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22 February 2018

Unintended Consequences

Ah, those pesky unintended consequences. Always lurking, just out of sight, ready to jump out and surprise the unwitting. When Franz Ferdinand’s driver turned down a side street in Sarajevo, it wasn’t his intention to deliver his master into the path of Princip’s bullet and the world into mayhem, and I’m sure when Marx wrote his tracts in the nineteenth century he didn’t intend the slave labour camps and tens of millions of deaths around the world that were their consequence. But that's what happened.

But here, we’re going to talk about electronic trading again. A clutch of European banks have just been fined by the CFTC for manipulating the precious metals markets by indulging in “spoofing”. Website Zerohedge (mostly known for purveying some - how shall I put this? - arcane theories on the state of financial markets) knowingly comments that “there are still the occasional idiots out there who say gold and silver were never manipulated.” Well, maybe, but let’s look for a moment at the actual issues. 

The findings were that at the banks involved, traders would put orders into the electronic trading platforms with the intent that they should not be executed and then very rapidly withdraw those same orders. Their intention, the authority found, was to suggest to the market that there was more buying (or selling) in the market than would otherwise have been thought, thus enabling the spoofers to achieve a better  price than they would otherwise have expected. Well, yes, but then, these are traders and what they are paid to do is buy and sell at the best level they can achieve. The further accusation is that the same activities could result in stop-loss orders being triggered, to the detriment of those who had placed them.

I do sort of get this, in the sense that what is happening is that a picture is being painted of the market which is impressionistic rater than realistic - Monet rather than Canaletto, let’s say - and the regulatory authorities don’t like it. To be honest, I kind of sit on the fence on this, because I can see two sides to the problem; but that may be because I come from an older generation of traders, where spoofing would have been regarded as a regular part of the business. 

The difference between then and now is, of course, visibility. The advent of electronic trading platforms means that everything is visible to everybody; so whereas before, it was possible to spoof one or two other traders - on a telephone call - now, the entire market can be conned, if that is one’s intention. And the regulator’s brief is to ensure that all market participants are in an equal position, so, per se, spoofing the market must of itself be wrong.

I think there is a lot of nuance in here, though, that is being glossed over. Trading is an adversarial activity; although at the point of the execution of the trade there is obvious agreement, nevertheless each side has initiated the operation in expectation that it will be beneficial, which obviously means detrimental to the other participant. After all, markets can only go up, down or remain the same, so Party A’s gain is Party B’s loss. What the in-your-face openness of the electronic platform effectively does is remove the possibility of negotiation, so that what this case seems to be saying is that a trader has an obligation to enter into the system exactly what he or she wants to do - no more, and no less. 

What I think I find uncomfortable about this is that it seems part of the assumption that has grown over recent years that ‘trader’ is a dirty word, that they are all, by definition almost, deliberately trying to cheat. For sure, there has been some egregious behaviour, and maybe there is more to this case than I have read in the reports, but this is why I talk of unintended consequences. I don’t believe that the electrification of trading platforms was designed to reduce the role of the trader to that of an order-enterer, but one can see that that is where we are heading. 

I’m not making any comment on whether this is good or bad - I’m simply making an observation that with the best will in the world, sometimes things have results which may not have been foreseen. As we march towards an AI-dominated investment world - which I firmly believe is where we are going - this won’t be the last unexpected shift in people’s roles.    

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