Mysterious algorithms

Here’s another bit that grabbed me from Matt Levine’s Money Stuff newsletter. In the 3rd January edition he talks about “flash crashes” in the markets and how they happen.

His explanation is long and clear and makes the case that the mysterious algorithms that get blamed for these dramatic and very brief events aren’t actually mysterious. Simply, traders put in orders to buy or sell a particular quantity of something (like shares in Apple) when its price reaches a certain point. As the price changes the mysterious algorithms execute these orders to buy and sell things. These trades may cause the thing’s price to increase or decrease… which in turn means more of the orders have their conditions met and they get executed. It can all move faster than expected.

I’ve read plenty of things about how algorithms are always subject to the biases of those who created them (e.g. Weapons of Math Destruction) but I liked this as an example not of them having biases, but of them lacking information.

If all those trades were happening “in the real world”, with humans talking to each other, not only would they (obviously) happen more slowly but they probably wouldn’t get so extreme — people might say, “Oh, no, I don’t actually want to buy it at that price now!” Also there are people who would, if asked at a certain time, buy or sell a thing at a particular price, but would never put in orders to do so far in advance. The algorithms don’t know about this information.

…it is not a story about inscrutable computer algorithms behaving mysteriously in ways that humans can’t understand. It’s pretty easy to understand! Instead it is really a story about humans being inscrutable to the algorithms. If everyone just entered their entire schedule of demand into the computer — if everyone told the system exactly how much they’d be willing to buy or sell at every conceivable price, and updated that schedule as information changed — then the computer could cheerfully handle everything for everyone and there’d be no problem. That of course is unrealistic. Alternatively if humans just tried not to use market orders — if the people who wanted to sell a lot always told the computer “but not below $9.50, come on, that would be crazy” — then that would get most of the way there. The computer is a tool to allow the humans to express their views efficiently, but that efficiency comes at the cost of not capturing their views completely. Sometimes that leads to trouble.

Anyway, Levine explains the whole thing better than my brief attempt.