Machines Will Do Shady Things in the Markets Too

A useful way to think about modern electronic market structure is that in the olden days humans traded stocks and options, making markets based on gut instinct, and then those humans were replaced by computers that used algorithms that largely replicated the humans' gut instincts but more efficiently. But also, in the olden days, those humans did various shady things, and over time the computers have started to replicate the humans' shady-thing-doing abilities, because, you know, the shady-thing-doing tradition runs deep.

And so the way human markets work is that Pension Fund X will buy a lot of Microsoft Corp. stock through Dealer Y, and Hedge Fund Z will call up Dealer Y and say "hey who is buying all this Microsoft stock," and the dealer won't say "oh it's Pension Fund X" -- that would be a hideous violation of client confidentiality -- but she might give the hedge fund some "market color." The exact flavor of market color will depend on her relationships with Pension Fund X and Hedge Fund Z, and on the norms of the particular market they trade in, but she might say something like "we're seeing long-term real-money flows into Microsoft" or whatever. And Hedge Fund Z will conclude that there's more Microsoft buying to come, and so will buy Microsoft itself to profit by selling into those additional long-term real-money flows. And Pension Fund X will have to pay a little more to complete its Microsoft buying, and will feel aggrieved that its trading strategy leaked out into the market and that it was "front-run" by Hedge Fund Z.