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Thread: General/Opinion

Author Image Gerry Patterson. The world's most humble blogger
There is no dark side in the moon --- Really! Matter of fact it's all dark!

Markets Plunge And Then Rebound

Chronogical Blog Entries:

Date: Tue, 11 May 2010 22:35:55 +1000

The strange case of the stock market plunge last Thursday is still being investigated. As information trickles out about this event, it seems to become increasingly weird and (curiously enough for "information") less "informative" ...

To date, analysts have not been able to come up with a coherent explanation for the dramatic tail spin that the market fell into. Reading between the lines, most of them (sort of) agree that the primary agent of this near catastrophe was a type of GIM (Ghost In the Machine) --- A weird and hitherto unanticipated consequence of the impressive speed of modern automated trading systems and the vain attempts by regulators to throttle them during a sudden market hiatus. Regulators realise that such uncommon events might have the potential of causing a financial "catastrophe" --- It's the type of effect that might best be described by the mathematics of chaos --- And as an explanation it seems to more rightly belong in the "X-files" rather than on the business pages of any credible mainstream journal.

Needless to say, this has left investors in a mood which most informed sources describe as "skittish" (which is polite informed source speak for "scared shitless").

Now dear reader, your blogger must confess that he is merely a humble systems analyst with very little understanding of the weird and wacky herd-like behaviour of crowds of investors. From a systemic point of view, the intriguing self-destruct artefact which manifested on Thursday (New York Time), appears to have arisen because automated trading systems don't have an adequate "fail-safe" (AKA a "dead man's switch").

As systems become increasingly complex, and automated, the fear is that a chain of unlikely circumstances might "run-away" and result in a catastrophe ... And so ... Trains, airliners and early-warning nuclear weapons systems have human operators whose principal task is to "baby-sit" the automated components of the system. In the case of systems that might be very hazardous there is considerable redundancy (for instance -- the requirement that TWO human operators both simultaneously confirm the decision to "launch the nuclear ICBMs").

And in order to examine automated systems that could be hazardous, the nuclear weapons system is a good example. In policy analysis No 399, May 3, 2001, Geoffry Forden, a research fellow at MIT catalogued four false alarms, originating from "Early Warning" systems, that might have triggered a Nuclear war. In the examples that he gives, drawn from both sides of the old "iron curtain", the incidents were managed by senior military personnel, who averted catastrophe by over-riding or ignoring the alarms. The frightening conclusion is that a totally automated system would most likely have initiated a (mistaken) retaliatory strike, triggering a total nuclear war.

Although a nuclear war is far more serious than a global market crash, analysts often use gaming theory to describe both events. Any scenario which leads to total annihilation is referred to as a "zero sum game". And for this reason participants should try to avoid it. And of course, in the nuclear game, the fact that your wife and children, your parents, aunts and uncles and in fact everyone you know on planet earth will probably die in this particular zero sum game gives additional weight to all players' commitment to avoid this most dismal of outcomes at any cost.

Investors on the other hand, moving as they do in vast herds, are more likely to gallop off a high cliff, and so fall, screaming, into the abyss. When it comes to a "first strike" before a stock trading Armageddon, this is just another zero sum game. Regulators deal with this by halting trading. This is especially important in the new world of automated trading.

But this is where it gets interesting. It seems that the contingency of arresting trade on the market floor ... An old manual process ... May actually exacerbate the crisis if the change is executed by newer automated systems. In the past, it was thought that calling a halt to the market would prevent the plunge over the cliff. It was hoped that rather than gallop to their collective doom, that decapitated investors would just run around in circles like a bunch of headless chooks until the crisis died down a little and the survivors could then contemplate the abyss ... And sensibly, pull back from it. However, automated systems are capable of responding extremely quickly to any changes in the market. Much more quickly then any "manual" process" ... And so when trading is suspended, some older systems perceive this as a "lack of buyers" ... And a tipping point is achieved ... Before the message about trading being suspended even gets out. And so the investors commence their head-first dive down into the depths of the "toilet of doom". And on Thursday this seems to be what triggered the sudden downturn. In the words of a recent article in the Wall Street Journal:

Several high-frequency firms, including Tradebot Systems Inc., which says it often accounts for 5% of the U.S. market's volume, stopped trading when the market grew volatile. With these traders on the sidelines, there were fewer potential buyers, which may have contributed to the plunge.

--- Tom Lauricella, "Market Plunge Baffles Wall Street", Wall Street Journal, May 07, 2010

Yes dear reader. There is a firm called "Tradebot". And it seems that attempts to throttle these automatons have created a fiscal "Doomsday Device". Some older readers may recall Stanley Kubrik's film, "Dr. Strangelove", which refers to a rogue (automatic) system known as a "Doomsday Device". In Kubrik's film, the President rings up his Soviet counter-part to tell him that the planes now inbound with large nuclear payloads are an "accident" and that he should not get the wrong idea! ... And we are working on the problem right now! Imagine the president's horror when he was told that there was a "Doomsday device" which would respond automatically to the threat!. It seems that there is now a financial equivalent of this device. Built into the clunky chaotic interface between financebots and human traders ... And it all happens automagically at the speed of electrons. No time to even pick up the "red phone". Of course the situation is probably made worse by the (so-called) "experts" who present one-dimensional linear models of a system that should more properly be described using the mathematics of chaos.

Over the past few decades, many financial products have been added to the markets. It is now possible to bet on the trend that prices will follow. One can bet on the prices of shares, commodities, property etc. The reason given is that it allows investors to "hedge" with derivatives and futures etc. But in fact these instruments facilitate gambling. Just as a casino offers additional options on their roulette wheel or betting agents offer additional "system" options to players. It's not about putting more capital into the development of products and services and creating employment (Which is what we are told is the purpose of "Free Enterprise") ... It's about greasing the cogs and gears of the giant "Wheel of fortune" which the modern market has become.

And so at the start of the week, as experts stood glumly considering the vast machinery that we have created ... Came news that the markets had rebounded! Happy investors everywhere celebrated. The problem was solved! All "is good" in the world of finance! Most market analysts attribute this remarkable revival to the ECB's decision to under-write a trillion euros of funny money that seems to have gone missing in Europe. This was a move that was akin to cutting one end off of a blanket and sewing it on to the other end --- In order to make it longer (??)

Which leads one to wonder ... Was the problem really the automated trading systems ... Or the over-burden of debt still sloshing around the entire system?

Note:This follows on from the previous blog entry here.

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