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July 30, 2013

The Supercomputers of Wall Street: Friend or Foe?

Alex Woodie

The face of Wall Street has changed significantly over the last decade. Where Gordon Gecko-types once dominated exchanges, today’s Wall Street is run by quantitative analysts who write the algorithms that run on the supercomputers that make the actual trades, using super high speed network connections to exchanges. While the new system has unquestionably enriched some, the question becomes: Has it benefited the rest of us? 

An informative article in The Telegraph paints a fascinating picture of how machine-based trading and high frequency trading (HFT) is changing Wall Street. From the increase in short-term volatility and propensity for “flash crashes” to harnessing scientific genius away from traditional fields and using “quants” to pursue of ever-bigger profits, the computer and network arms race has already had an irreconcilable impact on the culture of Wall Street.

Computers today already initiate about 70 percent of the buy and sell transactions on Wall Street, according to The Telegraph’s story. It’s common to have more trades executed in a single day than all of the trades over a 10-year space several decades ago.

The fact is, machine based trading is a requirement, because humans could never initiate trades at the speeds and volume that today’s HFT operations need to make a profit. One could have a reasonable discussion on the merits of long-term, buy-and-hold investing. But in the world of HFT, holding an asset for just few milliseconds too long can mean the difference between booking a million dollar profit or a million dollar loss.

When firms spend tens of millions of dollars are spent laying super-fast network connections between major trading hubs–like the Chicago Mercantile Exchange, the New York Stock Exchange, and the London Stock Exchange–expressly for the purpose of being able to execute transactions a few thousands of a millisecond quicker than competitors, you know that the trading game has changed substantially.

HFT and machine-based trading have combined to generate billions in profits for the firms who do it best. But things don’t always work out as planned. Exhibit A is the “flash crash” that took place on May 6, 2010.

According to The Telegraph’s story, the volume of trades that day overwhelmed the New York Stock Exchange online trading section. When the NYSE’s online trading system froze, the supercomputers of Wall Street firms initiated sell orders, and in just a few minutes, more than $1 trillion in value on the NYSE vanished. Then, just as quickly as it was lost, the exchange regained the value. 

This Flash Crash served as a wake-up call to some HFT practitioners. “None of us knew what to do or what would happen next,” The Telegraph quotes Dave Lauer, a quant who was working on a HFT desk that day, as saying. “I remember thinking, ‘How will I explain to my future child what I do for a living?'” Lauer quit his job and later spoke against the merits of HFT in a U.S. Senate committee hearing on the event. 

Not surprising, traditionalists do not like what the computers and HFT have done to Wall Street. Warren Buffett’s business partner, Charlie Munger, described HFT as “basically evil.” “I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short-term people trying to get information one millionth of a nanosecond ahead of somebody else,” The Telegraph quoted Munger as saying. “It’s legalised front-running.”

While the system has benefited quants, who can earn more than $1 million per year, some of them question whether their genius couldn’t be better utilized for the benefit of society. One of them is Simon Jones, a 36-year who The Telegraph identified as running the quants desk of a major bank up until a few months ago.

“My bank employed the brightest engineers, chemists, and scientists, and we were all working together to get richer,” The Telegraph quoted Jones as saying. “The chemical and physics and health industries are worse off because of what we do because I tell you this: if there was a pay bonus structure similar to what we had in the city for curing cancer, we’d have found a cure for cancer.”

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