Neil Johnson, Guannan Zhao, Eric Hunsader, Jing Meng, Amith Ravindar, Spencer Carran, Brian Tivnan

Abstract

Society's drive toward ever faster socio-technical systems, means that there is an urgent need to understand the threat from 'black swan' extreme events that might emerge. On 6 May 2010, it took just five minutes for a spontaneous mix of human and machine interactions in the global trading cyberspace to generate an unprecedented system-wide Flash Crash. However, little is known about what lies ahead in the crucial sub-second regime where humans become unable to respond or intervene sufficiently quickly. Here we analyze a set of 18,520 ultrafast black swan events that we have uncovered in stock-price movements between 2006 and 2011. We provide empirical evidence for, and an accompanying theory of, an abrupt system-wide transition from a mixed human-machine phase to a new all-machine phase characterized by frequent black swan events with ultrafast durations (<650ms for crashes, <950ms for spikes). Our theory quantifies the systemic fluctuations in these two distinct phases in terms of the diversity of the system's internal ecology and the amount of global information being processed. Our finding that the ten most susceptible entities are major international banks, hints at a hidden relationship between these ultrafast 'fractures' and the slow 'breaking' of the global financial system post-2006. More generally, our work provides tools to help predict and mitigate the systemic risk developing in any complex socio-technical system that attempts to operate at, or beyond, the limits of human response times.

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UPDATE:

You might also be interested in this collection of research on High Frequency Trading.

One of the authors of this paper, Neil Johnson, gives an interview here: “A great war of algorithms is already under way” – scientist Neil Johnson

There's also some interesting coverage of the paper over at the arXiv blog:

The evidence comes from Johnson and co's study of stock price movements between 2006 and 2011. These guys looked for extreme changes in a stock price, which they defined as a change greater than 0.8 per cent, over timescales shorter than 1.5 seconds.

Since human reaction times are about a second, this spans the regime when trades begin to occur faster than humans can monitor and react to them.

The first thing they discovered is that flash crashes and rises are not at all rare. Johnson and co found over18,000 of them, that's more than one a day on average. They call them black swan events, using the terminology developed by Nassim Nicolas Taleb in his book The Black Swan.

Curiously, they found that that change in the occurrence of crashes occurs at timescales shorter than 650 milliseconds, while the transition for price spikes occurs at 950 milliseconds.

Physics of Finance Blog also comments in an article: Approaching the singularity -- in global finance

The paper as a whole takes a bit of time to get your head around, but it is, I think, a beautiful example of how a simple model that explores some of the rich dynamics of how strategies interact in a market can give rise to some deep insights. The analysis suggests, first, that the high frequency markets have moved past "the singularity," their dynamics having become fundamentally different -- uncoupled from the control, or at least strong influence, of human trading. It also suggests, second, that the change in dynamics derives directly from the crowding of strategies that operate on very short timescales, this crowding caused by the need for relative simplicity in these strategies.

Wired were a little bit late to this piece of research with their article: Nanosecond Trading Could Make Markets Go Haywire

With many algorithms converging on just a few different strategies, the high-frequency trading market could become vulnerable to systemwide herd behaviors. Fortunately for us, the market seems to rebound from spikes almost as immediately as they occur — Johnson and Tivnan likened the effect to a “coiled spring” returning to form — but as seen in May 2010, this might not always happen.

Johnson and Tivnan also used another metaphor to describe the flash crashes and spikes: fractures. The events could be imagined as microfractures in the wing of an aircraft, accumulating unnoticeably until some critical, breakage-causing mass is reached. To that end, they found a correlation between rising frequencies of sub-950-ms flash events, market volatility after 2008, and the May 2010 flash crash. The 10 stocks most prone to crash-and-spiking were all financial companies, with Morgan Stanley, Goldman Sachs and Wells Fargo topping the list.

The Reign of Robots May Be Closer Than You Think: Mark Buchanan:

The futurist Ray Kurzweil has famously predicted that humanity is approaching a “singularity,” a fateful moment when our technology becomes smarter than us and able to learn faster than we can, when it becomes the principal creator of new technologies and machines race far ahead of us. Humans may effectively fall out of the loop -- a species demoted, if not eliminated.

For now, this world remains science fiction, at least at the level of humanity. But finance is flirting with a similar transition, as ever-faster computing and communications technology takes high-frequency trading into a regime of speed where human beings can no longer keep up. In fact, we may have already arrived.