Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents

Question 1

Moore’s Law

Answer 1

growth of semiconductor industry which had profound impact on the financial system.

Question 2

Murphy’s law

Answer 2

“whatever can go wrong will go wrong” and it corollary “whatever can go wrong will go wrong faster and bigger when computers are involved”

Question 3

Algorithmic trading

Answer 3

the use of mathematical models, computers and telecommunication networks to automate the buying and selling of financial securities.

Question 4

Authors’ idea

Answer 4

A more systematic and adaptive approach to regulating this system is needed, one that fosters the technological advances of the industry while protecting these who are not as technologically advanced.”

Question 5

Good aspects of algorithmic tradingo The regulatory framework doesn’t adjust so fast to technological innovation.

Answer 5

o Lower costs (bid ask-spread)
o Reducing human error (ex: broker doesn’t buy the needed stock)
o Increasing productivity

Question 6

Bad aspects of algorithmic trading

Answer 6

o The regulatory framework doesn’t adjust so fast to technological innovation.

Question 7

Facilitators of development of algorithmic trading:

Answer 7

1) Financial markets are becoming more complex
2) Developments in the financial technology/financial modeling.
3) Breakthroughs in computer technology.

Question 8

Five major developments that have fueled algorithmic trading’s popularity:

Answer 8

1) Quantitative models
2) Emergence and proliferation of index funds
3) Arbitrage trading activities
4) Push for lower costs of intermediation and execution
a. One doesn’t have to go to the market to sell all his stocks/bonds/CDOs etc.
5) Proliferation of high-frequency trading (40-60% of all trading activities)

Question 9

2 critical roles of arbitrage

Answer 9

liquidity provisions and price discovery

Question 10

High-Frequency trading

Answer 10

A form of automated trading that consumes extremely many trades per day/ second. It is an innovation in financial inter mediation that does not fit neatly into a standard liquidity-provision framework.

Question 11

“Spoofing”

Answer 11

placing an order to buy or sell a security and then cancelling it shortly thereafter.

Question 12

“Layering”

Answer 12

placing a sequence of limited orders at successively increasing or decreasing prices to give the appearance of change in demand or artificially increase or decrease the price.

Question 13

5 policies can be implemented for algorithmic trading

Answer 13

1) Do nothing
2) Banning high-frequency trading
3) Change the definition and requirements of a market maker
4) Force all trades to occur at distinct time intervals
5) Tobin tax (small transaction tax on all financial transactions)

Question 14

+ and - of doing nothing

Answer 14

+ Allow for intermediaries to find their own ways to optimize costs, leading to an even greater supply of immediacy and efficient trading
- Unlikely to address investor’s concerns about fair and orderly markets.

Question 15

+ and - of banning high-frequency trading

Answer 15

+ More fair and orderly markets in the short-run

- Reduce market liquidity, efficiency, capital formation

Question 16

+ and - to of Change the definition and requirements of a market maker

Answer 16

+ Fair and orderly market (No withdrawal when their services are needed)
- Increase the cost of intermediaries of being present, greater legal costs

Question 17

+ and - of forcing all trades to occur at distinct time intervals

Answer 17

+ Higher supply of immediacy

- Investors seemed to prove having preference for continuous systems

Question 18

+ and - of Tobin tax

Answer 18

+ Increase government budget

- Decrease liquidity, transactions will migrate to other countries

Question 19

four types of financial regulations

Answer 19

1) System engineered
2) Safeguards-Heavy
3) Transparency-Rich
4) Platform-Neutral

Question 20

System engineered

Answer 20

Financial regulations should approach automated markets as complex systems composed of multiple software, not only from human side perspective.

Question 21

Safeguards-Heavy

Answer 21

Regulation should encourage safeguards at multiple levels of the system to check the fairness and the order in all transactions.

Question 22

Transparency-Rich

Answer 22

Financial regulation should aim to make the financial operations more transparent and accessible.

Question 23

Platform-Neutral

Answer 23

Financial regulation should be designed to encourage innovation in technology and finance and should be neutral how computer systems in this financial system work.

Question 24

Examples how algorithm trading destabilized the situation, market

Answer 24

August 2007: Arbitrage Gone Wild - Record loss of hdge fund

May 6, 2010: The Perfect Financial Storm - Order imbalance; At some point of time investors saw the highest volatility (e.g. Apple stock) orders were really enhanced

March and May 2012: Pricing Initial Public Offerings in the Digital Age - i. Facebook IPO delayed by half an hour. Took more time to calculate initial price. And when it was recalculating new offers came in place and many were cancelled.; BATS Global Market, cancelled IPO, due to “computer” glitch

August 2012: Trading Errors at the Speed of Light - i. Knight Capital lost 400m USD and went bankrupt. Algorithm dint manage to pick errors and had to sell hundreds of assets in open markets. In half an hour, the whole capital was wiped out. (150 stocks decreased in their price)

September 2012: High-Frequency Manipulation - Put the orders, so that price would decrease

Question 25

Quantitative models

Answer 25

• Portfolio theory
• CAPM
• BS option pricing
• Optimization models

Question 26

Which three developments in the financial industry have greatly facilitated the rise of algorithmic trading.

Answer 26

• The financial system becoming more complex over time
• Breakthroughs in the quantitative modeling of financial market
• Breakthroughs in computer technologies