08 March 2010

Quants: Fear and Loathing in Computer Code...

The Operational and Systemic risk is still lurking in the zero's and one's masking itself in the mathematical blur of algorithms designed by the "Quants". Is "SkyNet" just a few lines of computer code away from creating an incident that no insider can reverse?

Jeremy Grant and Michael Mackenzie of FT are establishing an argument discussed on this blog soon after the economic meltdown began to take place:

Not long after lunchtime one day on the New York Stock Exchange three years ago, unusual things started to happen. Hundreds of thousands of “buy” and “sell” messages began flooding in, signalling for orders to be made and simultaneously cancelled.

The volume of messages sent in was so large that the traffic coming into the NYSE from thousands of other trading firms slowed, acting as a drag on the trading of 975 shares on the board.

The case was made public only last month when the disciplinary board of the NYSE fined Credit Suisse for failing adequately to supervise an “algorithm” developed and run by its proprietary trading arm – the desk that trades using the bank’s own money rather than clients’ funds.

Algorithms have become a common feature of trading, not only in shares but in derivatives such as options and futures. Essentially software programs, they decide when, how and where to trade certain financial instruments without the need for any human intervention. But in the Credit Suisse case the NYSE found that the incoming messages referred to orders that, although previously generated by the algorithm, were never actually sent “due to an unforeseen programming issue”.

It was a close call for the NYSE. Asked if the exchange could have been shut down as it was bombarded with false trades, an exchange official says: “If you had multiplied this many times you’d have had a problem on your hands.”

The Operational Risks associated with the software computer code and the development of the trading algorithms is at the center of the still untouched regulation of how financial products are designed. Once the SEC get's educated on a market practice that is creating substantial systemic risk then the wheels of monitoring and potential "Cramdown" begins to take place.

The difficulty is that responsibility for risk controls does not lie entirely with exchanges and trading platforms. Much of it rests instead with brokers, which increasingly provide access to such venues under an arrangement known as “sponsored access” whereby any trading firm that is not a member of an exchange can “piggyback” on a broker’s membership to gain direct access to an exchange. Until recently, before the SEC clamped down on the practice, traders were able to use a form of this process – “naked access” – to gain access to exchanges without brokers conducting pre-trade risk checks to ensure their algorithms were functioning properly.

In the latest books written by "Reporters" on the so called "Quant risk" going on within the ranks of trading firms across the globe, the focus is on the people themselves more than the systems. Comparing poker players to bridge players is only a small part of the issue at hand with regard to a quantitative traders point of view and mathematical orientation.

Imagine for a moment the complexity of the software systems that now control the trading mechanisms across the world. From Hong Kong to Wall Street, London to Tokyo, the software is written to accomplish tasks that the human is not capable of executing in the multi-split seconds that it takes for buyers to match sellers. One only has to spend a few weeks or a month inside the software coding life cycle management process within the walls of a JP Morgan, Goldman Sachs or Credit Suisse to better understand the Operational Risks that exist for the market as a whole.

The sheer complexity of the systems software code alone is enough to give an uneducated eTrader worry over whether the portfolio they are managing with their retirement nest egg is going to get destroyed by the likes a a super "Cyber Algorithm" designed to out smart and out think that last strategy from the previous nights episode of MSNBC's "Jim Kramer."

The next economic crisis will not be a war of who had toxic assets in their asset portfolio's. It will be a single line of computer code that initiated a sequence of risk mitigation strategies to hedge against another previously executed trade the month before. And because of the error that creates this cyber incident, the market detects a new "Fear Factor" on the horizon.

How about a little Deja Vu:

All of us have been watching the gyrations of Wall Street and the stock market in recent days. With the collapse of Bear Stearns and Lehman, the "rescue" of the failing Fannie Mae-Freddie Mac, and the bail-out of AIG, many people wonder, "Have investors completely lost their minds?" Well, the answer may be, "Sometimes". Here's how we might look at anxious investing during a time of market volatility, uncertainty, bad news, and fear.

How does the anxious investor think? Let's consider two possible investors--- one who is reasonably optimistic and the other who is pessimistic.

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