Discussion from Investment Analysis and Portfolio Management at Boston University:
Quick breakdown of derivatives: Unlike stocks, derivatives are not traded on exchanges. They are bilateral contracts between a bank and another financial firm or a company. As a result, figuring out who is on the other side of a deal during a period of financial stress can become quite challenging. I highly recommend – especially for those pursing the MSBFSM degree – to watch the documentary “Inside Job.” It is an Oscar winning documentary that provides a comprehensive analysis of the global financial crisis and how derivatives played a role. Forewarning: it takes a stab at capitalism, which I’m sure is a touchy subject for anyone making or pursuing a career in the financial sector. Nonetheless, it’s informative. Watch it free here: http://www.filmsforaction.org/watch/inside_job_2010/
On to business: everything addressed about derivatives in this week’s discussion is true; they promote efficiency, however, many bankers do not understand the underlying risks. For instance, in a recent WSJ article, it was showcased that 13 of the 19 firms managed to report weekly data on derivatives contracts to a central database within three days—the standard set by regulators. Nevertheless, some other U.S. banks provided worse data in 2012 than in previous years, and eight European Union banks, one U.S. and, one Canadian firm couldn’t update critical metrics required by regulators (1).
In my opinion, I think there needs to be a well-defined transparent market for derivatives. If some firms don’t know what exactly is tied to what in some of their complicated products, I think that will prove to be a disastrous domino effect during a time of crisis. Finance is a powerful technology, and I think that finance professionals have a moral obligations to be responsible. After receiving the Deutsche Bank Price in Financial Economics, Robert Shiller said, “Finance is a powerful technology, but a technology that has been only imperfectly applied for the betterment of humankind”(3).
Europe is taking the charge on inputting regulation and transparency in the derivatives field; however, even the proposed regulations are choppy. Heck, in a recent press release, the European Securities Markets Authority said that it had asked the Commission "to clarify the definition of a derivative or derivative contracts” (2). If regulators and bankers don’t know what is considered a derivative, how can we even go about trying to regulate it?!
To clarify my thoughts: yes, I think derivatives can promote efficiency, especially in risk management. However, the instruments are currently so complex that it may produce entirely opposite results; since the products are intertwined they can increase riskiness in the entire financial market. Transparency regulations in the derivatives market need to clearly defined.
Josh
(1) http://blogs.wsj.com/moneybeat/2014/01/20/banks-remain-vulnerable-in-a-key-area-years-after-the-crisis/?KEYWORDS=Derivatives
(2) http://online.wsj.com/news/articles/SB10001424052702304703804579383054267338542?KEYWORDS=Derivatives&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304703804579383054267338542.html%3FKEYWORDS%3DDerivatives
(3) https://www.db.com/presse/en/content/press_releases_2009_4619.htm
Tuesday, February 18, 2014
Wednesday, February 5, 2014
High-frequency trading: too fast for human comprehension
On May 6, 2010, following concerns about debt crisis in Greece, the DJIA to plunged roughly 9% in five minutes. Twenty minutes later, the market had regained most of the drop (1). High frequency trading (HFT) is credited for playing a major role in this flash crash. The simple fact is computerization of Wall Street is happening rapidly; HFT firms are responsible for about 50% of trading in the U.S. equities market (2).
High-frequency trading uses computers to make trades at lightning speed. Firms that employ HFT say users are merely harnessing available technology to make trades, resulting in increased price efficiency (3). Some market observers also emphasize that high frequency trading is simply faster trading, and that many of the trading strategies used by HFTs are not new, therefore nothing has changed in the economics of the market (4). Critics, however, say HFT leaves other investors at an unfair disadvantage and that it can be disruptive, with liquidity drying up suddenly when markets turn volatile and trading programs shut down (3). Furthermore, studies on low-latency activity – strategies that respond to market events within milliseconds – show that the algorithms involved are so fast that detect, analyze, and respond to a market event within 2-3 milliseconds (4). These statistics question the relationship between the interplay of algorithms and market dynamics; how can human traders accurately recognize the current state of the market if the speeds of market interactions occur too fast for human comprehension?
As for flash orders, some critics describe it as a way for a firm – and exchange – to hack the system. Technically, it is legal, and it barely makes it by the National Market System (NMS) regulations established by the SEC. The rationale for flash orders: better me than you. They allow a venue to execute marketable orders in-house when that market is not at the national best bid (NBBO) or offer instead of routing those orders to rival markets. They do this by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses. If there are no responses, the order can be canceled or routed to the market with the best price (5).
I'm not entirely sure how to feel about this topic. It's new to me, and I feel like I have a lot more to learn before I can prove valuable to a discussion. My initial reaction was "heck, it's capitalism, right?" Technology and innovation has removed or significantly decreased the human factor in all industries. There are factory's run by some sort of sophisticated technology that make automobiles and package our food and prescription drugs. I suppose the true question is how much responsible do we want to put in the "hands" of a computer when it comes to our money? We feel safe about computers running the production plants that make our cars and package food, why is it different in finance?
Josh
References
(1) Lauricella, Tom (May 7, 2010). "Market Plunge Baffles Wall Street -Trading Glitch Suspected in 'Mayhem' as Dow Falls Nearly 1,000, Then Bounces". The Wall Street Journal. p. 1.
(2) http://online.wsj.com/news/articles/SB10001424052702304887104579302681366721324
(3) http://blogs.marketwatch.com/thetell/2014/01/15/europe-plans-crackdown-on-high-frequency-trading/
(4) Tarun Chordia, Amit Goyal, Bruce N. Lehmann, Gideon Saar, High-frequency trading, Journal of Financial Markets, Volume 16, Issue 4, November 2013, Pages 637-645, ISSN 1386-4181, http://dx.doi.org/10.1016/j.finmar.2013.06.004.
(5) http://www.highbeam.com/doc/1G1-203482971.html
High-frequency trading uses computers to make trades at lightning speed. Firms that employ HFT say users are merely harnessing available technology to make trades, resulting in increased price efficiency (3). Some market observers also emphasize that high frequency trading is simply faster trading, and that many of the trading strategies used by HFTs are not new, therefore nothing has changed in the economics of the market (4). Critics, however, say HFT leaves other investors at an unfair disadvantage and that it can be disruptive, with liquidity drying up suddenly when markets turn volatile and trading programs shut down (3). Furthermore, studies on low-latency activity – strategies that respond to market events within milliseconds – show that the algorithms involved are so fast that detect, analyze, and respond to a market event within 2-3 milliseconds (4). These statistics question the relationship between the interplay of algorithms and market dynamics; how can human traders accurately recognize the current state of the market if the speeds of market interactions occur too fast for human comprehension?
As for flash orders, some critics describe it as a way for a firm – and exchange – to hack the system. Technically, it is legal, and it barely makes it by the National Market System (NMS) regulations established by the SEC. The rationale for flash orders: better me than you. They allow a venue to execute marketable orders in-house when that market is not at the national best bid (NBBO) or offer instead of routing those orders to rival markets. They do this by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses. If there are no responses, the order can be canceled or routed to the market with the best price (5).
I'm not entirely sure how to feel about this topic. It's new to me, and I feel like I have a lot more to learn before I can prove valuable to a discussion. My initial reaction was "heck, it's capitalism, right?" Technology and innovation has removed or significantly decreased the human factor in all industries. There are factory's run by some sort of sophisticated technology that make automobiles and package our food and prescription drugs. I suppose the true question is how much responsible do we want to put in the "hands" of a computer when it comes to our money? We feel safe about computers running the production plants that make our cars and package food, why is it different in finance?
Josh
References
(1) Lauricella, Tom (May 7, 2010). "Market Plunge Baffles Wall Street -Trading Glitch Suspected in 'Mayhem' as Dow Falls Nearly 1,000, Then Bounces". The Wall Street Journal. p. 1.
(2) http://online.wsj.com/news/articles/SB10001424052702304887104579302681366721324
(3) http://blogs.marketwatch.com/thetell/2014/01/15/europe-plans-crackdown-on-high-frequency-trading/
(4) Tarun Chordia, Amit Goyal, Bruce N. Lehmann, Gideon Saar, High-frequency trading, Journal of Financial Markets, Volume 16, Issue 4, November 2013, Pages 637-645, ISSN 1386-4181, http://dx.doi.org/10.1016/j.finmar.2013.06.004.
(5) http://www.highbeam.com/doc/1G1-203482971.html
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