In The Fear Index, the latest thriller by Robert Harris, now heading for the Christmas bestseller lists, a brainbox hedge fund manager with little in the way of interpersonal skills discovers that his computer-driven trading system has flown out of control and threatens to send the world’s stock markets into a tailspin. Anyone familiar with Mary Shelley’s Dr Frankenstein will recognise the genre of the oddball genius consumed by his own creation — populist fiction at its best.
But is it fiction? Not so fast, reader. As Harris makes clear in a footnote near the end of his novel, the market meltdown which Dr Alex Hoffmann’s trading system appears to have prompted in The Fear Index is one that actually happened. A ‘flash crash’ on 6 May 2010 sent US stockmarket indices tumbling by more than 9 per cent in 15 minutes, causing short-term panic. One blue-chip company, Proctor & Gamble, saw its shares fall 37 per cent before they — and the market — eventually recovered.
What caused the flash crash remains a matter of controversy. As with the notorious ‘Black Monday’ crash of October 1987, when New York’s Dow Jones Industrial Average fell by more than 22 per cent in a single day, the flash crash was swiftly blamed on computerised trading programmes, and it was not long also before conspiracy theorists started to take issue with the somewhat inconclusive findings of official enquiries into how such an alarming episode could have come about.
In 1987 computerised trading was still in its infancy. There seems little reason now to dispute the verdict that a relatively new technique known as portfolio insurance was a powerful contributor to the market crash. Untested in a major market move beforehand, portfolio insurance was sold to institutional investors as a computer-driven risk management system, designed, ironically, to protect their portfolios against large market moves. Using financial futures contracts to provide that insurance, it turned out in practice to have the effect of creating an automatic, self-perpetuating spiral of sell orders as the market started to fall, thereby defeating its own objective. Regulators subsequently introduced a system of automatic trading halts, known as circuit-breakers, to prevent a repeat.
After last year’s flash crash, a joint enquiry by the Securities and Exchange Commission and the Chicago Futures Trading Commission failed to identify a single cause for the market’s sudden heart attack. It did, however, draw attention to the rise of so-called high frequency traders, to whom it attributed at least partial responsibility. High frequency traders employ networks of powerful computers to generate and execute orders at lightning speed, using complex algorithms based on a wide range of historic data to identify tiny price anomalies that may persist for no more than a few seconds at a time.
High frequency trading is an extreme example of a technique also employed by some hedge funds. Like the fictional Dr Hoffman in The Fear Index, real firms such as Renaissance Technologies, Winton Capital and Man Group employ scores of scientists (rarely economists) to develop sophisticated algorithms that form the basis of trading strategies. The results can be spectacular. Winton Capital, one of the most successful ‘quant’ funds in the business, made a profit of £288 million in 2008 and £60 million in 2009, while the rest of the world was losing its shirt. Winton’s founder, David Harding, recently gave £20 million of his estimated £400 million fortune to fund research at the Cavendish Laboratory in Cambridge.
Not everyone thinks that the advent of these fast-moving computer-driven funds is good news. Last week, the head of the Chicago Futures Trading Commission called for high frequency trading to be more closely regulated. In the UK, Vince Cable’s Department of Business, Innovation and Skills has set up a working party to study the implications. According to the government’s chief scientist (straying a little, you might think, from his normal brief), high-speed traders now account for a third of the daily volume of equity trading on the London stock market and as much as three quarters of the volume in the US.
It defies common sense to argue that such a dramatic change in the trading environment can take place without some impact on the way that markets behave — and nor is there any doubt that financial markets have experienced extreme volatility since the credit crisis in 2008. In the last three months, daily moves in leading stock markets, have been way above the historical norm. Daily moves of 2, 3 and 4 per cent in both directions are commonplace, against a long-term average of just 0.8 per cent a day. OK, there’s a cataclysmic eurozone crisis going on, but surely computer-driven trading must be at least partly to blame?
Industry apologists argue that ever faster trading fulfils a useful function by providing additional liquidity to the market and ensuring keener prices, just as financial theory says it should. As such it may make markets more, not less, stable. Bureaucrats are inclined to disagree, though with varying degrees of emphasis.
The International Organisation of Securities Commissions found last year that while algorithms and high frequency trading technology are useful risk management tools, ‘their usage was also clearly a contributing factor in the flash crash event of May 2010’. In contrast, a working group of the Bank for International Settlements earlier this year dismissed high frequency trading as the key trigger for the flash crash, but warned that the technique could add to systemic risks in the financial system by ‘accelerating’ and ‘propagating’ shocks initiated elsewhere, just as happened with portfolio insurance. Meanwhile, academics commissioned by the UK Government’s Office for Science conceded (sorry, Vince) that research has so far found ‘no direct evidence that high frequency computer-based trading has increased volatility’, but went on: ‘Despite all its benefits, computer-based trading may lead to a qualitatively different and more obviously nonlinear financial system in which crises and critical events are more likely to occur in the first place.’
Robert Harris puts the same common-sense point more clearly and more forcefully. It is the novelist’s prerogative to know what others can only guess at. You have been warned.
Jonathan Davis is the founder of Independent Investor.