Saturday, March 19, 2011

A Point of Logic

James Mackintosh writes a generally perceptive column in the Financial Times called Short View. On March 11 he wrote:
The releveraging of America is under way. After a brief nod to the idea of cutting debt, US companies increased borrowing last year and reduced their equity. Easy money from the Federal Reserve was followed by ever-easier lending terms from investors: easier even before the credit crunch.

Perhaps the best indicator of this is the ease with which private equity houses are extracting money from lenders. Dividend recapitalisations, when a company borrows in order to pay its private equity owner, have soared ... In the first nine months last year, non-financial companies, listed and unlisted, paid out more to shareholders than they made in profits ... In other words, [the companies] took advantage of record-low interest rates to transfer money from lenders to bondholders to shareholders.
Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie Endowment. On March 15 he wrote in the same paper:
China’s breakneck economic growth was fuelled by vast transfers of household wealth, which subsidised the manufacturing and investment boom and paid for bad loans. The most important of these transfers is the very low interest rate set by the central bank, which takes at least 5-7 per cent of GDP every year from households to give to banks and borrowers.
Here is a question. Why is it – and how is it – that in China, the low interest rates – set by the central bank – result in “breakneck economic growth”, through the transfer of wealth from the households to banks? But in the U.S., the same low interest rates – set by the Fed – result in looting: companies borrowing money and paying up that borrowed money to the shareholders. They paid out more to shareholders than they made in profits – without, no doubt, uttering one word about “fiscal responsibility”, “moral obligation to reduce debt”, “the future of our children”, etc?

If you do not know the answer, you should. But I put the two stories next to each other to make a point about the identity and difference.

Nothing exists out of context. And until we know the context, we know nothing about the conditions in two countries by merely comparing the interest rates in them. (In deducing the difference from unity, Hegel says that in statement “A is A”, the first A is different from the second. That is because a relation implies at least two terms to be valid. If the two As were the same, there could be no relation. Hence his statement that “self relation is a negative relation” because it repels itself from itself. Rumi proves that in 5 words – and 500 years earlier.)

Keep that in mind next time some fool compares two countries on the basis of their GDP, or two markets on the basis of their performance. The subject is dear to me because it is the stuff that arbitrage is made of.

Thursday, March 17, 2011

Language, too? Language, too

Lots of you commented on the Descent of Man. Let me note here that the every-man-for-himself mentality is the byproduct of commodity salesmanship and was around long before speculative capital. Remember Michale Milken's famous utterance: “Who can we make a profit off of, if not our friends?” Change the euphemism of “making profit off” to “living off” and you have the script for the Night of the Living Dead, where friends and neighbors come to eat you up. That “conduct” – whether of Milken or the living dead – is the logical next step in a society in which every man is for himself. Speculative capital merely exacerbates it.

And it is not only the conduct. The language, too, reflecting the degraded relations, becomes degraded.

Let us look at two news stories. One is from the Financial Times of Monday, March, 14. Under the heading ‘Beijing rejects any N Africa analogy’ the paper reported:
China’s premier has rejected any comparison between his country and the troubled autocracies in the Middle East and north Africa … Wen Jiabao, in his annual press conference on Monday, said … that any attempt to draw an analogy between events there and situation in China was “not correct”.
FT wants to make us believe that there are people in the West who compare China to Tunisia or Egypt. Maybe there are – no doubt the offspring of Paul Samuelson who wrote at length comparing the U.S. navy and an apple.

To this nonsense, the Chinese premier merely says “not correct”. No ridiculing, belittling, shouting, cursing, mocking, intimidating, attacking, accusing, or slandering. Simply “not correct”, which is quite strong. If you think that one plus one is 3, “not correct” is all you need to be told. It is necessary and sufficient feedback and no expression can top it.

Now think of the language of Glenn Beck or O’Reily. They are not politicians? How about Newt Gingrich? Or that all-around thug, Rahm Emanuel, now the lord mayor of Chicago? And don't limit yourself to the U.S. Think Sarkozy, Berlusconi, or Tony Blair; this last one put a different kind of violence into the language, but it was due to moral certitude, no doubt.

That these characters merely reflect their societies is clear from the second story, this one from yesterday’s New York Times, under the heading From Cee Lo Green to Pink, Speaking the Unspeakable:
It’s some kind of milestone: Three of the Top 10 hits on last week’s pop music chart have choruses that can’t be played uncensored on the radio and won’t have their original lyrics quoted in this family newspaper. All three use variations on a familiar, emphatic, percussive four-letter word.

Chalk it up to post-World War II realism, demographic changes, bravado, freedom, permissiveness, the Beats, the 1960s, hip-hop, the Internet, the decline of Western civilization or all of them at once. Cussing in public has become more the rule than the exception, sometimes even on formal occasions.
I have a different take on the subject. I discuss it at length in the upcoming Vol. 4. Let me give you a sneak peek. Consider it a soft sales pitch:
When the “conduct” of the salesmen changes in a fundamental way, the effects reverberate across the social and cultural spectrum.

One such fundamental change took place after the collapse of the Bretton Woods system in 1973. The change which began gradually and continues to date was the intensification of competition due to the falling rates of profit. Coupled with the gradual desensitization and resistance of the population to the advertising pitches, the increased competition made selling a more stressful occupation than it was in the heydays of the U.S. industrial power. This gradual, but persistent and grinding trend demanded that the salesman be more “productive”; he had to sell more than before in less time than before.

But other salesmen faced the same conditions, so it became tough for everyone to make a living.

The ensuing stress darkened salesmen’s mood, with the result that passive Willy Loman gave way to the obscenities spewing, conniving and downright criminal salesmen of Mamet’s Glengarry Glen Ross. How much can a man take!

Given the salesmen’s social influence, his darkened mood and conduct have affected society in several unflattering ways.

One is the acceptance and institutionalization of rough language in the daily conversation. Salesmen are the point of contact of a business with the outside world, so their conduct, considered as the response of adults to the real-life conditions, is taken as the proper, logical and “natural” conduct. If the salesmen are cursing, then it must be how people in the “real world” communicate, how things get done in the real world.

This has been especially pronounced in the salesman-shaped and sales-man dominated cultures of the U.S. and U.K., where TV and movies, those reliable disseminators of salesman’s culture, incessantly propagate the message. Anyone comparing the language of a TV sitcom or a Hollywood “action movie” in 2010 with 20 and then 40 years ago cannot help being surprised at the tremendous downward spiral of language and manners.

The right-wing politicians in these countries blame the breakdown of the family and manners and even “the rap singers” for the spread of profanities. But rap singers, mostly young black men in the ghettos, could have never had a cultural impact on suburban whites if the groundwork had not been prepared by the salesman – many of them suburban white men. The rappers simply followed a road that was paved for them by the real cultural trend setters.

Monday, March 14, 2011

A Recurrent Theme

Many in the West have commented on the composure of the Japanese in the face of calamity – office workers who did not leave their seats, supermarkets clerks who held the racks so they would not fall – and contrasted it with how people would have reacted in the West with that every-man-for-himself-and-may-the-devil-take-the-hindmost attitude.

A couple of a years ago, I wrote a brief comment on the very same subject, in (What Lies Behind) The Descent of Man.

Read it. You may find it pertinent.

Sunday, March 13, 2011

High Frequency Trading and Flash Crash – 6: The Destruction Has Come (here to stay)

This series began six months ago. Let us see what we know so far.
  1. Speculative capital, capital engaged in arbitrage, dominates the financial markets. (See Vol. 1 for how and why).

  2. Arbitrage is simultaneously buying (low) and selling (high) two different “targets” to lock in a riskless profit.

  3. Buying X low and selling Y high raises the price of X and lowers the price of Y, narrowing their difference and reducing the potential profit for the next round of arbitrage.

  4. To compensate for shrinking spread, speculative capital increases its size and piles up on the leverage, with the result that spreads shrink even further – and faster. From there, the defining characteristic of speculative capital follows:

  5. Speculative capital is self destructive. It eliminates the opportunities that give rise to it.

  6. Let us be precise: Speculative capital eliminates only those opportunities that it actively exploits. That follows from arbitrage the way conclusion follows from premise. But speculative capital is not suicidal! It ferociously defends and preserves itself as the best man-made science-fiction monster ever could, precisely because it uses man to that end. So while destroying the arbitrage opportunities in one place, like expanding matter that creates space, expanding speculative capital at the same time creates opportunities elsewhere. Speculative capital is the quintessence of dialectics.

  7. The more recent opportunities tend to be more difficult to exploit because they: i) do not immediately stand out and must be uncovered; ii) generally involve several markets and jurisdictions where simultaneous execution of trades poses operational challenge; and iii) demand relatively larger capital by virtue of (i) and (ii).

  8. They are also riskier. It is risk management 101 that the more pieces a system has, the higher the chances of its breakdown. (Boeing engineers know that, too. A 747 has 5 million pieces. A 787, when it is finally delivered, will have 3 million.) It is one thing to buy a currency low in New York and sell it high in London. It is a different thing altogether to short Treasuries in the US and use the proceeds to create an equivalent option position on some equity index in Japan. In the latter example, if the source of funding dries up, the strategy would unravel. That is what happened in the market meltdown of 2008.

  9. What would you do, then, if you were speculative capital – by definition the fountain of riskless profit – in the face of such increasing risk?

  10. Why, you’d discover HFT.

    Or, rediscover, as HFT is the adaptation to the new circumstances of old ways.

    Here is the game plan. When a fund places an order to buy say, 100 thousand shares of a stock, the order has to be broadcast to reach the “market”. Before it reaches the market, we intercept it – like the “Rosenzweigs’ agent” – and get ahead of trade, buying as many shares as we could. After the order reaches the market, it would push the share price higher, by however small an amount. We then sell it for a profit. The profit would be razor thin and about a fraction of a penny. But as every retailer knows, we make up for low margin by volume, by repeating the process tens of millions of times a day. We do the same with the sell orders, only we sell instead of buying.
That’s HFT in a nutshell.

At its core, HFT is the old fashioned front running, that reliable strategy of pit traders and market makers when everything else had failed.

But as a dialectical entity, speculative capital never uses the opportunities it finds in their historical mode for long. Rather, it transforms them into a qualitatively higher mode, a synthesis which contains the older form but is something different from it.

In HFT, this transformation takes the form of the replacement of men by capital.

In the Rothschild story, the focus was on the man. Front running, too, has always been the story of unscrupulous traders and brokers.

In HFT, the individual is taken out of the picture. He is replaced by speculative capital. Speculative capital becomes the grammatical subject of the sentence as if it were alive: speculative capital engages in HF trading.

The transformation is liberating. In the old days, a broker could be charged with front running. In HFT, the idea becomes ludicrous. Surely you are not suggesting that the law should apply to a thing? That's how the modern economics is “value-free”.

But speculative capital is not a single entity. Nor does it have a command and control center. It is, rather, the sum total of all capitals engaged in arbitrage, spread among thousands of hedge funds and proprietary trading positions across the globe. At times, a large portion of this mass acts in unison, something that crack Wall Street researchers have recently noticed and dubbed “risk on, risk off”.

At other times, its different segments compete with, and go against, each other.

Only a small fraction of speculative capital is devoted to HFT – only so much that the relatively small field can absorb. And the return from HF trading is very low. A Kellogg Ph.D. dissertation concluded that 26 firms which control 75% of the HFT make about $3 billion annually on $30 trillion trading volume. Such low returns are expected from a business model which constantly squeezes the spreads.

Still, other segments of finance capital consider the interception of their orders and shaving off of even a fraction of a penny from their profits a flagrant robbery. (The business is actually that competitive.) They refuse to be robbed, and take actions to “protect” themselves. And what could be the defense against faster predators who feed on intercepting one's orders? Why, not showing the orders altogether. Hence the rise of private exchanges, dark pools and internal settlement mechanisms, all of which come into being so that large trades would be executed privately and out of sight of prying eyes.

The rise of these private exchanges and mechanisms diminish the role of the “market” and get in the way of “price discovery”, that leitmotiv of every clerk and scribe who taught business and finance in a Western university. (The above links give only a bland and bloodless description of private exchanges and dark pools. Still, the purpose of these new “developments” comes across. In internal settlement, a broker matches my order for buying 100 IBM shares with your order selling 100 IBM shares internally without transmitting them into the exchange. Again, the volume and price information is distorted.)

The ignorant, pompous academics who envisioned continuous-time finance considered it the crown jewel of their intellectual achievement. In addition to technical breakthroughs such as option valuation – and they got that one wrong too – two critical, ideologically empowering conclusions seemed to follow from it.

One was the participation of the populace in trading. Continuous-time finance meant continuous-time trading. And how could continuous, incessant trading be possible without the mass participation of the people – just like a highway that could be crowded only if everyone with a car is on it! That was the true spirit of democracy and the proof that free markets would strengthen democracy, and vice versa. Three cheers for markets and democracy, everyone.

And democracy was profitable, too, which is what mattered in the final analysis. This second benefit of continuous-trading came from price discovery. Everyone knew – the non-believers were directed to the “works” of Milton Friedman and Paul Samuelson – that the more frequent the trades in a market, the more transparent and efficient the prices. Naturally then, as these masters and their followers had shown, markets in democracies offered the best price to buyers and sellers. One only had to compare the liquidity and smooth movement of wheat futures prices in the Chicago Board of Trade with the arduous and time-consuming haggling over the price of goats in an Ulan Bator Friday market to be convinced of all self-evident truth.

That capital has a tendency to concentrate – a tendency that was well-known to even laymen as early as the mid 19th Century and the reason for the passage of many anti-trust and anti-monopoly laws – was never considered. It never crossed the minds of the luminaries of finance to examine the meaning of their discovery or put it in the context of the larger economic activities.

I pointed out in Vol. 1 that continuous time finance corresponds to continuous turnover of capital, “a notion so utterly absurd as to be insane.” And added later about continuous-compounding, a logical by-product of continuous-time finance: “Continuous compounding is the vision of a Shylock gone mad.”

Notice the words I used in 1998: mad, absurd, insane.

So, how are things now? What has in point of fact come to pass?

Two short news items will suffice for the answer. The first one pertains to the concentration of capital, from the Financial Times, Jul 29, 2009:
The Tabb Group, a consultancy, recently estimated that high-frequency trading accounts for as much as 73 per cent of the US daily equity volume, up from 30 per cent in 2005. Tabb estimates these players, some of the largest of which are hedge funds such as Citadel, D.E.Shaw and Renaissance Technologies, represent about 2 per cent of the 20,000 or so trading companies operating in the US markets.
There you have it: about 75% of the daily equities trading volume in the US is HFT. The order for this trading volume comes from just 2% of all the trading firms.

As for destruction of the market, let us hear it from an insider (Financial Times November 8, 2010):
“Most of the world views our market structure as a joke,” said Larry Leibowitz, chief operating officer at NYSE Euronext... “Our market is too fragmented. The challenge is, how much competition is too much competitions,” he said.
I don’t know Larry Leibowitz, but based on 8 words – Larry Leibowitz, chief operating officer at NYSE Euronext – I could write a 10,000 word treatise on him! And so could you. Imagine the number of times he must have been a keynote speaker talking about the merits of entrepreneurship.

Yet, there he is, the COO of an exchange, of all places, criticizing competition, of all things.

Larry, you hypocritical ass, we hardly knew ya!

But of course I am being unfair; too hard on Larry. Competition is the form under which the self-destruction of speculative capital appears to businessmen. That's how it manifests itself and impresses itself upon their minds. (The increasing instances of flagrant contradictions that you see – Tony Blair teaching religious tolerance, for example, or European Socialist government drastically cutting social services – are the result of the inability of businessmen and their minions in the government to comprehend their surroundings. In its advanced stage, speculative capital makes its working difficult to comprehend. For the first time ever, businessman becomes out of his element in the business environment. I will have more to say on this in Vol. 4.)

This doctor calls the patient: “I have good news and bad news.”

“Ok, doc, let’s hear them,” says the patient.

“The good news is that you’ve got 24 hours to live!”

“Gee, doc, is that your good news? Then what’s your bad news?”

“The bad news”, says the doctor, ”is that I forgot to call you yesterday.”

I have good news and bad news for Larry.

The good news is that soon no one will consider the US market structure a joke because everyone will have a similar structure. Everyone will go the way of the Turks and the Istanbul Stock Exchange.

The bad news is that the destruction is still in its early stages. Many markets have yet to be brought into the orbit of the HFT. Only then will the full scale of undoing become apparent. And that will come with the inevitability of night following day. Otherwise speculative capital would not be speculative capital. And that could not be!

I have not yet finished with the subject.