Do Androids Dream of Stock Prices?
Do Androids Dream of Stock Prices?
Thu 09 Feb 2017
We look at the rise of ‘robostocks’ and algorithmic trading, and consider the repercussions on financial markets.
An old investment adage mockingly states that “a failed trade becomes a long term investment”. The idea behind it is that if a security is bought and underperforms, investors tend to keep it until it eventually becomes profitable, in what Nobel laureate Daniel Kahneman described as the “endowment effect”.
Nowadays, however, the “trade” and the “investment” are mostly executed by different entities. Modern day trading is less dominated by human biases and more by algorithmic trading, computers trading on parameters set by mathematicians and CERN-educated physicists rather than fund managers driven by fundamentals.
The theme of a robot-dominated dystopia is prominent in fiction and our culture, with series such as “Westworld” and novels like Philip K. Dick’s wonderful “Do Androids Dream of Electric Sheep?”, and has been gaining prominence in the past few years. There’s good reason for this. 20 Years after a program called Deep Blue defeated World Chess Champion Garry Kasparov, another AI program called “Libratus” recently beat four of the world’s best poker players in a gruelling 20-day tournament.
Trading robots
Speed, hedging needs and best execution directives in multiple exchanges have taken precedence over cash flow and capital expenditure analysis. This is partly reflected in the huge growth in ETF assets, coupled with a decline in long-only fund assets over the past few years. Studies estimate the amount of algorithmic trading to be anywhere between 50% and 85% in the US, and a bit lower for Europe, rendering “Algos” a dominant market force. In a recent report, the Bank of International Settlements took a good look at the Sterling “Flash Crash” on October 7th 2016, during which the UK’s currency depreciated versus the Dollar 9% before retracing the move. The report cites, among other factors, the presence of staff “with less expertise in the suitability of particular algorithms for the prevailing market conditions”. What is particularly worrying is that currency markets are very deep and difficult to manipulate, which means that the fault probably lies not with one but with a large number of algorithms, set to react roughly the same way, a sort of computer “groupthink”.
Gavekal’s Anatole Kaletsky recently also cited the algorithms as key to explain buoyant market reactions after major events, like Brexit or the US election, the outcomes of which had been predicted as catastrophic by experts. He even went a step further, juxtaposing active management (like client portfolios and mutual funds) to passive management, which essentially means computers deciding instead of humans.
Insights from the GFC
It is, by now known that the 2008-2009 Global Financial Crisis did not begin with the demise of Lehman Brothers but with large size quantitative hedge funds going bust one year earlier, in August 2007, as automatic trading failed them. By their nature, algorithms are set to respond to a set of predictable circumstances, as they draw on past experience, and then use probabilistic models to assess future conditions. Also by design, they are short term. The longer one projects into the future, the more uncertain that future becomes. Robots can deal with probabilities of short term events but would find it harder to deal with the consequences of important market shifts, including the selloff by other robots. Thus, while “algos” may benefit from the Dow dropping 800 points in the hours after the US election, they could find it harder to respond to something more unpredictable and less binary, like for example China dumping US Treasuries in the open market, as a result of an escalating trade war. Policy changes, a shift in earnings trends, new regulations, anything “new” in nature is very difficult to program in advance. So, less policy guidance from central banks, for example, could level the playing field between fund managers and mathematical formulas.
However, unless Janet Yellen wakes up one morning to the belief that she doesn’t want to talk to the markets any more, or remove the Fed’s implicit protection, the interest rate environment is more predictable, allowing robots the edge.
What next for fund managers?
Fund managers now find their comfort zone in the “longer game”, where assessing the improbable is more than just about mathematical assumptions. In virtually 95% of the meetings we attend, we hear about the importance of security selection and the implementation of long term strategies. When we assess absolute return funds, the closest thing to a hedge fund with daily liquidity and within the UCITS frame, we are well aware that they best operate within predictable levels of volatility and could underperform if the market shifts completely, either to the upside or the downside.
A long term perspective
Could the next crisis then come from computers, as “Big Short” writer Michael Lewis hinted in his “Flash Boys”? Maybe. But, quite like other humans, we play the long game in our portfolios. We think of macro trends and how they may drive earnings. We ignore short-termism, not because we have no choice, but because the client’s objectives are set over the long term, and that is when they, and we, feel more comfortable. Thus portfolio owners should maintain their long-term perspective. As for investment managers and economists? We are driven to focus less on the repercussions of “known unknowns”, such as a surprise number in US payrolls, and are driven more towards focusing on the repercussions of “new events”, confident that humans can identify cyclical and structural breakpoints in the markets, even if computer trades persist in a different direction.
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The current pandemic is having far reaching consequences across all aspects of society. Compared to other industries the impact on the credit card industry is relatively mild and from a customer perspective the value of on-demand liquidity is now clearer than ever. However, there will be significant impacts on industry profitability. Reduced international travel will […]
How the insurance industry can emerge stronger
There is little doubt that Covid-19 has had a significant impact on insurers, but there were already factors in play that were adding pressure on the insurance industry. What covid-19 has done is to create new challenges, as well as bringing existing challenges to the foreground. Looking ahead, the actions insurers take now to deal […]
A Tax Playbook for the Digitalised Economy (Part 1)
In a series of articles aimed at promoting debate on the evolution of international tax regimes, Michael Lennard, Chief of International Tax Cooperation and Trade in the Financing for Development Office (FfDO) of the United Nations, discusses the tax-related challenges governments, professionals and practitioners face. In the first of this two-part article, Mr Lennard expresses […]
A Tax Playbook for the Digitalised Economy (Part 2)
In a series of articles aimed at promoting debate on the evolution of international tax regimes, Michael Lennard, Chief of International Tax Cooperation and Trade in the Financing for Sustainable Development Office (FSDO) of the United Nations, discusses the tax-related challenges governments, professionals and practitioners face. Following on from the first article on this topic, […]
Achieving digital operational resilience
The digitalisation of banking processes and the introduction of AI-led technology impact the central and strategic role of information systems within the banking system. The growing use of information and communication technology (ICT) exposes all financial institutions to an increasing level of digital risk that could weaken their operational resilience, in particular, due to more […]
New-style cyber insurance policy models on the rise
Regardless of geography or business sector, many groups and companies have taken out cybersecurity insurance policies in recent years. These policies cover companies against new threats to information systems, including ransomware and data theft incidents that have been making the headlines. For a long time, the risks identified in these policies were on the borderline […]
How the new prudential regime will impact EU investment firms notably French
A major step forward has been taken in implementing the European “investment firms” package in France*. The transposition of the package into local legislation, alongside EU Regulation 2019/2033 on prudential requirements for investment firms (IFR), came into full effect on 26 June 2021. In accordance with the proportionality principle, the IFR and investment firms directive […]
Deep hedging: application of deep learning to hedge financial derivatives
The recent breakthrough of data science and deep learning make a model independent approach for hedging possible. This hedging approach known as deep hedging is a robust data-driven method able to consider market frictions as well as trading constraints without using model-computed greeks. This article gives the main theoretical tools to understand the methodology and […]
ESG investing: From buzzword to mainstream
A growing interest in environmental, social and governance (ESG) issues is driving record inflows into the ESG-led investment sector. During 2020, sustainable funds available to European investors attracted net inflows of €233bn1, which saw assets under management hit the $1.1tn milestone, accounting for almost 10% of total European fund assets. A similar growth story in […]
ESG investing: Three risks to consider
The continued popularity of funds with an environmental, social and governance (ESG) focus has put global ESG assets on track to exceed $53tn by 2025, up from nearly $38tn at the end of 20201. As growth continues, expectations for effective compliance policies and controls in place are expected to become more rigorous as political and […]
Remote working: A growing target for hackers
The widespread use of working from home (WFH) during the pandemic, regardless of sector or geographical location has required organisations and their information systems (IS) management to be very agile in deploying or increasing their capacity for remote collaboration. Some institutions were already prepared – for example, following the wave of strikes at the end […]
The imperative of expanding the traditional MRM function
Financial institutions and non-bank financial technology companies (FinTechs) alike make extensive use of various machine learning models (MLOps) in core and non-core areas of their business. Banks, for example, rely on such models for a range of risk assessments, including predictive underwriting, credit risk management, suspicious and/or fraudulent activity management, fair lending compliance, derivative and […]
GDPR has controls over subcontractors in its line of fire
Like all industries, the real estate sector has to implement a range of legal, technical and organisational measures to protect the personal data of its employees, customers, prospects and suppliers. Processing must comply with several regulations related to data protection, including, for example, the General Data Protection Regulation (GDPR), applicable since 25 May 2018. Same […]
Eurofi financial summit addresses EU’s ecological and digital transition
As a setting for exchange between European Union (EU) economic and financial regulators and senior financial sector executives from the industry, one of the world’s largest financial services conferences, Eurofi, took place in Paris in February. Established in 2000, the Eurofi meetings occur bi-annually* alongside the Economic and Financial Affairs Council configuration (ECOFIN) meetings. The […]
Can markets in crypto-assets (MiCA) give banks a regulatory edge?
Crypto-asset markets have been on banks’ radar for some time. While interest and involvement have varied, regulatory developments have been a driving force. In September 2020, the European Union (EU) published a proposal for the regulation of Markets in Crypto-assets (MiCA), offering a uniform legal framework for crypto-assets in the EU. On 14 March 2022, […]
Should we be concerned by Facebook’s launch into cryptocurrencies?
Whether the launch of Facebook’s Libra will threaten global monetary and financial stability is a question that has been on all regulators’ and politicians’ minds since Facebook announced its cryptocurrency project on June 18, 2019. Donald Trump himself tweeted that, as a virtual currency, Libra “will have little standing or dependability” and that Facebook should […]