Meet the new market makers, the same as the old market makers (“Dark Pools” review)

Dark Pools is a fun and smart beach weekend read.

Besides the obvious Wall Street/HFT, the book struck me as a cross between War Games, The Matrix, and Terminator: Rise of the Machines.

You immediately enter a world of high-tech mayhem, with super-algos, robot blasters and hunter-sniper cloaking devices clashing at the speed of light.

Re, parallel War Games, you get an iconoclastic, vaguely adolescent anti-hero – Josh Levine, the misift-hacker-genius creator of Island – who pursues an idealistic vision of “liberating the markets”, without impure thoughts of capitalist gain, until one day his mutated ECN creation comes to life and says, “Hello, Professor Falken. Do you want to play a game?”

Re, parallel to the Matrix, at the end of the book, we have advanced rapidly from the humble beginnings of e-commerce to the near birth of AI (artificial intelligence)… the “desert of the real” (in this case, the real being the markets) … and the grand vision of supervillain networked underwater substructures, monitoring global data streams from strategic ocean points all over the world.

Re, Terminator, in the home stretch, I kept waiting for Patterson to write: “As future historians of technology will note, SkyNet showed signs of self-awareness as of XX, 2012…”

It was a bit too much, but in a good way. As Keynes once said, “Words must be a little wild, for they are the assault of thoughts on the thoughtless.” This book will certainly make you think about the impact of high frequency trading on the markets.

My two cents: Ultimately, high-frequency traders are the new market makers… the lightning-fast replacements for hand-signaled floor traders and former post-sit NYSE specialists.

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Yours truly predicted this would happen in a review of “The Predictors” by Thomas Bass, titled “The New Market Makers?” circa 2005 (still available via Mercenary Trader Amazon review page).

As I wrote nearly seven years ago:

“These guys occupy a very specific niche in the market ecosystem. Before the onslaught of computers, human traders provided vital liquidity to markets (and were paid well to do so). towards extinction, “smart” algorithms fill the shoes of floor traders, extracting tick-by-tick profits with high-volume, high-frequency strategies, thus these automated players become the new liquidity providers and market makers of the world. 21st Century Daytraders and scalpers may find themselves caught up in a technology arms race, but longer-term traders and investors have little to fear…it’s a different game.

That’s why this review is titled “Meet the New Market Makers (Like Old Market Makers)”. In many ways, despite all the advances in technology, the most important things haven’t changed.

Take the infamous “Flash Crash” of May 2010, for example. When you understand the role high frequency traders play these days – in terms of facilitating the majority of volume and


in the markets – it makes sense to expect chaos when they “all pull their deals” at once.

From the perspective of an anomalous event where much of the HFT community “backed off”, exposing ridiculously far-off placeholder deals that were never meant to be reached, 21st century market makers acted exactly like the market makers of the last century in the middle of the crash of 1987. They left a vacuum to a point of severe dislocation, just like the old school guys did so long ago.

Perhaps now that GETCO – which stands for Global Electronic Trading Co, the most super-villainous store of them all – has taken on the official duties of market maker in many household names, such an offer will not be an issue in the future.

The question remains: are the new ones worse than the old ones? I’m skeptical.

Anyone nostalgic for the old days of physical pits and human specialists may not remember the day-to-day reality of such a system.

As an international commodities broker in the late 1990s, I had the privilege of phoning into the stands on behalf of speculative and trading clients, to yell at some guy named Vinny or Frankie or Sol – inevitably the beau- brother or cousin of the Refco floor trader who executed our order – to try to obtain restitution for criminal misfilling. This sort of thing happened way too often.

And as for being an NYSE specialist? Talk about a license to print money. There’s a reason these jobs have been passed down from generation to generation. In many cases, the opportunities offered were the legal equivalent of theft.

Not to mention commissions – damn it, commissions! – that private and institutional customers were obliged to pay in the past. Add it all up, and I don’t think the pennies and nickels sucked up by HFT stores, mitigated by the incredibly inexpensive commissions available via technology today, is such a bad deal.

A bit of savagery that made me laugh out loud was the idea that computers are going to take over the markets one day, as in, putting directional investors and traders out of work. Seriously? Puhleeze. These bots can be great at nano-scalping, playing for large-scale blips, but the true directional involvement of the market is another matter altogether.

If you’re really worried about thinking machines eating your lunch over days or weeks, don’t be. Marvin Minsky, a proven progenitor in the field of artificial intelligence – a very confident optimist in AI 15-20 years ago – recently admitted the following:

“The bottom line is that we haven’t really progressed too far towards a truly intelligent machine. We have collections of mute specialists in small areas; the true majesty of general intelligence still awaits our attack.

“Stupid specialists in small areas” aptly describes the proliferation of tick-hungry algos. They’re good at what they do in a very short timeframe, but the inputs needed to analyze incalculable variables over extended time horizons are a whole different matter. As I wrote some time ago, the most powerful supercomputer on the planet isn’t smart enough to understand turbulence in a glass of water – and yet we expect it to crack the loop of self-referential human feedback what is the market?

The book ends with a glimpse into the supposed future of “Star”, the self-made, self-made virtual machine tasked with making investment decisions for a tiny hedge fund, Rebellion Research. Since Star is supposed to be a threat to humans, color me with skepticism. (Those who are just mediocre at their job – rather than very good – have reason to feel threatened, of course… but it always has been that way.)

Patterson briefly alludes to computer-assisted chess, the powerful combination of hardware and wetware (software programs plus human guidance). For the crème de la crème of fund managers, I think this is closer to the real way forward – using technology to enhance human capabilities, not replace them.

In terms of puzzle games, perhaps the best test of metaphor/AI-intelligence is not the fixed Western game, Chess, but the fluid Chinese game, Go, which contains far too many variables within the scope of possible moves for any computer, even Deep Blue, to brute force calculate the optimal strategic path. (For this reason, no Go champion has ever come across a machine.)

Ultimately, trading and investing strategies will continue to evolve. High frequency traders and various forms of new technology will continue to influence the markets in unexpected and interesting ways.

But I believe that the following words from “Reminiscences of a Stock Operator”, which were true in 1923, will remain just as true a century from now:

“There are men whose gait is much faster than that of the crowd. They are bound to lead – no matter how much the crowd changes.

smiling at the bots,

JS ([email protected])

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