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This episode aired on BloombergTV on Jun 21, 2012

Algo Trading

Algorithmic Trading relies on sophisticated computer programs and models to make automated decisions regading the market, without human input. Such models are especially popular in strategies such as managed futures, where trend following is prevalent. Algo trading is closely related to the more notorious “high frequency trading.”

Q. So, this is “algorithmic trading”, right? What is it, and why is it in the news right now?

A. First, it is exactly what it sounds like: trading that uses sophisticated computer programs to make automated decisions in the markets, with no human decision-making involved in individual transactions. Its a big idea in a lot of areas, like managed futures, which very often follow quant models… they are “trend followers” and the trends are monitored, and trades executed, by computers.

Q. But that’s not why its in the news right now…

A. No. It’s the news because of the CFTC’s efforts to define and regulate “high frequency trading”; a first cut definition was released yesterday. Now, it’s important to note that not all Algo Trading is HFT; but all HFT is Alto Trading. So one of the key elements of the CFTC’s proposed definition is that computers are being used to generate the trades. Other key elements of the CFTC rules are: “ultra low latency” connections, and high messaging rates: traders that are constantly pinging the system with bids and asks, essentially looking for current pricing information without actually executing trades.

Q. And why exactly is the CFTC so interested in this field right now?

A. Because it’s huge, and potentially dangerous: well over half the volume in stocks and futures. The famous flash crash finally illustrated that HFT is a potentially very destablizing force in the market… and that’s without the “bad actor” sort of scenario that Richard Falkenrath would worry about.

Q. But it’s not just flash crashes we worry about, right? Don’t lots of folks think that HFT had a role in the Facebook IPO problems?

A. Yes, and my own guess is that they’re right. Nasdaq had never seen the combination of IPO pricing system, big retail demand, and HFT all at the same time. To me, there’s no doubt HFT had a role in that fiasco, and it illustrates something very important. A lot of the HFT industry is saying: hey, being such frequent traders, we add liquidity to the system, we’re actually good for it. And they also say that even if they are essentially pulling pennies out of trades, there’s no net harm to retail investors. FB shows you one very clear case of harm; and the flash crash is another.