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High Speed (Frequency) Trading from a Scientific Point of View


By Miroslav B. Bonchev
There have been several programs on the internet media: RT America, Keiser Report and others on the subject of High Frequency Trading over the past few days. The hosts and guests on these shows typically have a background in economics and express their positions on the subject from that point of view. In this article, I will take a look at this subject from an information and engineering point of view, and in agreement with the aforementioned personalities I will show that High Frequency Trading is indeed undesirable, unsustainable and lead to dire consequences.

High Frequency Trading refers to the buying and selling of stocks and commodities in a fraction of a second. Before entering into the more interesting part of this article, I'd like to note that the name that has been given to these activities is incorrect and misleading. The word "Frequency" implies that there is periodicity of the process, which on its own terms means that there is a repetitiveness at an approximately constant interval. However buying and selling of any particular goods does not typically involve any type of repetitiveness or periodicity, and if it ever occurs, it is by pure chance. Therefore a more appropriate name would be "High Speed Trading". With this out of the way, I will look at two phenomena which are very important in all kinds of engineering, without which much modern technology would not exist.

The first phenomenon is called Hysteresis. It refers to the distance of levels when switching occurs. For example, if you flip the light switch on your wall, you should notice that it triggers ON at a particular position which is very different from the position where it triggers OFF. This distance between ON and OFF is called hysteresis and is extremely important for the stability and life of the system. If the hysteresis is too narrow then the system becomes unsustainable and possibly chaotic. For example, if the switching ON and OFF of the light switch is occurring at the same position or at two very close, there would be hundreds of quick ON/OFF when switching the light due to noise. As a result, the light bulb would last only a few days as opposed to years. Hysteresis exists not just in technical terms, but in society too. For example, during elections the candidate who wins just one more vote than the others wins the election. While children, and for that matter, most people are lead to believe that such an idea is noble and is to be praised, it is a devastatingly erroneous. In terms of hysteresis, this introduces switching with practically no hysteresis. Suppose that a candidate was elected with one vote more than his rival; is it possible that there were two people who wished to vote for the losing candidate but could not vote because of circumstances. Obviously, the election failed because of the lack of hysteresis. Therefore some hysteresis is necessary when voting, a 10% distance between the candidates might be a good beginning in order to eliminate noise from people switching their vote, failing to vote at all, fraud and others, but of course the width of the hysteresis depends on the circumstances. In terms of trading, hysteresis is also necessary, as otherwise the system becomes driven by noise. That is, the trading itself becomes noise and thus destroys the system itself, which is the market. The very act of placing an order is an instantaneous edge, which should be executed as quickly as possible. The act of cancelling the order should be also instantaneous, otherwise there would be an unwanted condition known as racing where at the same moment of time for some parts of the market the deal is ON while for other it is OFF. However, there must be enough time between the ON and OFF edges of an offer in which the owner of the subject of the trade can utilize it. What I mean by that is that hundreds of flicks of the lights in one-hundredth of a second would be meaningless for the man who switches the light. The light is meaningful only if it is ON for at least a second, in which time the person can see and make sense of what he is seeing.

The second phenomenon is called Clock, which in simplified terms is a beat in a processor, where time exists only on the edge of the clock. The different signals in the processor pass through different paths and arrive at their destination also at different time. The clock is used to synchronize all signals in the processor, so that there are no racing conditions. When the Clock clocks, all signals must already have arrived and the current state of the system is must be stable, so the clock accepts that and initiates the transition to the next state. When the signals are released, they again travel to reach their destination and place the system into its new state ready for the next clock. The clock has such speed that the slowest signal must have arrived at the next clock before the process can continue. No output element changes its state between clocks i.e. more than once per clock. Applied in the High Speed (Frequency) Trading, this means that in order for the market to be a stable and well functioning system it must have a clock which would allow the slowest trader to hear the state of any part of the market (i.e. the whole market), make their decisions, and submit them, which is the answer to the question how wide should be the hysteresis on the market.

Perhaps, having the slowest man determine the hysteresis width on the market-clock would be more than necessary, but I believe that we would agree that in the current state of telecommunications one minute hysteresis should be enough for an average trader to see what is happening, take a decision, and submit it, as well as enough time for an owner of a property to experience the feeling of owning it, before selling it if they wish to do so. The reality at the moment however is that trade is performed with no hysteresis at all, and the worst of all, the High Speed Trading is now the larger percent of all trading. Thus the noise is allowed to overtake the clear signal which will have devastating consequences for the system (market).
Miroslav B. Bonchev
14-th August 2012
London, England
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