I just noticed tht Moneyscience is beginning a several part interview with Cliff, the first part having just appeared. I'm looking forward to the rest. Some highlights from Part I, beginning with Cliff's early work, mid 1990s, on writing algorithms for trading:
I wrote this piece of software called ZIP, Zero Intelligence Plus. The intention was for it to be as minimal as possible, so it is a ridiculously simple algorithm, almost embarrassingly so. It’s essentially some nested if-then rules, the kind of thing that you might type into an Excel spreadsheet macro. And this set of decisions determines whether the trader should increase or decrease a margin. For each unit it trades, has some notion of the price below which it shouldn’t sell or above which it shouldn’t buy and that is its limit price. However, the price that it actually quotes into the market as a bid or an offer is different from the limit price because obviously, if you’ve been told you can buy something and spend no more than ten quid, you want to start low and you might be bidding just one or two pounds. Then gradually, you’ll approach towards the ten quid point in order to get the deal, so with each quote you’re reducing the margin on the trade. The key innovation I introduced in my ZIP algorithm was that it learned from its experience. So if it made a mistake, it would recognize that mistake and be better the next time it was in the same situation.Personally, I think there are two important things here. One is that, yes, trading will probably soon become almost all algorithmic. This may tend to make you think the markets will become more mechanical, their collective behaviour emerging out of the very simple actions of so many crude programs.
HFTR: When was this exactly?
DC: I did the research in 1996 and HP published the results, and the ZIP program code, in 1997. I then went on to do some other things, like DJ-ing and producing algorithmic dance music (but that’s another story!)
Fast-forward to 2001, when I started to get a bunch of calls because a team at IBM’s Research Labs in the US had just completed the first ever systematic experimental tests of human traders competing against automated, adaptive trading systems. Although IBM had developed their own algorithm called MGD, (Modified Gjerstad Dickhaut), it did the same kind of thing as my ZIP algorithm, using different methods. They had tested out both their MGD and my ZIP against human traders under rigorous experimental conditions and found that both algorithms consistently beat humans, regardless of whether the humans or robots were buyers or sellers. The robots always out-performed the humans.
IBM published their findings at the 2001 IJCAI conference (the International Joint Conference on AI) and although IBM are a pretty conservative company, in the opening paragraphs of this paper they said that this was a result that could have financial implications measured in billions of dollars. I think that implicitly what they were saying was there will always be financial markets and there will always be the institutions (i.e. hedge funds, pension management funds, banks, etc). But the traders that do the business on behalf of those institutions would cease to be human at some point in the future and start to be machines.
But the second thing is what this tells us about people -- that traders and investors and people in general aren't so clever or rational, and most of them have probably been following fairly simple rules all along, rules that machines can easily beat. So there's really no reason to think the markets should become more mechanical as they become more algorithmic. They've probably been quite mechanical all along, and algorithmic too -- it's just that non-rational zero intelligence automatons running the algorithms were called people.