Gambling across borders

A blog about the productive life of risk

Posts Tagged ‘CFDs

Beat the algorithms, the casino and the spread betting company

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As I wrote in an earlier post in April, High Frequency Trading (HFT) is perceived as making financial markets even more inhuman and evil than they already are. HFT has truly become the black beast of financial markets. Condemnations of HFT under such metaphors as that of an ‘hyper-speed casino’ bring to the table an interesting question: Is HFT making the market a more unfair game where a few players have a considerable technical advantage over the majority?

It is true that HFT is about working out gaps in the market and grabbing those opportunities to make profit. Being faster and being able to make many more trades than other traders is an obvious advantage since not everyone can afford it: keeping in the game of HFT is costly in investment and expertise.

It would be a mistake though to ascribe too much importance to those ‘supposedly smart machines’, a point that Michael Stothard raises in a recent FT article. After all, HFT and the algorithms behind it are not infallible. In the same manner that the dealer can be beaten by counting cards at blackjack, the algorithm can be beaten by spotting its failures.

Stothard tells us the story of how in 2007, a Norwegian trader, Svend Egil Larsen spotted a weakness in the computer system of Timber Hill, a unit of Interactive Broker. He found out that their algorithm reacted to trades in certain illiquid stocks and that he could take advantage of this by moving the price to his advantage to buy low and then sell  at a profit. Larsen made $50,000 in a few months but he was not the only trader to be operating in this way. Another trader, Peder Veiby, was also playing the ‘system’. Both Veiby and Larsen have since been charged with market manipulation. The most interesting point of this case is not so much that they beat the algorithm or were charged for it but that the courts has ‘found them not guilty, concluding that they were making the market more efficient by exposing a flaw in the system’.

This reminds me of the case of a spread better Barnett Alexander who was charged by the FSA last year for market manipulation for similar reason of price manipulation based on flaws in the spread betting companies. However, despite the case of Larsen and Veiby and the fact that they were cleared, Barnett Alexander preferred to avoid court. Instead he decided to settle with the FSA for £1.3m, a compromise, bearing in mind the potential costs of a lengthy court case were he to lose. Despite this however Alexander still believes that he could have won and as he rightly pointed out to me in an interview, technically he was not manipulating the market but the spread betting company’s prices. The distinction he makes is an important one and indeed, it makes the Swedish case even more interesting.

Barnett Alexander’s case is actually more similar to Larsen/Veiby than one might first imagine. Although Interactive Broker doesn’t call itself a spread betting company, it offers Contract For Differences which work on a similar principle to spread betting. In short, Interactive Broker offers a similar trading experience to Swedish traders than spread betting companies to British customers based on prices indexed to those of the market. This means that although traders have the feel of trading in the market they’re actually trading in another market: that the prices offered by spread betting companies and other financial institutions offering spread betting and CFDs. What those traders have found is that despite the fact that buying and selling stocks as spread betting or CFDs doesn’t affect the movement of share prices in the market (since no actual share is actually bought or sold), the reverse is certainly true: share prices in the market affect the prices offered by spread betting companies.

It seems, after all, that the comparison of HFT, or rather algorithms, to the casino has more to offer than merely a reference to unspecified evils. It’s important to underline here that the gambling industry also uses algorithms to facilitate random conditions and make prices for bets. Like spread betting companies, bookmakers, casinos and other gambling businesses are market makers, and although the house, in principle, will always win, it doesn’t mean that it cannot be beaten.

Written by Claire Loussouarn

May 28, 2012 at 7:06 pm