Sets of rules used in computing processes have enabled technological strides and caused US stock-market turmoil in 2010. The term for them is inspired by an Islamic genius from
As the author of a celebrated business text,
But you won't find this
Al Khwarizmi was one of the greatest minds of the Islamic Golden Age. He kept alive mathematical traditions dating back to the Greeks, and added many of his insights.
Ironically, he is best known today as the person who gave his name to one of the hottest ideas in 21st-century business: algorithms.
These mathematical recipes take their name from the Latinised version of Al Khwarizmi's name, which, when typed into
In the last few days alone, attributions have been made to algorithms for everything from weeding out spoof
But the term crops up most often in coverage of a major controversy shaking the financial world. It centres on the use of algorithms to make fortunes from stock markets.
This month marks the fourth anniversary of the so-called Flash Crash, when the Dow Jones Industrial Average plunged almost 1,000 points – about 9 per cent – in a matter of minutes.
According to the
The appearance of
While no permanent damage was done to share prices, the same cannot be said of confidence in the stability of financial markets.
Cramer's suspicions were roused by the stock price of Yelp, an online business reviews site. The company has never turned a profit, but recently announced quarterly results that narrowly beat analysts' expectations.
That would normally cause the stock price to improve briefly before falling back – often prompting similar stocks to fall as well.
This time, however, the market took a different view of Yelp's prospects, and its price did not experience the initial jump.
Then something weird happened: the stock price of similar companies started to rise. Cramer thought this was the result of trading algorithms, which had been designed to expect an initial jump in Yelp's share price, to be followed by a decline that dragged similar stocks down with it.
When this failed to happen, the algorithms became confused – and started driving up the price of the other stocks.
Cramer's suspicions might not be well-founded, but he was certainly right about one thing: trading algorithms can do things that baffle even their human creators.
This would not be such an issue were it not for the astonishing speed at which the algorithms operate. Carrying their instructions as electronic pulses, they can affect markets in millionths of a second.
Such speed is believed to have exacerbated the Flash Crash in
Such high-frequency trading algorithms are under intense scrutiny following the publication of Flash Boys by the financial writer
While some commentators have dismissed Lewis's claims as scaremongering, the
But the regulators are also turning their attention to another aspect of algorithmic trading, which is almost spooky in its implications.
In their endless quest for profit, finance firms began trading "off exchange" in the 1990s, where they could execute buy-and-sell orders without affecting share prices on the stock market.
Known as "dark pools", these private all-electronic marketplaces soon began to spawn their own special trading algorithms, triggering a Darwinian struggle for the survival of the fittest.
By the early 2000s, the algorithms were no longer just mindless lists of instructions such as "If the price of commodity X rises, then buy company Z". The fitter, smarter algorithms had been equipped with artificial intelligence code, which allowed them to spot the actions of less sophisticated algorithms and learn to outwit them.
Their success in squeezing profit out of trades has led to about 10 per cent of all stock trades in the US occurring in these dark pools now.
That means trillions of dollars worth of stocks are being traded by these incredibly smart algorithms.
Regulators are understandably concerned that some of these algorithms are more than just smart. They may also be capable of actions that constitute illegal behaviour, such as insider trading.
But there is another concern. Not even the designers of the algorithms can predict what their progenies will do in every circumstance.
The methods used to create the algorithms produce code which is often beyond analysis. Worse, as the algorithms evolve they can acquire traits never intended by their creators.
Four years on from the Flash Crash, it is far from clear that we have really got to grips with the digital beasts named after a long-dead Islamic genius.
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