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Wednesday, February 24, 2010

About Those Quants

I just finished The Quants by Scott Peterson, definitely an entertaining account of the rise and demise of  quantitative traders and the role they had in the financial crisis,

What was most striking was that when the models ceased working, the traders scrambled to stop the bleeding on the p/l by reverting to the trading style of the "gut feel" traders with long experience in the markets that they felt they had replaced.

Patterson recounts that Boaz Weinstein the top trader at Deutsche Bank pleaded with his risk managers to "ignore the models" and let him take massive short positions to try to salvage his funds' performance. A quant who argues with his risk managers that the only way to make money is to ignore the quantitative models.

Meanwhile Peter Muller head of Morgan Stanley and others were trying to make use of the skills they had honed at the high stakes poker games the quants loved in order to make their trading decisions. The only difference is that instead of the sums at stake reaching into the high 5 figures the numbers here were in the 10s an 100s of million$. .  The traders were trying to figure out who was liquidating positions, who was waiting to liquidate positions if the market stabilized, or whether the selling had been exhausted and there was a massive buying opportunity. Again the quantitative models were useless they were back to the techniques of poker and the old style market savvy traders.
As Peterson writes:

Muller kept ringing up managers trying to gauge who was selling and who was not . But few were talking. In ways Muller thought it was like poker. Some might be bluffing putting on a brave face while massively dumping positions some might be holding out, hoping to ride out the storm...... 

from AQR co founder John Lew:

It was a little bit lof  a poker game. When you think about the universe of  large quant managers, it's not that big. We all know each other. We were all calling each other and saying 'are you selling ?' 'are you".

Pretty scary: the fate of the worlds financial markets in many ways hanging on the outcome of a few guys playing massively high stakes poker with their lightly regulated hedge funds.

As Patterson notes in his final chapter the quants have moved on , Much as in the early days of their erstwhile quant strategies they seem to be reaping consistent profits with their new strategies based on super fast in and out trading based on quantitative algorithms.

The footprints of the impact of the growth of these strategies was evident in a recent study reported in the financial times. The average trade size on stock exchanges around the world is dropping sharply. For instance in 10 yrs the average trade size at the nyse euronext has dropped from just under $59,000 to $6,442.
The reason: (my bolds my comments in blue)

Orders are being sliced into smaller sizes amid a growth in algorithmic trading, a technique used by high-frequency traders at banks, hedge funds and specialist high-frequency firms.
Via software programs, algorithms decide when, how and where to trade certain financial instruments without human intervention.
High-frequency trading uses algorithms to trade at ultra-fast speeds - often 1,000 times faster than the blink of a human eye - seeking to profit from fleeting opportunities presented by minute price changes.....
And just as in the case of the earlier generation of quant trading the potential exists that these techniques could cause a major destablization in the global financial markets. Another FT article reports on market dislocations that have already been caused by this type of trading which only give a hint of the potential system risk. 

But once again the potential for their actions causing large scale market disruptions definitely hangs over the market.
The transformational extent to which markets are being moved by machines, and the scale of involvement by high-frequency firms, are raising two concerns. First, has technology reached the point where machines pose systemic risks if they go berserk? Second, if business is now dominated by a few participants that have this technology, does this threaten the integrity of the markets, where a broad mixture of traders has long cohabited peacefully?...

The Federal Reserve Bank of Chicago, part of America's central banking system, in a paper published this month, says: "The high-frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than in a floor or screen-based trading environment. Although algorithmic trading errors have occurred, we likely have not yet seen the full breadth, magnitude and speed with which they can be generated


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