Thursday, October 7, 2010

Positive Feedback is Making the Stock Market Increasingly Unstable

On May 6th 2010, the Dow Jones Industrial Average for the NY Stock Exchange dropped by 1,000 points in a matter a minutes in an event than has become known as the “Flash Crash”. Fortunately for people invested in the market, the Dow regained most of that loss very quickly. This was an unprecedented case, and a warning – how could the stock market change so much so quickly?

It turns out that the flash crash was caused by a single large stock trade, and the series of high frequency computer trades that quickly followed. This should be taken as a very serious warning of how unstable the market has become.

Stock markets are inherently unstable because of positive feedback. Positive feedback is a basic phenomena in control theory in which parts of a system function to increase the size of any change in either the positive or negative direction (negative feedback works to reduce or dampen any change). The market is full of positive feedback loops . Increasing stock prices attract more investors which produces even greater increases in stock prices. Falling stock prices scare away investors which causes even greater reductions in stock prices.

It is a basic principle of control theory that when positive feedback becomes large enough, the system becomes very unstable and begins to experience wild oscillations. The loud squealing you sometimes hear when there is too much feedback in a sound system with a microphone is closely related to this.

Unfortunately, the amount of positive feedback in the stock market is increasing in size and speed each year, being driven mainly by very high speed computer trading. There was a recent story about a new transatlantic cable being laid between England and the US primarily to allow faster computer trading on the NY stock exchange by firms in London. The current cables have a 65 millisecond delay, and the new cables will reduce the delay to under 60 milliseconds. I’ll save the commentary about the tremendous amount of waste in physical resources and intellectual talent that is going into this for another time. For now, I’ll just point to it as an example of the increasing speed and strength of the positive feedback effecting stock markets, bringing them ever closer to the point of wild instability.

No comments: