Algorithmic Trading Is a Huge, Ticking Litigation Bomb

 | Feb 10, 2016 | 8:00 AM EST
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As markets gyrate crazily (go figure, there was a rally in European banks going on in morning trading in Europe today, after banks tanked over the past few days due to investors' fears over their hybrid debt instruments) investors cannot help but wonder how much of it is due to algorithmic and high-frequency trading.

Real Money contributor James "Rev Shark" DePorre  summed up the market's feelings very well in a piece he wrote at the end of last year about "Our Brave, New World of Trading": "Instead of the usual human emotions of greed and fear driving the action, computer algorithms, large short-term funds and high-frequency ETFs rule things these days. And what drives all of those players isn't fundamentals, but the hope of gaining an advantage by trading around normal investor emotions."

Jim Cramer pointed out that the rise of the algos is keeping real, retail investors away from the markets by creating a sense that, in the words of Michael Lewis, the game is rigged.

About half, if not more, of trading on world stock markets is carried out by algorithms, and this has changed things so dramatically that an explosion of class action securities lawsuits could happen in the coming years.

"Algorithmic trading will create a whole host of litigation and litigation opportunities. I think we'll see that happening over the next few years," Mike Lange, counsel for securities litigation at Financial Recovery Technologies, which provides claim filing and monitoring services, told Real Money in an interview.

In theory, algorithmic trading should increase market efficiency, because it allows the moving of large trades without disrupting prices too much, faster rebalancing of indexes and quicker pricing in of economic and company-specific information.

However, Lange said a number of academic studies are now questioning this increased efficiency, while volatility has raised dramatically and is "punctuated by flash crashes" following the introduction of algorithms. In addition, algos have made the system "much more vulnerable" to fraud and manipulation.

"The fundamental problem is algorithms can't distinguish between fact and fiction. If you know how an algorithm is going to react to a given set of facts, you can simulate those facts, precipitate the response, and profit from it," he said.

Manipulating an algorithm doesn't even have to be a very sophisticated process. Lange recalled how last year, in May, a fake press release about a supposed bid for cosmetics company Avon (AVP) sent its shares surging by around 20% in intraday trading, while volume increased by 448% in one day. Avon later debunked the information in the press release and the price came back down.

"If a human had looked at the press release, and when they did, they saw that the press release looked bogus. But the algorithm can't distinguish between fact and fiction. I guarantee someone made money on the up, and probably on the down as well," said Lange.

"We have the same thing with spoofing and other techniques used by traders to simulate trading and then profit from the resulting price movement."

He said algorithmic trading not only has made the system vulnerable to manipulation, but it has changed the way investors can gauge sentiment in the market. For instance, someone writing a press release and knowing how algorithms are likely to react can choose the words in such as way as to blunt the market response if the news is bad.

The consequence would be that the correlation between negative news and the price movement by which investors judge materiality and damages is suddenly broken.

"This impacts the entire system. At its core, the securities laws are grounded on the notion of a 'reasonable investor': What would a 'reasonable investor' perceive as materially important? Well, if half your traders are non-reasoning algorithms, that notion sort of goes up the window," Lange said.

Before the wave of algo-induced litigation hits, however, investors need to know how to navigate current volatility. Here are just a few recent articles from Real Money and Real Money Pro that will help you do that:

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