• Christian Armbruester

The Dark Side


How risk-free trading was created and why it was too good to last.

In the late eighties, we learned how to use computers to manage our investment strategies. The ability to perform countless calculations with an ever-increasing set of available data, meant we could better optimise our portfolios. The capital allocation process was increasingly driven by statistics, regressions, and sophisticated risk management models. Then came direct market access (DMA) and by being able to connect our investment strategies electronically to the exchanges, sparked a revolution in the way we manage our money.

The efficiencies we derived from programming machines to do our bidding are manifold. Execution costs are lower. Remember when we had to call up market makers to fill our orders? These guys not only had a licence to print money, but were seemingly often at long lunches, and sometimes you could not trade certain securities for hours on end. I remember many stocks having more than a 1% difference between the bid and the ask price. Nowadays, comparable spreads are often less than 0.1% and we can essentially trade 24 hours a day. Commissions have also collapsed given the increased competition and the massive volumes that are traded today. By some estimates more than 60% of all global trading is now driven by machines, systematically and entirely devoid of any human interaction beyond the design stage.

So called high frequency trading systems were the culmination of all these efforts and developments. If you could buy 100 shares of BMW on the Frankfurt exchange and simultaneously sell 100 shares on the Berlin exchange for a higher price, it would create a perfect arbitrage. We were as surprised as anyone when we discovered that these inefficiencies existed. Even more surprised were we when we discovered that we could do these trades thousands of times per day, across thousands of different instruments and hundreds of exchanges.

Best of all, it did not require any capital. There simply is no investment risk when you own two fungible instruments, at the same time, for a few seconds. Operational risk there was in abundance, but then again, you could very easily see when the machine wasn’t working. If you saw a red number, instead of the normal continuous string of black numbers you knew something was wrong, and simply shut down the machine. The new role of the trader was to stare at the screen all day and press buttons when colours changed, with no bathroom breaks, ever, lest we lose any money.

Banks were eager to provide the leverage, given the proposition of huge volumes, and little risk of capital losses. The resulting economics were ridiculous. Imagine depositing £10,000 into a margin account, and then you turn on your machine and at the end of the day you have made £10,000. If you do that every day for the rest of the year, the return on invested capital is 25000%. Of course, as you make more money, you can also risk more, to make even more money. It is easy to see why you didn’t need any external capital to run these money printing machines, and it is why you could not get access to these strategies unless you developed them.

Then the inevitable happened, and all the machines essentially stopped working sometime in the last ten years, at the point when these types of inefficiencies no longer existed. Nowadays, people try to find other reasons why Vodafone would outperform British Telecom for a nano-second or two. However, that’s playing the probabilities. A pattern may or may not repeat itself, which makes it a completely different investment proposition versus making infinite and risk-free profits. Where can we find those and what is the next big thing? If I knew, I probably wouldn’t tell you. There is no gain, unless somebody loses in a zero-sum game. Welcome to the dark side of capitalism.

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