Super-fast computers lead financial markets under QE2

CME Feb11.pngSuper-fast computers continue to increase their role in financial markets.

They first came into prominence in H2 2009, when the ‘correlation trade’ began. Their role is nothing to do with price discovery, the traditional market function. Instead, they trade on algorithms.

Their aim is trade arbitrage opportunities between markets on a nano-second by nano-second basis. These discrepancies are incredibly small, so they make their returns by leverage, trading millions of contracts at a time.

18 months later, the computers now dominate many markets. The above chart from Petromatrix details the position during Q4 on one of the biggest US exchanges, the Chicago Mercantile Exchange (CME). It shows the Algorithm computers traded:

• ~70% of equity volume (red column) and 50% of all contracts (blue)
• ~50% of all energy volume, including oil, and over 30% of contracts
• ~80% of all foreign exchange (Forex) volume

The problem, of course, is that the correlation trade creates a situation where no single market knows what it is trading. Fundamentals of supply/demand become irrelevant, particularly if central banks such as the US Fed make available vast quantities of liquidity through QE2 to fund the trading.

Fundamentals will, of course, become important once the Fed withdraws its QE2 liquidity. When this happens, probably in Q2, we may well see considerable re-pricing take place, as physical market conditions suddenly become important once again.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. He also serves as a Global Expert for the World Economic Forum. The aim of this blog is to share ideas about the influences that may shape the chemical industry and the global economy over the next 12 – 18 months. It looks behind today’s headlines, to understand what may happen next in critical areas such as oil prices, China and Emerging Markets, currencies, autos, housing, economic growth and the environment. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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