The Problem with the Foresight Report on Computer Trading

It turns out that Paul Wilmott shares my views on the BIS Foresight  Future of Computer  Trading in the Financial Markets.  I have made the point that the Report is running the risk of appearing as what Roger Pielke Jr describes as "stealth advocacy", scientific research presenting itself as neutral technical analysis while it is in fact advocating a specific course of action.

My main issue with the Report is captured in its observation that (p 140, ss8.2)

In financial markets, the ideal is to discover the ‘fundamental’ price of assets

This statement is economically controversial, I do not think Keynes would agree with it.  Intuitively, if you have ever bought a house, did that house have a 'fundamental' price? Rather than develop these more philosophical points I shall focus on the mathematical objections to the statement after highlighting how this assumption drives the Report's overall conclusions.

If there exists a fundamental price, then the markets are attempting to solve an epistemological problem, and wish to identify the true price in a mass of noisy data.  This means that financial stability is defined as (p 19 n1)

the lack of extreme movements in asset prices over short time periods

and is closely related to volatility (p 19 n2)

variability of an asset’s price over time

which is a bad thing, so the report looks for evidence of HFT increasing volatility (which it does not find, but the FT cites research that suggests there is a link between increased volatility and HFT).  

The definition does mean, however, that the pathological behaviour described in Figs 4.2-4.6 of the Report is not market instability, they are localised transient effects that are quickly corrected.  The analogy is that it is OK for an aeroplane to go out of control, providing it does not crash, I do not think the aeronautical industry would allow itself to be run on this basis.

The problem is with the Report's treatment of High Frequency Trading.  The Report recognises that this aspect is controversial, particularly with pension managers and conventional fund managers.  Because it takes an approach that will see HFT as beneficial, because it increases information flows that help resolve the epistemological problem,  the concerns of those not involved in HFT, like the pension funds,  are counter-balanced/nullified. 

My concern is that in taking the epistemological approach to markets, it is inevitable that HFT is beneficial.  Just as if you model  credit default as some form of contagious agent, dynamical systems analysis will point to a solution involving a few, large, well defended financial institutions (i.e. how you deal with mad cow disease), while modelling the banking system as a communications network, loans are 'packets' that move around the network, a distributed system like the internet involving many small institutions with lots of connections, is best.  The result, by and large, depends on how you approach the problem.  The Bank of England seem to be moving to the Internet model of banking, rather than the Contagion model. 

The mathematical objection to the approach the Report takes is rooted in the Fundamental Theorem of Asset Prices, which indicates that a 'true' price of an asset only exists in an idealised situation, the second statement of the Theorem is explicit in stating that in actual markets, a unique, 'fundamental'  price is impossible to identify, there is a financial Heisenberg uncertainty principle going on.  The problem of a price is ontological, not epistemological.  I suspect this is one way of summarising the points Wilmott made to the enquiry, because it is such a dominant theme in contemporary mathematical finance.

The line the Report takes is explainable in terms of the background of the bulk of the contributors to the evidence based, they are in the main from dynamical systems (rooted in ergodic systems) and computer science (data and rules to manipulate data).  There are only a few who contributed to the evidence base whom I recognise would be familiar with the FTAP (Cont, Shied, Avellaneda, Mitra, Jaimungal, Cvitanic out of over 200, 2 of whom declare a commercial interest.  There were 11 alone at the Complex Systems workshop).

However, the Report, in taking a very particular approach  narrows the scope of discussion and leads the reader of the Report to a conclusion that is heavily dependent on the assumption that markets solve an epistemological problem.  The fact that there is such a bias towards market insiders on the High Level Stakeholder Group, there is no representation from pension funds but the ISDA, a lobby group for derivatives traders that gave us the infamous Potts opinion, are there,  lays the report open to the accusation that it is stealth advocacy.  Given that the public have been angered by the apparent privatisation of profits and socialisation of losses by banks in the past, appearing to side with the proprietary traders over pension fund managers, seems a very short-sighted approach to take.
I think these observations are compounded by the fact that the Report could have been clearer in distinguishing the various impacts computers are having on markets, rather than a focus on addressing HFT within this context described above.  The Report's Executive Summary opens with

A key message: despite commonly held negative perceptions, the available evidence indicates that high  frequency trading (HFT) and algorithmic trading (AT) may have several beneficial effects on markets.  However, HFT/AT may cause instabilities in financial markets in specific circumstances. This Project has shown that carefully chosen regulatory measures can help to address concerns in the shorter term. 

This distinction is lost in discussing the benefits of Computer Based Trading (the combination of the two) as improved liquidity, reduction in transaction costs and improved market efficiency.  

The risks are observed collapses in liquidity and instability.  When discussing instability the observation is made that HFT does not appear to increase volatility, but there are issues about stability, which the report describes in terms of non-linearities, incomplete information and what the report calls 'normalisation of deviance' but sociologists describe as 'counter-performativity' (markets follow a model and then discover the model is wrong).  

HFT is highlighted in regard to market abuse, which the report argues there is no evidence.  However the distinction between AT, usually conducted for agency trading, and HFT, usually conducted by proprietary traders, in their contribution to the risks is not really developed.  Can we explore this issue?

The report defines 'liquidity' (p 19, n3) as 

the ability to buy or sell an asset without greatly affecting its price. The more liquid the market, the smaller the price impact of sales or purchases

AT has made a significant contribution to this, particularly through the work developing out of Chriss and Almgren's pioneering research in optimally executing large trades.  The report's definition of liquidity is somewhat biased , a different definition associates liquidity with the 'depth' of the market, the ability to actually buy or sell an asset in the market.  HFT will not increase depth, but it may present a mirage of improved liquidity as assets are churned by proprietary traders.  This is associated with the Flash Crash, p 56. 

Liquidity is related to what the Report describes as  (p 19, n4)

price discovery ... the market process whereby new information is impounded into asset prices.

Clearly if trades are executed quickly, price discovery improves.  However there are issues with mechanistic approaches to news processing (Derwent Capital Markets' closure).

The Report notes that there has been a reduction in transaction costs since the introduction of CBT, but this cannot be ascribed to HFT and the FT cites 2012 research that suggests the reduction in costs occurred before HFT emerged.

Overall I think there is a good argument that the Report is far from being "pure science" and lacks the balance of "honest brokerage".

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