by institutional and retail investors, there will be consequences for the extent and distribution of risk-bearing, and ultimately on rates of job creation and economic growth.

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26 comments

  1. Too slow 2 play

    Behavioral economics meets a swarm of wall street supercomputers … not a good combo for society. These quants will have no one left to milk besides themselves!

    Old story: Now, thanks to the proliferation of HFT-Quants, Wall Street’s again racing at hyperspeed, gambling with the money it conned from taxpayers, using it to skim more from clueless investors. First the Fed and Treasury, now Wall Street’s “Too-Stupid-To-Fail” banks are stealing from Main Street’s “Too-Dumb-To-Stop-Trading” investors.

  2. financial matters

    http://www.cnbc.com/id/38816802

    Retail Investors Don’t Trust the Market: McCaughan

    Brooke Sopelsa

    “””“We look after millions of people’s 401(k)s, and we want to be able to look them in the eye and say the market is fair, and I’m telling you unfortunately at the moment it’s quite difficult to do that,” McCaughan told CNBC Monday.

    “There was the Flash Crash in May that hit the headlines, but there’s also been extreme volatility in the equity market for no major reason,” he explained. “Even in the last two or three weeks, we’ve seen 3 percent moves on no news.”

    McCaughan said reform of the U.S. equity market is going to be necessary for the retail investor to trust the market again.

    Front Running
    McCaughan told CNBC there is “very strong circumstantial evidence” that front-running with high-frequency trading is occurring in many places, and he said this is partly to blame for the recent volatility in the equity market.
    “When orders get pinged out to multiple trading venues there is at least circumstantial evidence that there’s quite widespread use of that information to front-run trades,” he explained.

    Front running is an illegal practice that occurs when stock brokers execute orders on a security for their own accounts with the knowledge of pending orders from their business.”””

  3. out of touch again???

    Re: “reform of the U.S. equity market is going to be necessary for the retail investor to trust the market again.”

    ==> You mean it’s not fixed … when did that happen?

  4. ex-PFC Chuck

    As I’ve previously commented on this blog:

    May we please now have a transaction tax? Preferably one with rates inversely proportional to the hold time on a LIFO basis?

    1. Aquifer

      NYS has had a stock transfer tax for over a hundred years. The problem is that it has been rebating 100% of it (minus “administrative costs”) to the payers of the tax for the last 30. Last year that amount was ~$16 billion (yup, billion) and this year it is projected at ~$14 billion.

      So, being returned to the payers doesn’t exactly result in putting any kind of break on frequency.

      The bigger “crime”, IMO, consists in the fact that the NY Gov. and leg are aping WI, if a bit more subtly, in blaming Public employees and in making up for our phony “deficits” by whacking public services while returning billions in tax monies to stock brokers who ain’t exactly “poor”.

      One thing i do not understand is why this is not getting the same amount/type of coverage in the press as, e.g., the WI farce is …..

  5. attempter

    the stability of a market depends on the composition of trading strategies

    Stable markets? I have a radical (i.e. rational, and therefore radical from the point of view of a demented system) idea.

    Since we know the stock market serves no purpose whatsoever but is purely destructive, let’s get rid of it completely.

    1. Cedric Regula

      The game started centuries ago and can’t be stopped. New owners buy out old owners. It’s way of the world. We just need to keep the clowns and crooks out of it.

        1. Cedric Regula

          Let’s not assume that they have the new model down quite right yet. Usually there all of a sudden one guy empties out the country’s bank account all at once, instead of just skimming a few pennies a microsecond.

      1. Toby

        It’s way of the world. We just need to keep the clowns and crooks out of it.

        “It’s the way of the world” at the moment. It was not always this way. Humans have been around for hundreds of thousands of years, stock market trading for but a fraction of that time. Once there were no humans, once there was no life on earth, once there was no earth, and so on. Change is the only constant.

        And I really don’t believe you can keep the crooks out of the market place. Not only does it attract them like shit attracts flies, the corruption and fraud actually keep the whole show together (I have that from a traders mouth). Ever since scarcity, surplus, specialization and private property have shaped our socioeconomics, we have had this issue of corruption at a depth the preceding commons-based, more egalitarian systems could not have imagined. And it’s not that humans are genetically predisposed to corruption and fraud, nor is it really that these things are Evil — corruption and ‘gaming the system’ seem to me to be part of creativity for example — they are simply predictable and organic manifestations of the way the whole shebang operates.

        Society needs stock markets while it holds certain things to be self-evident, such as private property, scarcity, perpetual growth, market-driven money creation, and so on. But the myths and justifications we have spun to sustain this ‘system’ are crumbling. I believe we are realizing in growing numbers that consumerism and ‘enlightened self-interest,’ coupled with a rigid hierarchy of psychopathic elites ‘looking after’ the ignorant masses who can’t look after themselves, is not a sustainable or healthy way of organizing society. There are indeed other ways. They are not fully defined, nor can they be, but the desire for radical and deep change is growing. I believe post-scarcity and resource-based economics offer important ideas on how we might transition away from ‘the way it is’ to something fundamentally different. I don’t know if we’ll succeed, but if we don’t it won’t be because there are no alternatives to stock market trading and capitalism generally.

    2. financial matters

      One of the strangest things that I saw several years ago was when Consumer Reports came out with an article on investing and said that the biggest mistake retirees make is not having 90% of their income in the stock market. There was not word one about any downside risk. Right now I hear people say why get a CD at 2% when I can get a safe conservative stock paying a dividend of 4%. And this is right after a huge market crash. How many individuals and pension plans are now again heavily into equities hoping for great growth? Many of these people don’t seem to understand the gambles they are taking and many investment advisors just tell them that over time stocks have always performed well… Oh really??

      The stock market is heavily rigged and probably should be used just for speculation and entertainment. And with the speculative percentage of your investments.. maybe 10%

      http://www.edge.org/3rd_culture/taleb09/taleb09_index.html

      TEN PRINCIPLES FOR A BLACK-SWAN-ROBUST WORLD [4.16.08]
      By Nassim Nicholas Taleb

      9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

      http://seekingalpha.com/article/205239-nassim-taleb-on-what-should-really-worry-us-about-the-flash-crash?source=article_sb_popular

      Nassim Taleb on What Should Really Worry Us About the ‘Flash Crash’

      Thinks the stock market should be used for entertainment rather than serious long term investment. (ie look for possible speculative trades but realize the market is ‘rigged’ in favor of big players) This is highlighted in his take on the 1000 point termporary/flash crash in that he thinks the market has serious structural flaws

      http://www.nytimes.com/2010/07/03/business/economy/03illinois.html?_r=2&partner=MYWAY&ei=5065

      Illinois Stops Paying Its Bills, but Can’t Stop Digging Hole

      By MICHAEL POWELL
      July 2, 2010

      Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.

      1. Cedric Regula

        I think a HFT dominated stock market is entertainment. Same as a toy airplane. The airplane is supposed to fly…everyone knows that. So the motor starts, propeller whirs, it takes off and just starts going up and up. Then along comes a gust of wind, it stalls because there is no pilot, and does a death spiral nose first into the ground.

        I gave up trying to fly RC airplanes too, and just stick with entertainment I can handle.

      2. Mat Albert 5416

        financial matters said: “The stock market is heavily rigged and probably should be used just for speculation and entertainment. And with the speculative percentage of your investments.. maybe 10%”

        And IMHO, even the speculative percentage (whatever percentage you choose to gamble with) should probably be in low-cost index funds that either track the entire market or broad segments of the market. As recommended by Malkiel, Swensen, Charles Ellis, etc who argue that stock picking is a loser’s game encouraged by Wall Street, and that trading is a zero-sum game. In Malkiel’s famous quote from his Random Walk book: “A blindfolded chimpanzee throwing darts at The Wall Street Journal could do as well as the experts at picking winning stocks.”

        So own the entire market with a passive index fund (or funds) understand that today even this strategy has to be considered gambling as opposed to investing (whatever “investing” would mean in a rigged market) or even better, stay out altogether. But whatever you do, don’t listen to CNBC, Wall Street analysts or read Barrons.

      3. Aquifer

        Thank you very much!

        As someone who, admittedly, understands little of much of this (the lingo trips me up every time), it has long seemed to me that “the Market” was a casino and, like the slots at Vegas, should only be visited by those who have money to throw away, so it is nice to see that someone who obviously knows considerably more about this stuff than i do seems to share that opinion …..

  6. Peripheral Visionary

    There is already a serious proposal in place to implement an audit trail, and despite resistance from the broker-dealers and the exchanges, both of whom would have to update their systems to a limited extent, I think it will happen.

    With respect to May 6, however, the faster algorithms may have caused the damage, but I think they also suffered from it. From the data I reviewed, the traditional market makers had huge numbers of buys at the bottom and huge numbers of sells through the recovery, and so may have come out net positive on the day, while the faster algorithms panicked when the market moved outside the range of expected behavior, and many were shut down, effectively locking in losses. In fact, I suspect that losses for HFT algorithms would have been much larger had not the exchanges canceled so many trades, with many, even most, of the sells at the bottom being algorithm trades.

    1. Percy

      As to the audit trail, the cost of implementing it is not insignificant (estimates are $4 billion to create it and $2 billion annually to maintain it). To many, this cost is so high that it is inconceivable that the SEC will ever follow through on these concepts. Even if it steels itself to do so, and manages it in a way that suirvives judicial review, it will take considerable time to do — about two and a half years, according to SIFMA. Absent such systems, the SEC will remain helpless in trying to unravel what has occurs at any given moment in the markets and who did what. HFT prop traders (scalpers parading as market makers and luquidity providers, as Leuchtkafer has correctly identifed them) will remain free to take unfair advantage, as they do, of other market participants, discouraging participation by sensible non-gamblers. This is not a good thing.

  7. readerOfTeaLeaves

    Markets have always been based on a shifting balance between information augmenting and information extracting strategies, but a computational arms race coupled with changes in institutions and regulation seem to have shifted the balance markedly towards the latter. Unless the structure of incentives is altered to favor longer holding periods, I suspect that we shall continue to see major market disruptions and spikes in volatility.

    Yes, markets appear to have become complex math formulas, and the math seems to be morphing in complexity. And without volatility, how could an HFT trader make any profit whatsoever? They won’t make a dime in a steady state.

    Looks like a nice piece of research to uncover the ecological dynamics in play; the way that I read this, the only way the HFTers can profit is to have price instability, so I’d expect periods of intense ‘chatter’ and disruptions in this system as trigger for some to profit. It’ll be interesting to see what kinds of predictions this research will allow the researchers to hypothesize.

  8. jake chase

    Perhaps someone can explain how high frequency traders know “when prices are about to change?”

    I have been trading since 1980 but this still escapes me.

    1. financial matters

      Front-running would seem to fit the bill. Helps to have a few seconds of insider informantion..

    2. Percy

      Knowledge of pending, unexecuted orders and other trading interest at a speed that surpasses others’ ability to get that information (co-location helps) coupled with lightening fast analysis of what others’ algorithms are likely to do under paticular sets of circumstances.

    3. TimHobbs

      From the paper:

      This can be interpreted as follows: a one tick increase in current price corresponds to a increase of
      about 32 contracts in the net holdings of HFTs. Moreover, a one tick increase in the
      current price corresponds to an increase of up to 67 contracts during the next 4 seconds.

      In contrast, estimated coefficients for lagged prices 10 to 20 seconds prior to the
      current holding period are negative and statistically significant. [..] This, in turn, means
      that a one tick increase in price 10 to 20 seconds before corresponds to a maximum
      cumulative decrease in net holdings of about 39 contracts.

      We interpret these results as follows. HFTs appear to trade in the same direction
      as the contemporaneous price and prices of the past four seconds. In other words, they
      buy, if the immediate prices are rising. However, after about ten seconds, they appear
      to reverse the direction of their trading – they sell, if the prices 10-20 seconds before
      were rising.

  9. eurostoxx

    does anyone know how you can identify a type of trader from their orders. I was under the impression that information like this is to remain anonymous.

  10. Hugh

    I am always left wondering what socially useful purpose any of this represents. Who really cares if HFTs provide liquidity to markets? Does this liquidity serve any function other than as bait in order to extract other people’s liquidity from the market? Do you notice how even the usual excuse of price discovery doesn’t even rate a mention?

  11. j gordon

    Let’s see , the insider selling is at all time high or close to that, but the crooked bankers tell you to buy .
    These people want to take us for a last ride before protestors show up on their door step on wall street and demand justice and the money back.

Comments are closed.