Volatility: how ‘algos’ changed the rhythm of the market

Critics say high-frequency trading makes markets too fickle amid rising anxiety over the global economy  writes Robin Wigglesworth in The FT

Philippe Jabre was the quintessential swashbuckling trader, slicing his way through markets first at GLG Partners and then an eponymous hedge fund he founded in 2007 — at the time one of the industry’s biggest-ever launches. But in December he fell on his sword, closing Jabre Capital after racking up huge losses. The fault, he said, was machines. 

“The last few years have become particularly difficult for active managers,” he said in his final letter to clients. “Financial markets have significantly evolved over the past decade, driven by new technologies, and the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerised models.” 

Mr Jabre is not alone. There has been recently a flurry of finger-pointing by humbled one-time masters of the universe, who argue that the swelling influence of computer-powered “quantitative”, or quant, investors and high-frequency traders is wreaking havoc on markets and rendering obsolete old-fashioned analysis and common sense. 

Those concerns were exacerbated by the volatility in financial markets in December, when US equities suffered their biggest monthly decline since the financial crisis, despite little fundamental economic news. And with growing anxiety over the strength of the global economy, tightening monetary policy across the world and an escalating trade war between China and the US, these trades are getting more attention. 

Even hedge fund veterans admit the game has changed. “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me,” Stanley Druckenmiller, a famed investor and hedge fund manager, recently told an industry TV station. 

It is true that markets are evolving. HFTs dominate the market-making once done by humans in trading pits and the bowels of investment banks. Various quant strategies — ranging from simple ones packaged into passive funds to pricey, complex hedge funds — manage at least $1.5tn, according to Morgan Stanley. JPMorgan estimates that only about 10 per cent of US equity trading is now done by traditional investors. Other markets remain more human, yet are slowly but surely being transformed. 

This has made “the algos” a fashionable bugbear whenever markets tremble like they did in December. Torsten Slok, Deutsche Bank’s chief international economist, put them at the top of his list of the 30 biggest risks for markets, and even Steven Mnuchin, the US Treasury secretary who caused market unease with comments on liquidity late last year, has said the government will study whether the evolving market ecosystem fed the recent turmoil. 

But markets have always been tempestuous, and machines make a convenient, faceless bogeyman for fund managers who stumble. Meanwhile, quants point out that they are still only small players compared with the vastness of global markets. 

“It’s insane,” says Clifford Asness, the founder of AQR Capital Management. “People are missing the forest for the trees. That we trade electronically doesn’t change things, we just deliver the same thing more efficiently . . . It’s just used by pundits and fund managers as an excuse.” 

The recent turmoil has unnerved many investors, but two other debacles stand out as having first crystallised the fear that algorithms are making markets more fickle and fragile. 

At 2:32pm on May 6 2010, US equities suddenly and mysteriously careened lower. In just 36 minutes the S&P 500 crashed more than 8 per cent, before rebounding just as powerfully. Dubbed the “flash crash” it put a spotlight on the rise of small ultra-fast, algorithmic trading firms that have elbowed out investment banks as the integral intermediaries of many markets. 

Michael Lewis, author of Flash Boys, fanned the flames with his book by casting HFTs as mysterious, investor-scalping antagonists “rigging” the stock market. What was once an esoteric, little-appreciated evolution in the market’s plumbing suddenly became the topic of a vitriolic mainstream debate. 

“It was a wake-up call,” says Andrei Kirilenko, former chief economist at the Commodity Futures Trading Commission who wrote the US regulator’s report on the 2010 event and now leads Imperial College London’s Centre for Global Finance and Technology. “The flash crash was the first market crash in the era of automated, algorithmic trading.” 

In August 2015, markets were once again abruptly thrown into a tailspin — and this time volatility-sensitive quantitative strategies were identified as the primary culprits. The spark was rising concern over China’s economic slowdown, but on August 24, the S&P 500 crashed on opening, triggering circuit-breakers — implemented in the wake of the flash crash to pause wild trading — nearly 1,300 times. That rippled through a host of exchange traded funds, worsening the dislocations as they briefly became divorced from the value of their underlying holdings. 

Many investors and analysts blamed algorithmic strategies that automatically adjust their market exposure according to volatility for aggravating the 2015 crash. Targeting a specific level of volatility is common among strategies known as “risk parity” — trend-following hedge funds and “managed volatility” products sold by insurance companies. Estimates vary, but there is probably more than $1tn invested in a variety of such funds.

Risk parity, a strategy first pioneered by Ray Dalio’s Bridgewater Associates in the 1990s, often shoulders much of the opprobrium. The theory is that a broad, diversified portfolio of stocks, bonds and other assets balanced by the mathematical risk — in practice, volatility — of each asset class should over time enjoy better returns than traditional portfolios. Bonds are less volatile than equities, so that often means “leveraging” these investments to bring the risk-adjusted allocation up to that of stocks. As volatility goes up, risk parity funds in theory rein in their exposure. 

However, risk parity funds can vary greatly in the details of their approach, and are generally slower moving than the $300bn trend-following hedge fund industry. These funds surf market momentum up and down, and also use volatility metrics to scale their exposure. When markets are calm they buy, and when turbulence spikes they sell. 

This has been a successful strategy over time. But it leaves the funds vulnerable to abrupt reversals — such as the market tumble last February — and means they can accentuate turbulence by selling when markets are already sliding.

Leon Cooperman, the founder of Omega Advisors, has argued that the US Securities and Exchange Commission should investigate and tame the new “wild, wild west environment in the stock market” caused by these volatility-sensitive strategies. 

“I think your next guest ought to be somebody from the SEC to explain why they have sat back calmly, quietly, without saying anything and allowing these algorithmic, trend-following models to wreak havoc with what has, up to now, been the best capital market in the world,” he told CNBC in December. 

Some quants will grudgingly admit that volatility-targeting is inherently pro-cyclical and can at least in theory exacerbate market movements. But they say critics wildly overestimate just how much money is invested in these strategies, how much they trade, and their impact. 

“Risk parity is basically a passive portfolio with some periodic, counter-cyclical rebalancing. Our volatility targets aren’t perfectly static, but they only change over a 10-year window,” says Bob Prince, co-chief investment officer at Bridgewater. Other risk parity strategies may vary, but overall “it's only ever going to be a drop in the ocean”, he adds. 

Markets had been vulnerable to panicky plunges long before trading algorithms emerged, yet fears over machines seem deeply embedded in our psyche. A 2014 University of Pennsylvania paper found evidence of what it dubbed “algorithm aversion”, showing how human test subjects instinctively trusted human forecasters more than algorithmic ones, even after seeing the algo make fewer and less severe forecasting errors. 

And there are plenty of other potential culprits to blame for exacerbating recent turbulence. Many traditional active funds suffered a battering in 2018. That has led to a rise in investor redemption notices and has forced many to sell securities to meet the end-of-year withdrawals. 

Hedge fund flow data come with a lag, but traditional equity funds saw withdrawals rise to nearly $53bn in the seven days up to December 12, according to data provider EPFR — comfortably the biggest one-week outflow on record. That probably both reflected and exacerbated the slide that left the S&P 500 nursing a 6 per cent loss for 2018. 

At the same time, market liquidity— a broad term denoting how easy it is to trade quickly without causing prices to move around too much — tends to weaken in December, when many fund managers become more defensive ahead of the end of the year. Liquidity can be particularly poor in the last weeks of the year, when bank traders ratchet back how much risk they take on to avoid extra regulatory charges. 

“This makes it more expensive for dealers to perform their essential functions: providing liquidity, absorbing shocks and facilitating the transfer and socialisation of risk,” Joshua Younger, a JPMorgan analyst, wrote in a recent note. “These costs are generally passed on to customers in the form of higher rates on short-term loans, thinner markets and the risk — now realised — of spikes in volatility.” 

That markets are undergoing a dramatic, algorithmic evolution is an inescapable fact. Although some humbled hedge fund managers may unfairly castigate “algos” for their own failings, there are real risks in how some of these different factors can interact at times of market stress. 

HFTs are far more efficient market-makers than human pit traders. Yet the entire sector probably has less capital than just one of the major banks, says Charles Himmelberg, head of global markets research at Goldman Sachs. It means that they tend to adjust their bids aggressively when market mayhem breaks out. 

Under those circumstances, even a modest amount of selling could have an outsized impact. This is an issue both for human traders and quants, but quant strategies are programmed, quick and on autopilot, and if they start pounding an increasingly thin market, it can cause dislocations between buy and sell orders that can produce big gains or falls. 

For example, JPMorgan estimates that the depth of the big and normally liquid S&P 500 futures market — as measured by how many contracts trade close to the current price — deteriorated in 2018, and was exceptionally shallow in the last months of the year. In December it was even worse than the levels seen in the financial crisis. 

“While it is incorrect to say that systematic flows are the sole driver of recent market moves, it would be equally incorrect to say that systematic flows don’t have a meaningful impact,” says Marko Kolanovic, head of quantitative strategy at JPMorgan. 

Poor liquidity and market volatility have always been linked, and it is in practice impossible to dissect and diagnose the myriad triggers and drivers of a sell-off. But modern markets do appear more vulnerable to abrupt dislocations. 

The question is whether anything should, or even could, be done to mitigate the risks. Mr Kirilenko cautions that a mix of better understanding and modest tweaks may be the only conclusion. 

“We just have to accept that financial markets are nearly fully automated,” he says, “and try to make sure that things don’t get so technologically complex and inter-connected that it’s dangerous to the financial system.” 

Anxiety inducing: the triggers for market fears 

Although the recent market slide has reawakened the debate about whether modern machine-driven markets can exacerbate the severity of any volatility, the fundamental drivers of the turbulence are more conventional. As 2018 progressed, investors grew concerned at three factors: signs that the global economy is weakening; the impact of tighter monetary policy in the US and the end of quantitative easing in Europe; and the escalating trade war between the US and China. The global economy started last year on a strong footing, but markets are always focused on inflection points. Since the summer the impact of US tax cuts has appeared to fizzle, European growth has slowed, and China’s decelerating economy has been buffeted by the trade dispute. That has led analysts to trim their estimates for corporate profits in 2019. At the same time, the Federal Reserve raised interest rates four times last year, and has kept shrinking its balance sheet of bonds acquired in the wake of the financial crisis. That has lifted short-term ultra-safe Treasury bill yields to a 10-year high, and undermined the long-term argument that “there is no alternative” which has helped sustain market valuations. As a result, Treasury bills beat the returns of almost every major asset class last year. Goldman Sachs says that over the past century there have only been three other periods when Treasury bills have enjoyed such a broad outperformance: when the US ratcheted up interest rates to 20 per cent in the early 1980s to subdue inflation; during the Great Depression; and at the start of the first world war.

Saffron storm, hard cash

Jawed Naqvi in The Dawn

A young man described himself as a dejected Muslim, and punctured the sharp analysis that was under way about the Uttar Pradesh defeat. The venue was a well-appointed seminar room at the India International Centre. Why don’t we show our outrage like they do in America, the young Muslim wanted to know. People in America are out on the streets fighting for the refugees, Latinos, Muslims, blacks, everyone. One US citizen was shot trying to protect an Indian victim of racial assault. Why are Indian opponents of Hindutva so full of wisdom and analysis but few, barring angry students in the universities, take to the streets?

It’s not that people are not fighting injustices. From Bastar to Indian Kashmir, from Manipur to Manesar, peasants, workers, college students, tribespeople, Dalits; they are fighting back. But they are vulnerable without a groundswell of mass support like we see in other countries.

Off and on, political parties are capable of expressing outrage. A heartbreaking scene in parliament is to see Congress MPs screaming their lungs out with rage, but that’s usually when Sonia Gandhi is attacked or Rahul Gandhi belittled. Yet there is no hope of stopping the Hindutva march without accepting the Congress as a pivot to defeat the Modi-Yogi party in 2019.
It’s a given. The slaughterhouses may or may not open any time soon, but an opposition win in 2019 is easier to foresee. It could be a pyrrhic victory, the way the dice is loaded, but it is the only way. Will the Congress join the battle without pushing itself as the natural claimant to power? Without humility, we may not be able to address the young man’s dejection.

Like it or not, there is no other opposition party with the reach of the Congress, even today. Should we be saddled with a party that rises to its feet to protect its leaders — which it should — but has lost the habit of marching against the insults and torture that large sections of Indians endure daily?
A common and valid fear is that the party is vulnerable before the IOUs its satraps may have signed with big league traders, who drive politics in India today.

If religious fascism is staring down India’s throat, there’s someone financing it.

The Congress needs to ask itself bluntly: who chose Mr Modi as prime minister? It was the same people that chose Manmohan Singh before him. The fact is that India has come to be ruled by traders, though they have neither the vision nor the capacity to industrialise or modernise this country of 1.5 billion. Their fabled appetite for inflicting bad loans on the state exchequer is legendary, though they have seldom measured up to Nehru’s maligned public sector to build any core industry. (Bringing spectrum machines from Europe and mobile phones from China for more and more people to watch mediocre reality shows is neither modernisation nor industrialisation.)

The traders have thrived by funding ruling parties and keeping their options open with the opposition when necessary. It’s like placing casino chips on the roulette table, which is what they have turned a once robust democracy into. If there’s religious fascism staring down India’s throat, there’s someone financing it.

The newspapers won’t tell you all that. The traders own the papers. The umbilical cord between religious regression and traders has been well established in a fabulous book on the Gita Press by a fellow journalist; same with TV.

Nehru wasn’t terribly impressed with them. He fired his finance minister for flirting with their ilk. Indira Gandhi did one better. She installed socialism as a talisman against private profiteers in the preamble of the constitution. They hated her for that. The older Indian literature (Premchand) and cinema were quite a lot about their shady reality — Mother India, Foot Path, Do Bigha Zamin, Shree 420, to name a few.

At the Congress centenary in Mumbai, Rajiv Gandhi called out the ‘moneybags’ riding the backs of party workers. They retaliated through his closest coterie to smear him with the Bofors refuse. The first move against Hindutva’s financiers will be an uphill journey. The IOUs will come into play.

For that, the Congress must evict the agents of the moneybags known to surround its leadership. But they’re not the only reality the Congress must discard. It has to rid itself of ‘soft Hindutva’ completely, and it absolutely must stop indulging regressive Muslim clerics as a vote bank.

For a start, the West Bengal, Karnataka, and Delhi assemblies will need every opposition member’s support in the coming days. The most laughable of the cases will be summoned against the unimpeachable Arvind Kejriwal, a bête noire for the traders, whose hanky-panky he excels in exposing.

For better or worse, it is the Congress that still holds the key to 2019. Even in the post-emergency rout, the party kept a vote share of 41 per cent. And after the 2014 shock, its vote has grown, not decreased.

While everyone needs to think about 2019, the left faces a more daunting challenge. It knows that the Modi-Yogi party does not enjoy a majority of Indian votes. However, the majority includes Mamata Banerjee, who says she wants to join hands with the left against the BJP. Others are Lalu Yadav, Nitish Kumar, Arvind Kejriwal, Mayawati, Akhilesh Yadav, most of the Dravida parties and, above all, the Congress. The left has inflicted self-harm by putting up candidates against all these opponents of the BJP — in Bihar, in Uttar Pradesh, in Delhi. In West Bengal and Kerala, can it see eye to eye with its anti-BJP rivals?
As the keystone in the needed coalition, the left must drastically tweak its politics. It alone has the ability to lift the profile of the Indian ideology, which is still Nehruvian at its core, as the worried man at the Indian International Centre will be pleased to note.

No Walmart, Please

By Justice Rajindar Sachar (retd)

17 December, 2011
The Tribune, India

Govt’s claim is questionable

If the combined Opposition had sat down for weeks to find an issue to embarrass the UPA government and make it a laughing stock before the whole country, they could not have thought of a better issue than the free gift presented to it initially by the government by insisting that it had decided irrevocably to allow the entry of multi-brand retail super stores like Walmart and then within a few days, with a whimper, withdrawing the proposal.

As it is, even initially this decision defied logic in view of the Punjab and UP elections and known strong views against it of the BJP and the Left. Many states had all the time opposed the entry of Walmart which would affect the lives of millions in the country.

Retail business in India is estimated to be of the order of $ 400 billion, but the share of the corporate sector is only 5 per cent. There are 50 million retailers in India, including hawkers and pavement sellers. This comes to one retailer serving eight Indians. In China, it is one for 100 Chinese. Food is 63 per cent of the retail trade, according to information given by FICCI.

The claim by the government that Walmart intrusion will not result in the closure of small retailers is a deliberate mis-statement. A study done by IOWA State University, US, has shown that in the first decade after Walmart arrived in IOWA the state lost 555 grocery stores, 298 hardware stores, 293 building supply stores, 161 variety stores, 158 women apparels stores and 153 shoe stores, 116 drug stores and 111 men and boys apparels stores. Why would it be different in India with a lesser capacity for resilience by small traders.

The fact is that during 15 years of Walmart entering the market, 31 super market chains sought bankruptcy. Of the 1.6 million employees of Walmart, only 1.2 per cent make a living above the poverty level. The Bureau of Labour Statistics, US, is on record with its conclusion that Walmart’s prices are not lower.

In Thailand, supermarkets led to a 14 per cent reduction in the share of ‘mom and pop’ stores within four years of FDI permission. In India, 33-60 per cent of the traditional fruit and vegetable retailers reported a 15-30 per cent decline in footfalls, a 10-30 per cent fall in sales and a 20-30 per cent decline in incomes across Bangalore, Ahmedabad and Chandigarh, the largest impact being in Bangalore, which is one of the most supermarket-penetrated cities in India.

The average size of the Walmart stores in the US is about 10,800 sq feet employing only 225 people. In that view, is not the government’s claim of an increase in employment unbelievable? The government’s attempt is to soften the blow by emphasising that Walmart is being allowed only 51 per cent in investment up to $100 million. Prima facie, the argument may seem attractive. But is the Walmart management so stupid that when its present turnover of retail is $ 400 billion it would settle for such a small gain? No, obviously, Walmart is proceeding on the maxim of the camel being allowed to put its head inside a tent and the occupant finding thereafter that he is being driven out of it by the camel occupying the whole of the tent space. One may substitute Walmart for the camel to understand the danger to our millions of retailers.

The tongue-in-cheek argument by the government that allowing Walmart to set up its business in India would lead to a fall in prices and an increase in employment is unproven. A 2004 report of a committee of the US House of Representatives concluded that “Walmart’s success has meant downward pressures on wages and benefits, rampant violations of basic workers’ rights and threats to the standard of living in communities across the country.” By what logic does the government say that in India the effect will be the opposite? The only explanation could be that it is a deliberate mis-statement to help multinationals.

Similar anti-consumer effects have happened by the working of another supermarket enterprise, Tesco of Britain.

A study carried out by Sunday Times shows that Tesco has almost total control of the food market of 108 of Britain’s coastal areas — 7.4 per cent of the country. The super stores like Walmart and Tesco have a compulsion to move out of England and the US because their markets are saturated. These companies are looking for countries with a larger population and low supermarket presence, according to David Hogues, Professor of Agri-Business at the Centre for Food Chain Research at Imperial College, London. They have got nowhere else to go and their home markets are already full. Similarly, a professor of Michigan State University has pointed out that retail revolution causes serious risks for developing country farmers who traditionally supply to the local street market.

In Thailand, Tesco controls more than half the Thai market. Though Tesco, when it moved into Thailand, promised to employ local people but it is openly being accused of indulging in unfair trading practices. The claim that these supermarket dealers will buy local products is belied because in a case filed against Tesco in July 2002 the court found it charging slotting fees to carry manufacturers’ products, charging entry fee of suppliers. In Bangkok, grocery stores’ sales declined by more than half since Tesco opened a store only four years ago.

In Malaysia, seeing the damage done by Tesco since January 2004, a freeze on the building of any new supermarket was imposed in three major cities and this when Tesco had only gone to Malaysia in 2002.

It is worth noting that 92 per cent of everything Walmart sells comes from Chinese-owned companies. The Indian market is already flooded with Chinese goods which are capturing the market with cheap offers, and traders are already crying foul because of the deplorable labour practices adopted by China. Can, in all fairness, the Indian government still persist in keeping the retail market open to foreign enterprises and thus endangering the earnings and occupations of millions of our countrymen and women?

The writer is a former Chief Justice of the High Court of Delhi

The trader who lifted the lid on what the City really thinks

One man reveals how economic disaster would let him and his colleagues profit 

By Tom Peck
Tuesday, 27 September 2011

The world may be teetering again on the precipice of economic disaster but those with any investment in the popularity of Alessio Rastani, a hitherto unknown "independent trader", had a worse day than most after his memorable appearance on television yesterday morning.

"I have a confession, I go to bed every night and I dream of another recession, I dream of another moment like this," he told dumbstruck BBC News presenter Martine Croxall, when asked if the proposed eurozone bailout would work.

The interviewer thanked the trader for his candour but told him that "jaws had dropped" around the BBC newsroom while they listened to his answers shortly after 11am.

"I'm a trader," he said. "We don't really care whether they're going to fix the economy, our job is to make money from it.

"The 1930s depression wasn't just about a market crash," he added. "There were some people who were prepared to make money from that crash. I think anyone can do that. It's an opportunity."

The three-minute clip quickly spread online, provoking outrage. In the interview, Mr Rastani went on to advise "everyone watching this" that, "This economic crisis is like a cancer, if you just wait and wait hoping it is going to go away, just like a cancer it is going to grow and it will be too late."

He said it was "wishful thinking" to believe that governments could prevent another recession.

On his Twitter profile Mr Rastani describes himself as an "experienced Stock Market and Forex trader" who is "dedicated to helping others succeed".

Some were as quick to praise him as others were to damn him. Comments on his Facebook page included: "Great interview" and "talk about the truth," while others described Mr Rastani as a hero.

The current crisis bears considerable similarity to that which engulfed the world in 2008, though thus far it lacks the talismanic hate figure generously provided in the form of the former RBS chief Sir Fred Goodwin. The slick-haired, pink-tied and American-accented Mr Rastani may yet fill the void.

Quite how much he personally stands to gain should the financial world collapse again is unclear. The profile on his website, Leadingtrader. com, would suggest he is more reliant on "professional speaking" than his wizardry in the money markets to keep in him in hair gel. But after his performance yesterday it may just be that, like the eurozone, that particular sideline is beyond salvation.

"My belief is that anyone who wants to improve their income and achieve success in life, cannot afford to ignore learning how to trade," he says.

"Based on Alessio's sound advice, I pulled my money out of the markets just before the 2008 stock market crash. He saved me a fortune, not to mention my pension!" claims a client named as Maurice E.

Though Twitter users were quick to pick up on Mr Rastani's outburst, his dire forecast went mysteriously unnoticed by the wider financial markets. Shares in French and German banks rose by as much as 10 per cent, as traders analysed a proposed three trillion euro (£2.6 trillion) rescue package for the single currency.