The Reign of Robots May Be Closer Than You Think:
Mark Buchanan
2012-03-07 00:03:44.0 GMT
By Mark Buchanan
March 7 (Bloomberg) -- The futurist Ray Kurzweil has
famously predicted that humanity is approaching a
“singularity,” a fateful moment when our technology becomes
smarter than us and able to learn faster than we can, when it
becomes the principal creator of new technologies and machines
race far ahead of us. Humans may effectively fall out of the
loop -- a species demoted, if not eliminated.
For now, this world remains science fiction, at least at
the level of humanity. But finance is flirting with a similar
transition, as ever-faster computing and communications
technology takes high-frequency trading into a regime of speed
where human beings can no longer keep up. In fact, we may have
already arrived.
The Flash Crash of May 6, 2010, was a landmark event
hinting that something may be amiss in the high frequency
markets. Now it is clear that odd market behavior at high
frequencies is systematic.
In a recent study, physicist Neil Johnson and colleagues
found more than 18,000 instances over the past five years where
markets, in about a second and a half or less, either ticked up
or down at least 10 times in a row, making prices rise or fall
in that span by more than 0.8 percent. Many of these mini-
crashes and mini-booms took place in well under a tenth of a
second, effectively instantaneous from a human perspective. And
they have been happening roughly 10 times per day. It’s as if
the markets are throwing off sparks reflecting mysterious
frictions or stresses.
Striking Difference
These sparks show up in market statistics, too. The same
study looked at the incidents on different timescales, both
above one second and below, and found a striking difference.
Over periods of one second or longer, the distribution of events
by size has the familiar “fat tailed” distribution -- the norm
for markets, broadly speaking, which reflects their pronounced
susceptibility to large price changes.
In contrast, the distribution for events that last less
than one second looks very different. Here, the distribution is
“fatter than fat” and shows an even greater than normal
tendency for Black Swan-type upheavals.
What’s so special about one second? Why is this sharp and
distinctive boundary located at that period of time, rather than
at, say, one minute or a 10th of a second? Well, it is more than
a little suspicious, the researchers point out, that one second
happens to be right around the speed limit for fast human
decision making. Experiments with chess grandmasters, for
example, show they can assess a complex chess situation and
identify a threat of checkmate in about two thirds of a second.
Other people operate at comparable speeds in their own areas of
expertise.
When it comes to making conscious decisions, one second is
about the limit. Coincidence? Or are the markets at this
timescale showing the signs of an emerging all-machine phase of
trading over which human decisions have little influence or
control?
Further evidence for the latter interpretation comes from
simple models of markets as ecologies of interacting strategies,
models of the kind I wrote about in my last column. These models
reproduce many of the realistic qualities -- or “stylized
facts” -- of real markets, and can help us anticipate how
markets might do surprising things. In particular, they can give
hints about how seemingly innocuous, gradual changes might push
markets across a threshold and into a regime of dramatically
different behavior.
Crowded Markets
Mathematical studies of these models show that one of the
most fundamental factors influencing their basic dynamics is how
“crowded” the market is -- crowded in an intellectual and
strategic, rather than physical sense. If the participants in a
market use a wide and diverse range of trading strategies, then
the market is uncrowded. In this case, the typical behavior is
akin to that in a world with few predators and relatively
plentiful prey. A healthy diversity of participants earns
profits in different ways -- thinking and acting on different
timescales, taking different views on the future and so on.
Real markets, the models suggest, look a lot like this
uncrowded phase, with highly irregular market fluctuations and
fat tails.
In contrast, if a market becomes overcrowded -- that is, if
many traders chase few opportunities and use very similar
strategies to do so -- then the continuity of the market tends
to break down. In this regime, the market becomes prone to what
might be called “glitches” or “fractures,” sudden moves up
or down much like those now observed in the sub-one-second
trading regime.
There are good reasons, Johnson and colleagues argue, to
think that high frequency markets have indeed entered such a
crowded phase. After all, high frequency algorithms by their
nature compete on speed and have to act extremely quickly. As a
consequence, they must be relatively simple, and can’t waste
time analyzing too much information about the past. Given these
constraints on the range of possible strategies, and given the
number of traders operating within them, overcrowding is quite
likely -- as are the fractured, troubled market dynamics arising
from it.
This is an instructive example of how a simple adaptive
model of markets can give rise to important and non-obvious
insights. As trading moves to inhumanely short timescales, we
shouldn’t be surprised, but should actually expect to see
increasingly frequent Black Swan events in microscopic
timescales. They may well be the natural consequence of machine
trading that is becoming uncoupled from the strong influence of
conscious human decision making.
We’re moving, as Johnson and colleagues put it, “from a
mixed phase of humans and machines, in which humans have time to
assess information and act, to an ultrafast all-machine phase in
which machines dictate price changes.” We’re crossing a
boundary into a trading twilight zone, and doing so without much
thought or awareness of the potential dangers.
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