The Future of Computer Trading in Financial Markets

Complexity Matters Workshop Report v1.1, November 2010 Written by Michael Reilly
Additional notes: Yasmin Hossain, Chris Griffin, Isabel Hacche (All Foresight) and Zubin Siganporia (University of Oxford)

Foresight, Government Office for Science

This workshop report has been commissioned as part of the UK Governments Foresight project on the Future of Computer Trading in Financial Markets. The views expressed in this report are not those of the UK Government and do not represent its policies.

Contents

Executive Summary ............................................................................................................................. 3 1. Introduction ...................................................................................................................................... 4 2. What emerged? ................................................................................................................................ 5 2.1 Stasis in modelling .......................................................................................................................... 5 2.2 Endogenous risk in market microstructure ...................................................................................... 6 2.3 The human-algorithm interface ....................................................................................................... 9 2.4 Network and social structures ....................................................................................................... 11 2.5 Engineered socio-technical systems ............................................................................................. 12 2.6 The politics of decision-making ..................................................................................................... 14 2.7 Risk and intervention .................................................................................................................... 14 3. Chairs perspective ........................................................................................................................ 15 4. What work could the project commission? .................................................................................. 17 Appendix A: Workshop Agenda ........................................................................................................ 19 Appendix B: Workshop Participants ................................................................................................. 21

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Executive Summary
The computer-based trading system offers an ideal laboratory for studying complex systems: variation and selection processes are operating at rapid evolutionary timescales because of the intense pressure to stay in business. The main finding of the workshop was that modelling of the computer-based trading system is inadequate, and that this is principally because of a paucity of high-quality data with which to calibrate and validate predictive models. Without accessible high-quality datasets (especially with identity data) many of the important hypotheses raised on the day could not be tested. Participants called upon the Foresight project to address this by acquiring a highquality dataset that could be made available for comparative research. Models that can assume deviations from market efficiency are necessary: inefficiencies need to be understood because deviations can be dramatic. There may be a fundamental transition in market microstructure at the sub-second scale. Nanex data for the S&P 500 index revealed - over a 2-year period - 150,000 sharp dips and spikes in price. The unusual distribution of these dips and spikes might be explained as the ecology of machines. A small strategy space of algorithms is likely to be inducing phase transitions through crowding. If the evolution for algorithmic agents is occurring at much faster timescales than for biological agents, the question arose as to how the processes of variation, selection and amplification are modulated by human agents. This human-algorithm process of learning may be a crucial driver of change. Diversity is a risk driver and more analysis of diversity and its effects throughout the system is required. More insights were needed not just on the diversity of strategies and market participants but also on the operational risks surrounding the diversity of software and platforms. Phase transitions are possible if a liquidity-shock on one venue results in capital constrained high-frequency trading firms reducing network connections across venues. There is an urgent need for investigation of this network topology. Fragmented social structures within firms, between firms, between firms and regulators, between exchanges, between academic disciplines, and between academics and regulators, have repercussions for risk. If these structures fracture then risk may escape from these social fissures. When risk is managed across fragmented social structures it can also lead to operational complexity. Ways are needed to rebuild bridging social capital across the system. Without this, a serious evaluation of the social costs and benefits of the financial system and the opportunity costs to society of its growth is likely to be obscured. The computer-based trading system is a highly-engineered, possibly unknowable, complex socio-technical system vulnerable to systemic risk. As a consequence - in the short-term at least - contingency and resolution ought to be the predominant principles of intervention. There was a call for a study on the politics of decision-making in the system. Financial market participants may have the political ability to override regulators. Regulators in turn may be wary of the responsibility of acquiring and managing the data required to provide real-time surveillance of the market because of the political consequences if systemic events are not anticipated. Who owns the risk, and what is safety in the computer-based trading system? There needs to be clear oversight for the properties that emerge from the complex interactions of interdependent market participants. The risks (and the opportunities) associated with complexity in the computer-based trading system are not well understood. This can be partly attributed to the fact that the regulatory system is not evolving as quickly as the markets being monitored. -3-

1. Introduction
The Foresight Future of Computer Trading in Financial Markets Complexity Matters Workshop in London on 26th October 2011 had the following objectives1: Understand better how complexity manifests itself in the computer generated trading system Learn lessons from other complex systems on how risk can be managed and regulation can be effective Sketch out work that the project could commission to embed complexity in its analysis and findings

Several of the Driver Reviews commissioned by the project have used the lens of complexity to explore the future of computer-based trading and they highlight the need for further research2. In comparison with other disciplines, the study of complexity systems is nascent and definitions of complexity are imprecise. As a working definition for this report, we have defined a system to be complex if it consists of many heterogeneous agents behaving with a high degree of interdependence. But this is a necessary and not a sufficient condition for complexity. Complex systems are further identified by the surprising collective behaviour of their individual entities. In particular, complex systems exhibit properties that appear only in the aggregate (emergence), small changes can through non-linear effects induce much larger changes in system behaviour (phase transitions), and long-term system behaviour can be influenced by short-term events (path-dependence)3. In the aftermath of the Flash Crash of 6th May 2010, this fuller description of a complex system is highly relevant to computer-based trading. More than this, complexity is of interest to economists because it is an attempt to deepen our understanding of the relationship between micro-level behaviour and macro-level system behaviour. In so much as this relationship remains enigmatic, the study of complex systems can offer insights into the dilemma of managing agent and system-level risk and thereby help to craft more effective approaches to intervention. Professor Sir John Beddington, the UK Government Chief Scientific Adviser, encouraged the group at the beginning of the day to bring ecological and engineering perspectives to the project. Many Foresight projects take as their horizons 50 years in the future but ten years is a long time for a rapidly evolving financial system. Professor J. Doyne Farmer, in his role as workshop chair, provided valuable context on the computer-based trading system. The computer-based trading system offers an ideal laboratory for studying complex systems: variation and selection processes are operating at rapid evolutionary timescales because of the intense pressure to stay in business4. In contrast, natural selection in biology can take thousands of years to produce noticeable effects. The computer-based trading system has many market participants but because it is a highly-constrained decision-making environment - put simply market participants either buy or sell - it is also highly quantifiable and statistical mechanics techniques are useful. There is also a human element as humans

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See Appendix A for Workshop Agenda and Appendix B for a list of multi-disciplinary participants http://www.bis.gov.uk/foresight/our-work/projects/current-projects/computer-trading/working-paper. In particular, see DR2, DR4, DR6, DR9 and DR14. 3 The application of these definitions to economic systems needs a strong empirical underpinning. See Durlauf, S. 2005. Complexity and empirical economics. Econ. J. 115, p22543. 4 Professor Farmers own Prediction Company endured 7 years of losses with financial support but then recouped these losses in one year; it was eventually sold to UBS.

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currently programme the algorithms usually based on rules-of-thumb and a few lines of code. Professor Farmer argued that while it is impossible to anticipate the behaviour of all the individual agents, it may be possible to anticipate the behaviour of their system. Rationality has been the underlying paradigm of economic theory for some time but it is now being questioned including by some economists based on new understandings around asymmetric information and institutional constraints. At the other extreme of rationality, what would it mean if market participants were just coin-flippers? The concept of bounded rationality is somewhere in between the two extremes. Finally, Professor Philip Bond, an ex-trader and one of the projects Lead Expert Group, provided background and context on the project to the workshop participants. The project has an eight-month commissioning window for new work.

2. What emerged?
2.1 Stasis in modelling
Professor Robin Bloomfield - one of the four workshop speakers - put forward a useful categorisation of models for the group to explore: Conceptual Analytical Predictive Operational

Concepts and metaphors analogous (and dis-analogous) to computer-based trading were identified, such as evolution, market ecology, social independence, financial engineering and diversity. The most influential metaphor for the group on the day proved to be a digging the tunnel at both ends5 this was a call by Professor Farmer for economists and physicists to bolster inter-disciplinary engagement in order to face the considerable challenge of modelling the economy. But the metaphor could equally apply to co-ordination challenges facing market participants, exchanges, academics, regulators and politicians. Although realtime surveillance operational models were considered by several participants to be highly desirable, others were less sanguine about their prospects. Toy models - which can be both analytical and predictive - had the potential to offer insights into system dynamics, if not predictive power. The main, if unsurprising, finding of the workshop was that modelling of the computer-based trading system is inadequate, and that this is principally because of a paucity of high-quality data with which to calibrate and validate predictive models. There was a strong support for accessible data to be treated as a valuable public good. Almost all the relevant datasets are proprietary, beyond the reach of academics, and unavailable for comparative research. It follows that in many existing studies the limitations of the datasets used are poorly understood and results are not independently replicated. Without accessible high-quality datasets (especially with identity data) many of the

Doyne explained this ancient practice in his introduction ancient Polynesian tribes had an uncanny ability to dig tunnels from either end and meet accurately in the middle.

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hypotheses raised on the day could not be tested. Identity data were crucial because without it there would be no way to tell foxes from rabbits or who is eating whom. Several participants suggested that the FSA has the necessary data for analysis but observed that is not available for research. Exploring how it could be accessed would be worthwhile and the group argued that there should be greater advocacy to release this data6. The Foresight project might address this externality by acquiring a high-quality dataset that could be made available for comparative research. Any costs were considered to be greatly outweighed by the benefits of improving knowledge of the system and potentially averting systemic events of value destruction. This data challenge apart, an analytical model or framework for understanding complexity in the computer-based trading system did emerge and is described in sections 2.2-2.7. This framework suggests a system of (interdependent) systems each operating at very different evolutionary timescales (from very fast to very slow)7.

2.2 Endogenous risk in market microstructure

The project had previously identified several feedback loops that may contribute to endogenous risk in market microstructure but this was based on limited empirical evidence8. Professor Neil Johnson began the workshop with an (unpublished) analysis of Nanex data for the S&P 500 index time-stamped at the sub-second scale. The data revealed 150,000 sharp dips and spikes in price over a 2-year period. Given that these price volatilities were occurring at 10 millisecond timescales - far beyond the reaction times of humans and the impact of exogenous news - Professor Johnson argued that this is an endogenous phenomenon.

Figure 1, Evidence that sub-second dips and spikes are not random. Source: Professor Neil Johnson.

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Anonymising data might make release more feasible but could be costly. For a deeper understanding of systems of systems see DR4. 8 See http://www.bis.gov.uk/foresight/our-work/projects/current-projects/computer-trading/working-paper. In particular, see DR2.

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There may be a fundamental transition in market microstructure at the sub-second scale. If these sharp dips and spike were random we would expect their cumulative distribution to be linear. Evidence was presented that this was far from the case (see Figure 1). Their distribution is not fat-tailed and is not exactly a power-law distribution. Professor Johnson concluded that these dips and spikes are dragon-kings, following a definition developed by Prof. Didier Sornette (see Box 1).

Box 1, What is a dragon-king? Dragon-kings are statistical outliers that co-exist with power law distributions. For example, the size of urban agglomerations in France have a power-law distribution but an extraordinary city such as Paris is an anomaly to this distribution (see Figure 2). Dragon-kings have been associated with phase transitions or tipping points9.

Figure 2, Rank-ordering plot of the population size of French cities as a function of their rank with sizes ordered in decreasing values. Source: Laherre and Sornette (1998).10

The unusual distribution of these dips and spikes might be explained as the ecology of machines. A small strategy space of algorithms is likely to be inducing phase transitions through crowding. The group deliberated on this analysis. If there is an increased endogenous risk from the ecology of machines, is it important? Who is doing what, to whom, and when? Are there contagion effects? Does short-lived price volatility at the sub-second scale have any

Sornette, D. 2009. Dragon-Kings, Black Swans and the Prediction of Crises. Swiss Finance Institute Research Paper No. 09-36. ETH Zurich. 10 Laherre, J. and Sornette, D. 1998. Stretched exponential distributions in nature and economy: fat tails with characteristic scales. Eur. Phys. J. B 2, p525-539.

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meaning for humans? Most participants agreed that since exogenous information at the subsecond scale was unlikely to be producing these micro-fractures then relatively simple, homogenous algorithms were the cause. Others wondered about the influence of market conditions and herding effects. There were some reservations expressed at the quality of Nanex time-stamped data at the millisecond scale. To test these hypotheses robustly would inevitably require better and more granular data. Nevertheless, the group agreed that eliminating exogenous information was a useful method for assessing endogenous risk. Dr Ryan Woodard hypothesised in a subsequent presentation that endogenous feedback effects in financial systems might be identified and monitored. The specific mechanism is less important than identifying instability in the system11. He agreed with Professor Johnson that phase transitions in the financial systems can resemble dragon-kings and, with this insight, explained the structure of a log periodic power law model that attempts to forecast the end of financial bubbles. The dynamics of bubbles were illustrated for an Exchanged Trade Fund (ETF) for silver and for the repo market before the 2008 financial crash at the timescale of years (see Figure 3); such dynamics were also present at very short-term timescales of 1 week and even intra-day for the price of crude oil.

Figure 3, Dynamics of a bubble in the repo market, 2007-2008. Source: Yan et al (2010)12 This led to two hypotheses: firstly financial bubbles can be diagnosed in real-time before they end, and secondly probabilistic forecasts can predict the end of the bubble more reliably than chance. These hypotheses are being tested at the Swiss Federal institute of Technology by a project called The Financial Bubble Experiment13. If the results prove

This reiterated Professor Farmers point that while it is impossible to anticipate the behaviour of all the individual agents, it may be possible to anticipate the behaviour of their complex system. 12 Yan, W., Woodard, R. and Sornette, D. 2012. Leverage bubbles. Physica A 391 (In press). 13 http://www.ethlife.ethz.ch/archive_articles/100503_prognosenexperiment_nsn/index_EN

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consistently successful then the experiment could result in a system for early warning signals. Dr Woodward was also open to using high-frequency data to test these hypotheses at the sub-second scale. He concluded by raising the intriguing question that if a system with early warning signals for the end of financial bubbles was available to policymakers, what subsequent actions would improve market outcomes? Should they do nothing? Issue a warning to the market? Suspend trading? Dictate trading limits? In a way, this last question anticipated feedback from the group who were quick to point out that trading on a forecast will make it go away. In other words the model will change by revealing results: financial markets are not invariant under observation.

2.3 The human-algorithm interface

The implications of a lack of diversity of algorithms for endogenous risk vexed workshop participants. If the evolution for algorithmic agents is occurring at much faster timescales than for biological agents, the related question arose as to how the processes of variation, selection and amplification are modulated by human agents. Towards the end of the workshop one participant argued that this human-algorithm process of learning was a crucial driver of change. Earlier in the day, Professor Lord Robert May had explored the relationship between complexity and stability in both ecological and financial systems. Ecosystems such as food webs have survived hundreds of millions of years and may provide clues to the characteristics of complex systems that correlate with resilience. Lord May took as his main theme the perils of unexamined assumptions as he compared misunderstandings in ecology with those in finance. Ecological wisdom in the 1960s was based on an incorrect assumption that stability in food webs was positively correlated with connectivity. On the contrary, there appears to be a trade-off between agent-level diversity and system diversity. Similarly, Arbitrage Pricing Theory (APT), a theory that owes more to engineering than science, has underpinnings (e.g. perfect competition, market liquidity) that break under market stress. The theory has also become intertwined in the system it purports to observe14. Lord May highlighted some toy modelling work that finds the proliferation of financial instruments erodes systemic stability and it drives the market to a critical state characterized by large susceptibility, strong fluctuations and enhanced correlations among risks.15 In other words, diversification can be good at an agent-level yet bad at the systemlevel. When systems go beyond a critical level of complexity they may become vulnerable to phase transitions (see Figure 4)16.

The salient metaphor here is that APT is an engine not a camera. MacKenzie, D. 2006. An engine, not a camera: how financial models shape the markets. Cambridge (MA): MIT Press. 15 See F. Caccioli, F., Marsili, M. and Vivo, P. 2009. Eroding Market Stability by Proliferation of Financial Instruments, EPJB 71, p467-479. 16 Lord May repeated Warren Buffets famous quote In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal

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Figure 4, Discontinuous transition to instability of derivatives as complexity increases. Source: Cacciolo et al (2009)17. Toy modelling was also used to explain that excessive homogeneity (banks doing the same thing) within a financial system may seemingly minimise risk for agents (individual banks) but unintentionally maximise systemic risk for all18. Lord May argued that recent banking regulation (Basel I,II) had - by virtue of encouraging institutional-level resilience - the unintended consequence of making the banking system more fragile. In other words, regulation that imposes the same constraints on individual banks makes their decisions more highly correlated, which can lead to herding effects. Lord May compared the higher concentrations of assets between five largest banks in the world with those of the five largest hedge funds to support this hypothesis. The implications of these insights for computer-based trading were discussed. One participant had anecdotal evidence that worldwide only a few thousand people were designing algorithmic strategies for financial markets. The group wished to know in more detail how many firms were developing in-house algorithms and how many others were simply adopting their packages. In other words, is the diversity of strategies increasing or decreasing? Dis-analogies between ecosystems and financial systems were also discussed. Ecosystems tend to have a very large population of heterogeneous agents with local spatial distributions. Global banking systems can be scale-free networks with a small number of highly connected hubs19, and, as one participant quipped, based not on survival of the fittest but on the survival of the fattest.

F. Caccioli, F., Marsili, M. and Vivo, P. 2009. Eroding Market Stability by Proliferation of Financial Instruments, EPJB 71, 467. 18 See Haldane, A.G and May, R.M. 2011. Systemic risk in banking ecosystems. Nature 469, p351-355. 19 Scale free networks contain a small number of hubs with a very high number of network connections. The number of links tends to follow a power law distribution.

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2.4 Network and social structures

Lord May also posed the question of what kind of network configuration could optimise the trade-off between complexity and stability. He encouraged the group to investigate the complex network topologies of financial systems. Analysis of the topology of the Fedwires Funds Service had found that the network is scale-free with a tightly connected core of banks to which most other banks connect; and that the properties of the network changed markedly in the immediate aftermath of the events of September 11, 200120. Toy modelling suggests that the resilience of the banking system depends not only on the relative size of capital reserves but also on the network topology (see Figure 5).

Fig 5, Results from a toy model of the banking system showing the effect on failures of the relative size of capital reserves of small and big banks. Diagram B shows the impact on bank failures of a more realistic network topology. The importance of the structures and networks connecting human and institutional agents for market outcomes emerged in discussions. The Project Lead Expert Group has expressed interest in understanding the impact of liquidity shocks of the highly dynamic network topology created by algorithms trading across multiple venues. Phase transitions are possible if a liquidity-shock on one venue results in capitalconstrained high-frequency trading firms reducing network connections across venues. Several participants highlighted the need for investigation of this network topology (see Figure 6).

Soramaki, K., Bech. M.L., Arnold, J., Glass, R.J. and Beyeler, W.E. 2007. The topology of interbank payment flows. Physica A 379, p317333.

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Figure 6, Systematic divergence feedback loop. Source: FCTFM Working Paper21. But the social structures in the computer-based trading systems, evolving at markedly slower timescales, were also considered important. Fragmented social structures within firms, between firms, between firms and regulators, between exchanges, between academic disciplines, and between academics and regulators, had repercussions for risk. If these structures fracture then risk may escape from social fissures. In many ways, the Flash Crash can be understood from a sociological perspective as well as from a financial and technological view of the system. In social science terms, the system may be suffering from low levels of bridging social capital22. An early seminal example of complexity research examined neighbourhood formation in the US: even if agents desire some degree of integration, at the system level there can be complete segregation23. A symptom of this disjuncture might be the emotive discourse around the future of financial system, which Lord May described as a Socratic dialogue appealing to philosophical beliefs supported by appropriate authorities. It may also mean that a serious evaluation of the social costs and benefits of the financial system and the opportunity costs to society of its growth is being obscured24.

2.5 Engineered socio-technical systems

The trade-off between complexity and stability was explored further but this time in the context of the nuclear industry in the UK. Professor Robin Bloomfield, an expert on engineered socio-technical systems, suggested that in many ways finance was similar to the nuclear industry in the 1980s. The nuclear industry has learned lessons since this era (including from judicial inquiries) by examining systemic risk, governance and trust. There has been a positive correlation between safety and profitability. Diversity of views (and of computer software), dissent and social independence are important elements of safety in the nuclear industry. Good communication builds trust and it has proved important not just to be safe but to let everyone know that you are safe. At the same time, the trade-off between design and complexity is an unsolved problem, and too much emphasis on safety can lead to over-design. Safety in the industry is the responsibility of the operators and is based on

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See http://www.bis.gov.uk/foresight/our-work/projects/current-projects/computer-trading/working-paper. Putnam, R.D. 2000. Bowling alone: the collapse and revival of the American Community. New York: Simon & Schuster. 23 Schelling, T. 1971. Dynamic models of segregation. Journal of mathematical sociology 1, p143-186 24 Lord May mentioned an article by Professor Benjamin Friedman in the Spring 2011 issue of Bulletin of the American Academy of Arts & Sciences. See http://www.amacad.org/publications/bulletinspring2011.aspx.

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Safety Assessment Principles (SAPs). Computers need not necessarily be mistrusted. The nuclear industry has to rely on computers but it uses specialised safety systems to do so (see Figure 7).

Figure 7, Relying on computers requires a different level of protection based on a different level of trust. Source: Professor Robin Bloomfield. Professor Bloomfield suggested a systems of systems approach to safety in the computerbased trading system with different layers of protection based on different levels of trust. For example, algorithms most likely merit a different level of trust from platforms and applications. There should also be an emphasis on black start the likelihood of system failure means that there needs to be preparation in how to recover and on learning lessons from extreme events and crashes. If complex systems are built on experimentation and imperfect learning, then systematic learning from failures should be a universal principle. The need to evaluate and communicate risk in the financial system is urgent. Differences between the nuclear industry and the computer-based trading system were informative: The nuclear industry is engineered from the top-down whereas the computer-based trading system is bottom-up The nuclear industry is a natural monopoly Complexity in the financial system is different - there are arguably more complex interdependencies Strong science underpinning the nuclear industry in the short and long term The financial system responds dynamically to analysis regarding the system Tempo of financial and nuclear disasters can vary greatly Less fear about safety among financial market participants

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Some participants in the financial system benefit from deviations from the norm and from system failure

2.6 The politics of decision-making

Further differences between the systems included regulatory capture, or the political ability of the financial system to override regulators. Black start in the financial system could be impeded if it is a political decision not to look at the worst case scenario. Regulators may be wary of the responsibility of acquiring and managing the data required to develop operational models that provide real-time surveillance of the market. They may be wary because they do not have sufficient resources to carry this out and because of the political consequences if systemic events are not anticipated. In the US, when hurricane forecasting proves inaccurate, the temporarily displaced population can almost be disappointed if their homes are not destroyed. Another participant pointed to the seismologists currently on trial in Italy for failing to anticipate the earthquake in LAquila in 2009. Based on these observations, there was a call for a study on the politics of decision-making in the computer-based trading system from the perspective of a political scientist.

2.7 Risk and intervention

Professor Johnson hypothesised that sharp sub-second price dips and spikes in the Nanex dataset were the result of crowding in a relatively small strategy space. If these phase transitions were indeed a serious endogenous risk, what interventions would be appropriate? Rather than stopping trading, or taking traders out of the market he suggested that it may be best to explore ways to create diversity. The challenge, however, is not straightforward. For example, shifting traders around may reduce risk but the computerbased trading network structure is highly dynamic. The network structure created by computer-based trading across multiple trading venues itself may increase risks to market outcomes. Lord May, similarly, highlighted diversity as a risk driver and there was a consensus that more analysis of diversity and its effects throughout the system was necessary. More insights were needed not just on the diversity of strategies and market participants but also on the operational risks surrounding the diversity of software and platforms. The risks of a false or forced diversity were also raised. Participants identified the human-algorithm interface as a risk driver because computerbased trading depends on rule-of-thumb experiments in a highly-connected environment. Participants were sceptical that algorithms were being tested rigorously. The computerbased trading system may show path dependency if HFT firms drive faster markets. Leverage also arose as a risk driver because the capitalisation of HFT firms could have nonlinear effects leading to phase transitions. Fragmented social structures had repercussions for risk especially if they lead to fracture. Another issue the project has begun to explore is operational complexity in the system. When risk is managed across fragmented social structures it can lead to unmanageable and counter-productive processes. There were several suggestions of how to recapitalise social structures. One promising approach was to encourage regulators and governments that the development and accessibility of high-quality datasets was a public good. In order to ameliorate the commercial sensitivity of such data, it could be released to strictly certified researchers who would carry out analyses in a carefully controlled environment. The newly established Office of Financial Research created by the Dodd-Frank Act in the US may also

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serve as an exemplar to the UK25. Another way forward could be to facilitate more multidisciplinary thinking among academics and regulators26. On the fractured relationship between regulators and market participants there was a telling quotation: policing is what you do with people not to them. It was argued that the low quality of the discourse around the future of the financial system was a major risk driver if this meant that a serious evaluation of the social costs and benefits of the financial system was being obscured27. As the workshop progressed, an engineering perspective proved helpful: participants increasingly perceived the computer-based trading system to be a highly engineered, possibly unknowable, complex socio-technical system vulnerable to systemic risk. It followed that in the short-term at least contingency and resolution ought to be the predominant principles of intervention. This notwithstanding, several participants maintained the possibility of developing early warning signals through improved modelling and scenario analysis. Principles-based regulation was perceived by some to be more difficult to define in the financial system but was preferable to the risks of rigid tick box or checklist regulation. The unintended consequences of Basel I and II, where bank-level heterogeneity actually made the system more homogenous, meant that a sharper focus on the implementation of regulation was required. There was a call for a set of systemic risk indicators and for better regulatory oversight but difficult questions arose as to who owns the risk, and what is safety? There needs to be clear oversight for the properties of the system that emerge from the complex interactions of interdependent market participants. Perhaps the risks (and the opportunities) associated with complexity in the computer-based trading system are not well understood because the regulatory system is not evolving as quickly as the markets being monitored.

3. Chairs perspective
Professor Farmer also spoke later in the afternoon to stimulate participants and to provide his own perspective as an expert on complex systems. He produced a long list of financial crises and then considered whether they were primarily exogenous or endogenous in origin. The fundamental point made was that returns have power law tails and the need to explain this has not been adequately appreciated by economists. Comparing the list of crises with their corresponding New York Times headlines is revealing because the crises are often described using psychological terms such as fear28. The standard explanation of market returns by mainstream economists relates to exogenous information. On the contrary, the explanation by alternative economists using agent-based modelling (ABM) is that ecological

http://www.treasury.gov/initiatives/Pages/ofr.aspx The Complexity Matters workshop brought together economists, physicists, ecologists, engineers, financial market participants, and regulators. Foresight projects take a specifically multi-disciplinary perspective on major strategic issues. 27 Lord May recommended an article by Professor Benjamin Friedman in the Spring 2011 issue of Bulletin of the American Academy of Arts & Sciences. See http://www.amacad.org/publications/bulletinspring2011.aspx . 28 For more on how human psychology can affect economic decisions see Akerlof, G.A. and Schiller, R.J. 2009. Animal spirits: how human psychology drives the economy, and why it matters for global capitalism. Princeton University Press: Princeton. The authors make a case for confidence, fairness, corruption and antisocial behaviour, money illusion and stories.
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shifts of trend followers and value investors can endogenously create these effects. A large number of financial crises are endogenous: there is often no exogenous news that can explain such market crashes. Computer-based trading will increase and some research suggests that at faster timescales endogenous events will be more frequent29. An evolutionary approach to computer-based trading can help to illustrate complexity in models and explore risks to social welfare. Professor Farmer mentioned some work he had done with a value investor leverage ABM model. It was able to reproduce the clustered volatility and heavy tails in returns that are observed in real-life markets. It is leverage that causes positive feedback as banks react to risk controls, recall loans and generate adverse price pressure (see Figure 8)30. Evolutionary pressure favours aggressive hedge funds but less aggressive funds can also survive crashes. In this way, ABMs based on evolutionary processes can provide more realistic insights into the workings of the economy than existing models. They can be used to study how populations of agents change over time, to examine how such changes correlate with volatility and crashes, and to assess the value of diversity. Better calibrated ABMs could prove useful to policymakers because rules such as maximum leverage can be imposed to see what impact they may have on the system31.

Figure 8, Leverage causing a power law tail for stock market returns. Source: Professor J. Doyne Farmer.

As an example see Sornette, D. and von der Becke, S. 2011. Crashes and high frequency trading. The Future of Computer Trading in Financial Markets - Foresight Driver Review DR 7. 30 Other causes of non-linear feedback include: trend following/value investing; stop loss orders; bank runs; fire sales; housing prices /oreclosures/housing prices; credit/stock markek/real economy; demand/employment business cycle. 31 See Farmer, J.D and Foley, D. 2009. The economy needs agent based modelling. Nature 460, p685-686.

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This perspective provoked a debate about the development of economic thinking on financial crises. One participant defended economics methods by explaining that even if interest in ABMs may have waned since the 1960s, much work had been done on heavytailed data. He also highlighted Eugene Famas nuanced research on the weak, semi-strong and strong forms of the efficient markets hypothesis32. Milton Friedmans unguarded view on efficient markets is also illuminating33: Warren Buffett proves that theres not an efficient market, and yet Warren Buffett is what makes the market efficient, and both statements are right. If the market were 100% efficient, nobody could make any money making it efficient, and then it wouldnt be efficient again. So in a way its self-contradictory to suppose that there really is an efficient market. Professor Farmer concluded that we need a broader style of model that can assume deviations from efficiency: inefficiencies need to be understood because deviations can be dramatic.

4. What work could the project commission?

Participants were tasked in the final plenary with recommending to the project what further work should be commissioned by the project. In particular, they were challenged to define what data would be most useful and for what purpose. Table 1 summarises this plenary session and also includes the other suggestions that were made during the workshop.

Figure 9, Does complexity matter at the sub-second scale? Source: Professor Neil Johnson.

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A market in which prices always fully reflect available information is called efficient. Fama, E. 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance 25, p383-417. 33 http://www.byjustinfox.com/2006/11/milton_friedman.html

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Workshop theme
Stasis in modelling

Recommended work
Develop a long-term framework to improve accessibility to high-quality datasets Acquire a high-quality dataset (preferably with identity data) to encourage comparative research What are the strengths and weaknesses of the current models? What existing datasets and platforms are available for research? Critically examine the feasibility of a real-time surveillance operational model Does seemingly short-lived price volatility at the sub-second scale have implications for systemic risk? Test the hypotheses that bubbles can be identified and their ends forecast at the sub-second scale Use data on margins and haircuts to examine system resilience Is the number of trading strategies increasing or decreasing? Use evolutionary game theory to study changes in the diversity of the population of strategies Look at very short-run volatility to test further the link between HFT and volatility What is the impact of Contracts for Difference34 on equity trading? What psychological factors affect computer-based trading? How is variation and selection modulated by humans? How might it change in the future? Map out the highly dynamic complex network created by computer-based trading across multiple venues Provide a sociological perspective of the system What are the costs and benefits of computer-based trading to society? What are the opportunity costs? Assess the operational risk of computer-based trading infrastructure Commission engineers working with other analogous systems (eg smart grids) to provide perspectives How many firms are developing in-house algorithms and how many others are adopting their packages? Commission a political scientist to study the politics of decision-making in the system Does the capitalisation of firms in the system make it vulnerable to phase transitions? Simulate the impact of a financial transaction tax Who owns the risk in the computer-based trading system? What is safety in the computer-based trading system? New measures and definitions of risk; develop a set of systemic indicators Provide an anatomy of risk management in the system

Endogenous risk in market microstructure

Human-Algorithm Interface Network and social structures

Engineered socio-technical systems Politics of decision-making Risk and intervention

Table 1, Recommendations for work the project could commission

34

http://lexicon.ft.com/Term?term=contracts-for-difference

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Appendix A: Workshop Agenda

FUTURE OF COMPUTER TRADING IN FINANCIAL MARKETS PROJECT: COMPLEXITY MATTERS WORKSHOP DATE: 26TH OCTOBER 2011 VENUE: 30 PAVILION ROAD, LONDON SW1X 0HJ (map overleaf) CONTACT: CHRIS GRIFFIN (chris.griffin@bis.gsi.gov.uk, +44 (0)20 7215 4223 PROJECT WEBSITE: http://www.bis.gov.uk/foresight/our-work/projects/currentprojects/computer-trading WORKSHOP AGENDA Key Workshop Objectives: Understand better how complexity manifests itself in the computer-generated trading system Learn lessons from other complex systems on how risk can be managed and regulation can be effective Sketch out work that the project could commission to embed complexity in its analysis and findings

0900 Coffee 0930 Introduction by Professor Sir John Beddington, UK Government Chief Scientific Adviser 0940 Introduction by Professor J. Doyne Farmer, Santa Fe Institute, Workshop Chair 0950 Introduction by Professor Philip Bond, University of Oxford, Project Lead Expert Group Member 1000 Summary of workshop agenda and objectives by Alun Rhydderch, Foresight 1005 Presentation 1 Taming complexity: From the ecology of insurgent wars to subsecond computer trading Professor Neil Johnson, University of Miami Presentation 2 Stability and Complexity in Financial Ecosystems Professor Lord May, University of Oxford 1045 Coffee

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1100 Table discussion and plenary What are the parallels between the systems described in the presentations and the computer-based trading system? In what ways is the computer-based trading system complex? What risks are associated with this complexity? What opportunities are associated with this complexity? Are there useful analogies to other complex systems?

1150 Presentation 3 - Meltdown in the markets a nuclear perspective Professor Robin Bloomfield, City University London Presentation 4 - Using complexity to identify and predict financial bubbles and crashes Dr Ryan Woodard, Swiss Federal Institute of Technology, Zurich 1230 Table discussion What are the parallels between the systems described in the presentations and the computer-based trading system? In what ways is the computer-based trading system complex? What risks are associated with this complexity? What opportunities are associated with this complexity? Are there useful analogies to other complex systems?

1300 Lunch 1345 Plenary 1410 Workshop Chairs perspective 1430 Table discussion What have we learnt? What tools are available to analyse complexity in the computer-based trading system? What does this complexity mean for current methods of risk management? What interventions (including regulation) are needed to improve market outcomes?

1510 Coffee 1530 Final Plenary What work could the project commission to embed complexity matters in its analysis and findings?

1630 Workshop close

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Appendix B: Workshop Participants

Participant Professor Sir John Beddington Professor J. Doyne Farmer Professor Lord Robert May Professor Philip Bond Edgar Peters Dr Jon Danielsson Professor Jean-Pierre Zigrand Professor Dave Cliff Professor Oliver Linton Professor Iain Main Professor Seth Bullock Professor Spyros Skouras Professor Robin Bloomfield Institution \ Organisation UK Govt Chief Scientific Adviser Santa Fe Institute, US University of Oxford, UK University of Oxford, UK First Quadrant, US London School of Economics, UK London School of Economics University of Bristol, UK University of Cambridge, UK University of Edinburgh, UK University of Southampton, UK Athens University of Economics and Business, Greece City University London, UK - 21 Workshop Speaker Lead Expert Group Lead Expert Group Lead Expert Group Additional Title Project Director Workshop Chair Workshop Speaker Lead Expert Group

Dr Alfonso Dufour Kevin Houstoun Andrew Bowley Professor Neil Johnson Dr Anne Wetherilt Professor Peter Allen Professor Rosario Mantegna Dr Ryan Woodard Chris Sims Dr Enrico Gerding Dr Graham Fletcher Professor Sheri Markose Dr Claire Craig Professor Sandy Thomas Dr Miles Elsden

University of Reading, UK Chairman, Rapid Addition Managing Director, Nomura University of Miami, US Bank of England, UK Cranfield University, UK University of Palermo, Italy ETH, Zurich, Switzerland Ignis Asset Management University of Southampton, UK Cranfield University, UK University of Essex, UK Government Office for Science, UK Foresight, UK Government Office for Science, UK Workshop Speaker Workshop Speaker Lead Expert Group

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Zubin Siganporia

University of Oxford, UK

Derek Flynn Lucas Pedace Michael Reilly Alun Rhydderch Yasmin Hossain Christopher Griffin Isabel Hacche

Foresight, UK Foresight, UK Foresight, UK Foresight, UK Foresight, UK Foresight, UK Foresight, UK Project Leader

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