Stop blaming the machines. Algorithms aren’t causing the wild stock market swings.

Market robots are under fire for causing wild stock swings.

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Market robots are under fire for causing wild stock swings.
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  • Big fund managers tend to blame algorithmic trading when things go haywire in the stock market.
  • But there are other factors adding complexity to this argument: A boom in disparate trading platforms makes price discovery difficult, and low trading volume.
  • “The electronification era remains one of the lowest-volatility periods on record despite the rise of high-frequency trading,” according to trading news site Curatia.
  • No, machines aren’t causing all these wild stock market swings.

The wild swings and see-sawing of markets these last few days was unprecedented in many ways. But one aspect of the week ended up being very predictable: Like clockwork after any sudden jolt and market event, big investors come out and point the finger at algorithms.

The argument goes something like this: Electronic trading programs feed off each other to cause an “invisible herding effect” that amplifies price moves, capable of turning a minor downward market trajectory into a full-blown bloodbath, all in a matter of milliseconds. Now that electronic trading makes up huge swathes of the market, a sea change from only a few decades ago, it’s obvious that robot traders are causing the plunges and rallies like those of this week.

“Electronic traders are wreaking havoc in the markets,” Leon Cooperman, the billionaire stock picker who founded hedge fund Omega Advisors, told the Wall Street Journal.

JPMorgan Asset Management’s chief global strategist, David Kelly, also chimed in this week, blaming algorithm-led passive investment vehicles for the Christmas week volatility. And next year might be worse: Star economist Torsten Slok at Deutsche Bank said an “algo-driven fire sale” might be one of the big risks of 2019.

Again and again, market structure experts have pushed back against this oversimplified narrative. But much of the counterbalance is seldom noticed. (Perhaps jargon like “latency arbitrage” in 30-plus page reports from institutions with unsexy names like the Bank for International Settlements are less than headline grabbing.)

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But there are plenty of holes to poke in this theory: For one, as trading news site Curatia notes, linking the increase of the machines to the rise in volatility doesn’t even work from a timing standpoint.

“Huge, rapid stock swings occurred well before the advent of algorithmic trading,” it said. “On the whole, the electronification era remains one of the lowest-volatility periods on record despite the rise of high-frequency trading. And the recent surge in volatility doesn’t correlate with any specific increase in market automation.”

Adding to the complexity – besides the boom in algos, the market has changed in so many other ways, too.

There’s been an explosion in different types of trading venues, both inside and outside of big banks, that has created more tectonic plate-like platforms in the market. That can make “price discovery” trickier. This is especially true in periods of low liquidity, or thinned out buying and selling, which tends to happen over the holiday period.

And there was plenty of human-led activity going on in the world this year that was arguably scarier to investors than any Skynet-style cyborg speed trader: Federal Reserve policy, the US-China trade war, the “leveraged loan” boom, eurozone drama, emerging-market turmoil, volatile oil prices, and Brexit, to list just a few.

“We often talk about volatility in financial markets, but we must recognize that we now live in a volatile political climate,” the European Principal Traders Association has said in one analysis of “flash crashes.” Knee-jerk blame of robots, it says, “is irresponsible.”

Curatia sums it up well: “For all the good things about machines, arguably the best is that when you point a finger at them, they don’t point back.”