Monday, May 30, 2011

High Frequency Trading and Flash Crash - Part 9: Concluding Remarks

Since this series began last October, we have established that:
  • HFT is the latest mode, i.e., the form of movement, of speculative capital in markets. Like the previous forms such as derivatives and day trading, this form first appears in the most developed markets and then, having grazed the profit opportunities there, simultaneously creates, and migrates into, new, “emerging” markets. That is signature form of the expansion of speculative capital which I described in Vol. 1:
    After arbitrage opportunities in the home market have been grazed, speculative capital sets out to find virgin markets outside the original national boundaries. This excursion begins with more developed markets. That is partly because they can more easily accommodate the large size of speculative capital. Also, the primary tools of speculative capital–derivatives–are more likely to be found in these markets. Gradually, even in these markets, the profit opportunities are arbitraged away. So speculative capital sets out to seek even more virgin territories outside the developed markets and economies. When these markets are found, they become the “emerging markets.”
    From the Financial Times of April 13:
    Low market volumes and stiff competition have led to a sharp fall in “high frequency” trading as industry experts warn that the past two years of rapid growth may be coming to a halt. Instead, high-frequency traders are flocking to emerging markets such as Russia, Brazil and Mexico where exchanges are beginning to revamp their systems to attract such players.
  • Because speculative capital dominates the markets in terms of tempo and trading volume, its modus operandi is the modus vivendi of markets. That means how markets functionally are, i.e., the way securities are traded in them. This state – how markets functionally are or the way securities are traded in them – is the result of a dialectical process and irreversible. There is no going back to the “quiet days” or “rational days” of yesteryears. The cogwheel that in practice prevents this process from going back is “efficiency”.
  • HFT eliminates the specialist and market makers system from the U.S. equities market, as it must. Speculative capital is antithetical to regulation, having been born out of a legal/regulatory vacuum in the aftermath of the Bretton Woods regime. The result?:
    With the demise of old-fashioned floor broker and traditional market makers, new so-called high-frequency equity players, which include proprietary trading desks at investment banks, have become the main providers of liquidity for the overall US equity market.
Only that the “main providers of liquidity” have no obligation whatsoever to do so. There is, in other words, no one “in charge”.

  • HFT mode of speculative capital is unstable. It constantly simulates the crash conditions and occasionally, as all simulations do, finds it. Hence, the progressively more frequent flash crashes, as the speed and the domain of the operation of speculative capital increase.
That is the situation we are currently in.

It is impossible to understand this situation without the Theory of Speculative Capital and the force that is speculative capital. In his doctrine of essence, Hegel reaches the concept of “force and manifestation of force”, as described by Stace in his Philosophy of Hegel:
Force not only does, but must, manifest itself. For it is nothing but its manifestation, and without its manifestation, it is nothing, merely non-existent. Force is not one thing and its manifestation another. They are the same thing. The force is unthinkable without its manifestation. And for this reason, too, it is absurd to say, as it is often said, that we can only know the manifestation of force but that what force is in itself must remain unknowable. It is only unknowable because there is nothing to know.
And naturally, see.

That is why various groups which investigated the flash crash of last May came out empty handed. The physicist who led the forensic study of the crash for the SEC told the New York Times that his report would “zero in on a specific sequence of events that preceded the crash and will tell a clear story about what happened in the markets on that stomach-churning day.” His report did all that but got no closer to understanding the cause of flash crash than the fellow investigation the hanging chad got to understanding Gore v. Bush presidential election controversy. “In the analysis of economic forms ... neither microscopes nor chemical reagents are of use. The force of abstraction must replace both.”

Naturally, then, in the same way that superstition grows out of ignorance of nature, Ms. O’Leary’s Cow’s school of explanation grows out of ignorance of finance: there was this broker somewhere in the Midwest and then it bought 71,000 E-Minis contracts and then kaboom – the market went bust. (To be fair, the official investigation exonerated Mrs. O’Learly’s cow in the Chicago Fire. The official flash crash investigation, by contrast, pointed the finger.)

The ignorance of theory also creates malaise. You “feel” or “sense” that there is something wrong but cannot put your finger on it, much less come up with a solution. “Theory delivers us from submissive acceptance of events just because they occur and allows us to interpret them within the body of a logically constructed system and, if need be, take action to influence them,” I wrote in Vol. 1

See this malaise in the writing of two influential U.S. senators in the New York Times of May 6, 2011:
America’s capital markets, once the envy of the world, have been transformed in the name of competition that was said to benefit investors. Instead, this has produced an almost lawless high-speed maze where prices can spiral out of control, spooking average investors and start-up entrepreneurs alike.

The flash crash should have sounded an alarm. Unfortunately, the regulators are still asleep.
Levin and Kaufman sense that something is wrong, as most people have. They refer to the “lawless high-speed maze where prices can spiral out of control”; we know exactly what they mean. They even take a potshot at the cherished American word, competition, which I said is one guise under which speculative capital self-destructs. But they do not know or understand what is happening. So they turn to regulators: regulators must have been asleep if all these terrible things happened.

But regulators are not asleep. They are in fact quite vigilant. That’s the good news. The bad news is that there is nothing they could do. They, too, must operate within the parameters set by speculative capital. All that the SEC chairwoman can do about last May’s flash crash is to express dismay:
Securities and Exchange Commission chairwoman Mary Schapiro has expressed dismay that active traders fled the stock market during the May 6 “flash crash.” … “The issue … is whether the firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times,” Ms. Schapiro said in a speech earlier this month.
But there is no issue. It is rather the SEC chairwoman, missing the entire point of the specialist system being destroyed precisely in order for others to flee the market in tough times.

As for the destruction of “price discovery” or equities not being what they used to be?:
Mary Schaprio, SEC chairman, says: “This transformation of market structure has raised serious questions and concerns.”

She questions whether the quality of “price discovery” has deteriorated as a result of fragmentation and whether these changes to market structure could “undermine the fair and level playing field essential to investor protection, capital formation and vibrant capital markets generally”.
Well, yes, Ms. Schapiro, the quality of “price discovery” has deteriorated, and that undermines fair and level playing fields, etc., etc. What, exactly, are you going to do about it?

By way of answer, I know she does not have a word to throw at a dog.

That is where we stand now with high frequency trading and flash crash.

But where is it, this “where” we have arrived at, you might ask. Is there a way to grasp it or remember it without long concluding remarks?

I say there is. It is Kurosawa’s Ran. If you have not seen this masterpiece, I suggest you get it – buy it, rent it, download it, whatever – and watch it today. For the U.S. readers, it is a specially fitting movie in this patriotic weekend. Pay attention to the last few minutes. That is where “we” and the “markets” are in the age of HFT. The analogy is not exact – no analogy is – but I think the point will be made.

If you write back with comments, we will discuss them.

Sunday, May 22, 2011

When Greenberg Does a Zuckerberg and Both Do (well in) America – or the Values That Stanford Business School Imbues

You must have heard of Charlie Wilson’s comment that what is good for GM is good for America. Wilson was the CEO of GM in the mid 1950s and there is some question as to what he actually said. But regardless, the statement caught on because it summed up a relation that defined a system. It was a goose-gander type relation with a bit of dark undertone. It implied that the U.S. government had to adopt policies favoring GM – which it did.

Dark undertone or not, the fact remained that you could go to work for GM after high school, like your father and uncle had done before you, and retire after 30 years with a decent pension and medical insurance. In the intervening years, you bought a house, several cars and supported your stay-at-home wife and three kids through high school and at times, college.

And it was not only the jobs. The modern American management system that conquered the world was a GM creation. MIT’s Sloan School of Management is named after Alfred Sloan, a long time GM chairman and CEO. The school was housed in a science and engineering university because GM thought of management as a scientific discipline; it could not be otherwise with an industrial conglomerate whose products manifested scientific and engineering principles.

That was then.

A couple of weeks ago, the New York Times ran an article on how the Stanford Business School became the hotbed of application development for Facebook. If you are a Times subscriber or have not yet exhausted your 20 articles per month ration, you can read the article here .

For the rest, I am quoting selective passages, starting with the “lesson” that students learned. I suppose you could call it the moral of the story:
By teaching students to build no-frills apps, distribute them quickly and worry about perfecting them later, the Facebook Class stumbled upon what has become standard operating procedure for a new generation of entrepreneurs and investors in Silicon Valley and beyond. For many, the long trek from idea to product to company has turned into a sprint.
So the message from the Stanford Business School which has now become the guideline in Silicon Valley and beyond is this: put together a crappy doodad – it doesn’t matter what, as long as you are first out of the gate. There is a lip service to “perfecting it later” but that merely shows what is really important. To wit:
“The students did an amazing job of getting stuff into the market very quickly,” says Michael Dearing, a consulting associate professor at the Institute of Design at Stanford, who now teaches a class based on similar, rapid prototyping ideas. “It was a huge success.”
Note the “stuff” – not software, not even app, but stuff. What the stuff is does not matter. And when the stuff itself does not matter, its quality cannot possibly be of any serious concern, as Johnny Hwin discovered for himself:
Johnny Hwin and his Stanford class team set out to build an app ... It never took off.

Seeing his classmates strike gold with simpler ideas proved to be a valuable lesson. In 2009, he began working on, a Facebook marketing tool that helped bands and musicians connect with fans online.

It opened last June and was acquired in January by FanBridge, where Mr. Hwin is now a vice president, for a few million dollars, he say ... “[Previously] we wanted to be perfect,” he says. With Damntheradio, he found his first clients by showing mockups of the product. “We were able to launch within weeks,” he says.
Seeing his classmates strike gold with simpler ideas, Johnny learned a valuable lesson at Stanford. “We wanted to be perfect,” says twenty-something Johnny with the air of a man recalling foolish youthful idealism. But Stanford made him grow up, wise up. He is now rich.

With America’s best and brightest simultaneously creating and being thrown into this entrepreneurial pressure-cooker, the school itself could not help but change:
“It really felt like an incubator,” says David Fetterman, a Facebook engineer who helped develop the applications platform.
“Incubator”, in case you are not in-the-know, is a facility that houses a group of start-up businesses which share the resources in order to minimize the expense. The incubator the Facebook engineer is talking about is the Stanford Business School.

Now, if your school is a business incubator and you felt you could survive on your own, you would have no reason to stay in it, would you now? For App-happy Danny and his daddy this was a no-brainer:
DAN GREENBERG was sitting at the kitchen table one night when he and another teaching assistant decided to get into the app game. Mr. Greenberg … hadn’t planned to get app-happy. But the students’ success whetted his appetite.

Four weeks into the quarter, he and his colleague, Rob Fan, set out to create an app that would let Facebook users send “hugs” to one another.

It took them all of five hours.

The app took off. So they moved on to apps for “kisses,” “pillow fights” and other digital interactions — 70 in all.

Their apps caught on with millions of people and were soon bringing in nearly $100,000 a month in ads. After the class ended, the two started a company, 750 Industries, named after the 750 Pub at Stanford where Mr. Greenberg and Mr. Fan where drinking when they decided to become business partners.

But juggling the business and schoolwork was too much for Mr. Greenberg, then 22. So he called his father.

“I said, ‘Dad, it is 10 p.m., and I’ve got so much stuff to do,’ ” Mr. Greenberg recalls. “ ‘We’re running this business, and I’ve got customers, and we are earning money, and we got financing and we have people to hire. But I have to write a paper tonight, and I just don’t have time for it.’”

His father advised him to pull a Mark Zuckerberg and drop out. The next day, Mr. Greenberg did just that.
Note the dialectical irony of an elite school teaching, fostering and imbuing values that negate school and education. In the age of speculative capital, speculative capital is not the only self-destructive entity around.

But, Nasser, aren’t you overreacting to the story? As long as there have been schools, there were students who dropped out. Bill Gates famously dropped out of Harvard more than 30 years go. Was that, too, a dialectical irony?! And isn’t the entire point of going to a business school making money? If so, what is wrong with a bit of early start? In fact, isn’t that what an elite business school supposed to do?

The answer is that Stanford’s “Facebook Class” is an institutionalized creation. It did not begin as an individual initiative. Nor did it spring in an ad hoc manner from the school’s Entrepreneurial Club. It was rather, funded, supported and nurtured as part of the formal curriculum of the Business School:
The Facebook Class was the brainchild of B. J. Fogg, who runs the Persuasive Technology Lab at Stanford. An energetic academic and an innovation guru, he focuses on how to harness technology and human psychology to influence people’s behavior.
Prof. Fogg no doubt thinks of himself as being on the cutting edge of “behavioral science”. But no matter how fancy his methods are, they are old hat; every Phoenician peddler of maritime goods would recognize his gig. Dale Carnegie would have smiled at his “harnessing technology and human psychology to influence people”. From the upcoming Vol. 4 of Speculative Capital:
[Selling] is the driver and creator of the culture, especially in the “Anglo-Saxon” U.S. and U.K., where the businessmen’s influence goes further than other nations. The culture in these countries is the salesmen’s culture, as it is shaped by the salesmen’s habits, sensibilities, tastes and priorities. The influence is in plain view in Dale Carnegie’s How to Win Friends and Influence People.

The book’s title is precise. Carnegie wants to win friends. Why? Because he wants to influence them. But he is not interested in showing people the righteous path and saving them. Carnegie is no religious zealot. He wants to influence people in order to sell to them. Friendship is a strategy, a means, towards that end. Note the word “win” – not finding friends or making friends but “winning” friends. The aim is to use them, after which “friends” become what they always were: people. It is a singularly cold-blooded and cynical title.

Dale Carnegie did not invent the ways of salesmanship. But he categorized them. His is the authentic voice of a salesman the way braying is the voice of a donkey.
What is being taught at Stanford is naked “pushing the product”, naked in the sense that intermediary steps of product development cycle, from the idea to production to marketing and sales, have been relegated to the back seat. The end result alone, conversion of product to money, has been made supreme, with the added benefit that there is not much of product to speak of; only junk Facebook apps. Give credit to Stanford B-School for truly cutting down to the chase in search of money, the way only speculative capital could.

But the intermediate steps, the means of getting money, are precisely the steps that require imagination and thinking. In doing away with them, the school has done away with teaching abstract thinking to its students. And that is precisely what sets apart a university from a vocational school. Abstract thinking is what “dissemination and assimilation of knowledge” is all about. Absent that, the destruction of the university that I spoke of.

The first victims of this academic retrogression are the students.

From the tone of the passages quoted here – and more clearly still if you read the entire article –you notice a remarkable absence of thinking on the part of the “Class”. The “attitudes” such as “curiosity, originality and integrity” that Webster defines as the essential in relation with the word “scholar” are just not there. Like rats looking for cheese in a maze, the students move and “stumble” – stumbling here, stumbling there – until they find money:
Three days before a presentation was due, Mr. De Lombaert accidentally deleted the computer code he was tinkering with. “We kind of freaked out,” he recalls.

Rebuilding the app would take too long. So, working around the clock over a weekend, they built another version, with a more rudimentary algorithm.

The stripped-down app took off. In five weeks, five million people signed up. When the team began placing ads on the app, the money poured in.

They had stumbled upon one of the themes of the class: make things simple, and perfect them later.
We kind of freaked out.

Here is a man in what is arguably one of the most competitive universities in the world. He no doubt had a perfect SAT score. He no doubt attended a good school and graduated with honors. He must be a reasonably intelligent fellow. Under the right circumstances and in a true institution of higher learning, he could have become a contender. He could have class. As is, he has become a moron, undisciplined, unorganized and with a thought process reflected in his speech that is indistinguishable from a Paris Hilton or Kim Kardashian. We kind of freaked out. He would not last a day in a GM assembly line.

They are all morons. Look at the name and function of their apps: hug me, kiss me, pillow fight. And you thought you could not get lower than Hollywood in producing “content” that could be fully telegraphed in a one or two-word name. They give the word low a bad name, these best and brightest of America. Maybe the love of money is the root of all evil.

My concern is with these morons’ value system. I know from Hegel that the thesis – their value system in question here – goes out of itself into its opposite and returns into itself in the synthesis. What is their value system and how does the dialectical process work in that regard?

Change the names in the article – Danny, Mark, Johnny – to Jamal, Lamont and Angel, change the location from Stanford Business School to any inner city ghetto of your choice, change the product from Facebook apps to drugs and change the role model and mentor from Prof. Fogg to neighborhood wholesale distributor and you will at once see the similarities of values in two camps.

The analogy is not exact.

Jamal, Lamont and Angel have no choice.

And “we” are “protected” from them by a flange of social and physical barriers. As I write in the upcoming Vol. 4:
The right-wing politicians blame “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.

Not so with the “Facebook millionaires”. By virtue of being rich, they become cultural trend setters and social movers and shakers. The media constantly promote them, reinforcing the message that wealth is wisdom. Think of Sage of Omaha; he is the man behind the Geico business model. Or the way a petulant fool like Mark Zuckerberg, a blind hen having stumbled on a kernel of corn if there ever was one, being constantly promoted as a visionary entrepreneur. (His business card read: “I am the CEO, bitch”.)

I returned to this two-week old article about Stanford app developers because in today's New York Times there was an article about how, through a maze of foundations, Bill Gates influences the education policy in the U.S. I have already written about the plans to privatize the public education in the U.S. It turns out that Bill Gates is one of main forces behind the initiative. A man who, at the tender age of 55, uses gee and gosh in his speech, sees himself fit to re-engineer the U.S. educational system. Here is a brief passage:
For years, Bill Gates focused his education philanthropy on overhauling large schools and opening small ones. His new strategy is more ambitious: overhauling the nation’s education policies. To that end, the foundation is financing educators to pose alternatives to union orthodoxies on issues like the seniority system and the use of student test scores to evaluate teachers.

Given the scale and scope of the largess, some worry that the foundation’s assertive philanthropy is squelching independent thought, while others express concerns about transparency. Few policy makers, reporters or members of the public who encounter advocates like Teach Plus or pundits like Frederick M. Hess of the American Enterprise Institute realize they are underwritten by the foundation.

“It’s Orwellian in the sense that through this vast funding they start to control even how we tacitly think about the problems facing public education,” said Bruce Fuller, an education professor at the University of California, Berkeley.
The Times also reported the happy news that in his endeavor, Bill Gates is receiving help from Eli Broad. Imagine: Bill Gate the engineer of the country's education system; Eli Broad, the arbiter of its culture.

That’s the good news.

The bad news is that Bill Gates is the grand daddy of successful college dropouts. Thanks to passage of time perhaps, he manages at times to be coherent.

Imagine now the near future with the Facebook millionaires. Imagine their view on social services, the country’s direction, value of education (they know from personal experience it is a bunk) and the lesson they have learned: that one has to aim low, not worry about perfection and money comes to people who get there first.

Imagine these people setting the country’s social agenda and having the means to push it through.


Saturday, May 21, 2011

A Perfect World

In a perfect world, everyone produce something.

Farmers grow plants, feed chickens, fishermen catch fish, builder made homes etc. So we can sit together at night and enjoy a complete dinner in our nice homes. It was easy to know who is suppose to do what, who produces what.

When there are too many fish caught, it has to be sold out of town. The fisherman doesn't have time to travel that far. So a delivery boy is helping the fisherman. The fisherman save time, hence catch more fishes and therefore its worth him paying the delivery boy. It is a value added chain, so service has become a part of perfect world too where everyone produce something, everyone produce some values.

It gets a bit complicated cause service is not as easy to quantify as materials. But its still ok.

A $1 fish may cost $2 in out of town because there are delivery cost incurred.

Soon more delivery services are needed. It is not easy to decide which of the 100 delivery boys is most reliable. So a manager came and organize a delivery company. The fisherman no longer need to worry about delivery, the delivery company will handle and be 'responsible' for the delivery part. If any single delivery boy does not perform, the company will immediately replace with a better one. Fish still reach destination on time. The fisherman doesn't need to worry a thing. What the management provided is a service on a service, there is still value provided.

Now the fish is $3 in out of town. The manager needs to eat too.

The fisherman's business grow much larger thanks to the great leveraging techniques. One day, the fisherman's primary school friend drop by and have a nice chat with the fisherman, asking the fisherman to let him handle the delivery part. Because he is more trust worthy, that they have known each other for so long etc. The fisherman agreed, perhaps due to the drinks or due to the flowery talks.

The primary school friend simply take orders for the fisherman and pass to the delivery company. Jobs still get done as usual but while doing that, he has raised the fish price to $5 in out of town. He gets $1 just for the deal he made. The fisherman gets $1 extra simply by letting his primary school friend take over the delivery part. The delivery company has nothing to loose.

Now it gets really tricky.
What did the primary school friend produces ?
What value has he added ?
What service has he provided ?

You can't say he has done nothing. He is instead smart, creating something from nothing. Is creativity really worth nothing ? He capitalize his relationship into a real asset.

The fisherman gets more value ( money ), the primary school friend earn something, the delivery company didn't loose anything. So theoretically speaking, the primary school friend has added value to the fisherman and himself. So it doesn't really break the law of perfect world.

The smart you may have already spotted the difference.

But at whose price ? Out of town folks used to pay $3 for a fish. $1 for the fisherman, $1 for the manager to make sure fish reach them on time and $1 for the delivery boy. Now the fish is $5! What is the other $2 for ? Well, that has nothing to do with any value received by the people in out of town. That was just a deal made between a primary school friend and the fisherman. The fisherman and the friend gets the whole $2!

Smart yes, add value to one or two persons yes, nothing wrong was done yes .... but whatever the primary school friend did, should NOT be included in the formula of 'PERFECT WORLD'.

In a perfect world, everyone produce something

Sounds familiar yet ? If not, may be you haven't read about Malaysia's GST yet.

This article was suppose to be read in this sequence.

Friday, May 13, 2011

the Magic of GST - reveal !

The 2 sides of GST are shown earlier, one is generally the consumer side who say NO, the other is the government side who say it will be OK.

The "magic" highlighted is everyone pay less and yet the government can earn more, how is that possible ?
First of all, the trick in that statement is 'tax payers'. Malaysia has about 27 millions people, only 1 million is paying taxes. So the rest of the 26 millions people who are NOT paying taxes now will be affected once GST is on. Even your underage kid buy a candy tomorrow, GST would have been included (depends on at which level of the distribution channel). So you "MAY BE" paying less tax, but everyone else in your family will be paying GST. Thats why you pay less tax and yet government can collect more, from people around you.

Secondly, not ALL industries will save money. This is a lengthy strategical discussion but in short; industries who optimize and/or shorten their distribution channels will survive, while others who don't will be dead. ( assuming everyone play fair and nice ). So small boys will die off, big boys will take over their market. Who pay the government more money ? Yes, the big boys. So big boys grow bigger and government gets more $.

Lastly, government doesn't really earn more money, at least not now. You see, the biggest income of the country comes from petroleum and this natural resource is going to end soon ( in less than 10 years ? ) So where else can the government continue to get the money from ? Well, what is the biggest asset of a country ? Its people. So GST will diversify the country's income portfolio. In other words, a country that live on GST income is self sufficient ie. the people are keeping their own country alive. Sounds nice isn't it ? Again, assuming everyone play fair and nice ya.

The panic of general public is only valid if one day we lost the income from petroleum and the similar income is projected into GST directly. I haven't done any calculation yet but I wouldn't be surprise that will be equivalent to 80% GST. So what will happen in coming near future is the increase of GST almost exactly as how it has been done with our petrol prices. May be you will see a GST 95 and GST 97 story ?

Worry no more, the next article will share "what we could do" . . . but before that, we may have to talk about "a perfect world" in order to really understand "what we could do".

This article was suppose to be read in this sequence.

Wednesday, May 11, 2011

the sides of GST

Actually GST is good, at least in theory. In practice, it could really go either way. And either way could mean good or bad for somebody and not everybody. This has already been proven in many countries who has adopted GST for ages. But one thing for sure, GST gives the government full Flexibility.

Now or in the past, it started with "I will tax this and that". So sales tax, service tax, government tax, custom tax etc. were introduced. With GST, it started with "I will tax everything" except those I give exceptions.

So system wise, GST is also better. Or in another word, GST is more systematic.
Most people may have known the devil of GST from many blog posts by now, but seriously if you look at the topic with a clear mind and NOT just from consumer point of view, you may realize those are really just purely speculation. However, it may still happen but when it does, it is because the consumers ourselves are making it happen. By thinking it might happen.

Interestingly however, not many people know the official GST info. What is the government thinking with regard to GST ?
Got it ?
People who buy will pay less,
people who sell will pay less and
government will have more money.

Interesting or not ? its MAGIC !!

At the end, it really doesn't matter what the big boys are doing. What really matter is what affects you. So forget about agreeing or disagreeing with GST. IT WILL HAPPEN ! You may as well start thinking how to make use of this GST to turn yourself into a part of the HIGH INCOME GROUP.

For that, you may want to check out .... Exempted stuffs

This article was suppose to be read in this sequence.

Tuesday, May 10, 2011

High Frequency Trading and Flash Crash - Part 8: How Does Flash Crash Come About?

Consider this game. You are given $20 to take part in a game of 3 consecutive coin tosses. In each toss, you win $5 if you guess right and lose $5 if you do not. You must leave the game with at least $10.

Here is the lattice of the game’s possible outcomes:

If your first call is right, starting with $20 at S, you will win $5 and end up with $25 at A. In the second toss, if you win, you will have $30 (B); else your money will be reduced to $20 (E). After the third and last toss, depending on whether you start from B or E, you will end the game with $35, $25 or $15. In all cases, the condition of having at least $10 would be satisfied.

If your first call is wrong, you will end up with $15 (point D). If your second call is also wrong, you will be at X with only $10. That is the end of the line for you. Technically, the game is not over yet. One more toss is left. And if you guess right, you might end up with $15 at point G. But you cannot take that chance, because if you lose, you would violate the condition of leaving the game with at least $10. So there is no going forward from X, which is why it is no longer connected to the mesh “going forward”.

Taking the outcome of the coin toss as the proxy for change in the stock price, this game is the principle of portfolio insurance, which, as you can surmise from the name, aims to prevent the value of a portfolio from dropping below a prescribed amount. Virtually all portfolio managers employ a variation of this strategy to ensure that they would not suffer catastrophic losses.

There are a couple of differences between coin tossing and real life portfolio insurance, though.

One is that coin tossing is a discrete game; we “jump” from point to point – S to D to X – based on the outcome of coin toss.

Portfolio insurance is closer to continuous-time. A portfolio insurer arrives at his exit-from-market point only gradually and through piecemeal actions.

“Action” is the clue to the other difference between coin tossing and portfolio insurance.

In tossing coins, we were passive. There was nothing to do but wait for the outcome.

Portfolio insurers, by contrast, are active. They must constantly adjust the composition of their portfolio – sometimes daily, sometimes several times a day – in response to market conditions. As prices fall, they sell, in anticipation of markets moving towards point X. As prices rise, they buy, in anticipation of more profit.

This trading pattern is “pro-cyclical”. It creates a self-reinforcing, self-perpetuating process that exacerbates the market trend.

As for the mechanics of the portfolio adjustment – how much of which security to buy and sell – it is formulaic and algorithmic. A machine could be programmed to do it and, as a matter of fact, that is how it is done. Hence, the other name for portfolio insurance: program trading.

We now have the cause of speculative capital-driven market crash before us. It is a state when many portfolio managers simultaneously exit the market. When that happens, the bid side disappears. With few active buyers left, prices collapse. It is as if the synchronized withdrawal creates a resonance in the form of a market crash. From Vol. 2:
If the market falls [to point X), there is the chance that it could fall still further to [to point H.) That eventuality is unacceptable to the [portfolio] insurer. The only way to eliminate it is to leave the game, to stop playing. That is precisely what he does at that point. When the market falls [to X], he sells all his [shares] ... and stays on the sidelines ... We now have the meaning of the “riskless portfolio”. It is not a portfolio that earns a riskless rate of return but, rather, a portfolio that is kept out of the market. Risk [arises from] the presence in the market.
To be capital, in other words, is to have an inherent risk of diminution of size. The only way to eliminate the risk is not to be capital. And the way to do that is to leave the markets.

None of the luminaries of quantitative finance who devised portfolio insurance understood this point, but their methodologies nevertheless led to it, in the same way that the medieval irrigation methods of the European peasants conformed to the laws of fluid mechanics without the peasants being aware of the discipline or its laws.

Recall that we were able to take the coin toss game as a model for stock price movement because in short time intervals, stocks prices could also be assumed to be binary; they either go “up” or “down” by a “tick”.

Coin toss problems, as some of you may know from the example of a wheat grains on a chess board, begin simply but “branch” rapidly and multiply exponentially. As a result, the outcome of one particular sequence rapidly decreases.

To give you an indication of the magnitude, imagine the number of times you have to throw a coin to get 500 consecutive heads! That is a very crude approximation of the possible “up” and “down” scenarios a portfolio manager tracking S&P 500 index would have.

Now imagine the odd that a group of people doing the same would get the same result at about the same time!

The odd borders on impossible, which is why we do not have crashes every day. But when HFT is the dominant form of trading, the sheer number of “tosses” – trades – brings the near zero probability into life, so to speak. It turns a near zero probability not expected to be encountered in 100s of years – the so-called 100-year flood – into a not-so-insignificant probability with some chance of materialization every now and then, which is why we are beginning to have crashes every now and then.

This dynamic, if you know your probability and statistics, is the basis of simulation: a rapid sampling of random data to explore the size of the improbable areas. That’s how the so-called value-at-risk of trading portfolios is calculated. So, what is taking place every day in equities markets is the simulation of trading conditions that is meant to collapse hundreds of years into a single trading day.

As the purpose of simulation is to find the crash conditions (as well as unlikely sharp market surges), it eventually finds them, only that such findings are not virtual but very real. That’s how markets crash.

Crashes of this sort are purely technical. They are not driven by any underlying fundamental condition because stocks subject to such trading no longer reflect any fundamental underlying conditions; Recall the lament of Financial Times about the loss of the purpose of equities: What are the equities market for these days?

Unsurprisingly, then, the damage from the crash does not reach the general economy. A short while later, the markets recover because “simulation” takes them to the price rise path. The recovery in Oct 87, for example, came the next day. On May 6, the last day, it took 20 minutes. That’s an indication of how much the speed of execution has “collapsed” the time: the old 24 hours is now a mere 20 minutes.

We now have all the pieces of the puzzle. I will return with concluding remarks.

Saturday, May 7, 2011

Old Post - Write Will For FREE

Pardon my long silence. I am back and starting to clear some of my old drafts. But once I published them, they stay in their own old timestamps and hence not easy to be found I suppose. Below is draft I created in 2009 but only get to release now.

Below are my other drafts, I am no longer sure which is more important than which. Do comment if there is anyone you would like to know more.

Malaysia 2011 Budget
FMB - Financial Mediation Bureau
AS1M Prospectus The price of AS 1Malaysia unit is...
futures tutorial from Ino
Retire with Young Kids
It was already mentioned in last article that gett...
agent commission takes up a big chunk of insuranc...
Hong Leong Flexi FD
How to choose fund manager ?
Debt consolidation non profit - your savior in fin... case study, Loan
Getting Rich has NOTHING to do with Personal Finan...

Sunday, May 1, 2011

The Supreme Court Rules Out Class Actions

Last November I wrote how some unscrupulous companies – many of them quite large – had expropriated Apple's business model in a perverse way.

Apple charges a small amount, say $2, for an app but sells it to millions of users. Both the company and the app developer benefit.

In the perverse version of this business model, a company, say, a telecom or a bank, defrauds millions of customers out of a small sum, say, 99 cents. Even if you, as an individual customer, notice the fraud, what are your options – sue a telecom for 99 cents?

The only remedy for such fraud in the U.S. was a class action suit, a legal mechanism that dealt with cases when a company had set out to “deliberately cheat large numbers of consumers out of individually small amounts of money,” in the words of the California State Supreme Court.

This past Wednesday, in a 5-4 ruling, the Supreme Court banned consumers from coming together in a class action suit to fight such fraud. According to Brian T. Fitzpartick, a law professor at Vanderbilt University who was quoted in the New York Times:
“The decision basically lets companies escape class actions ... This is a game-changer for businesses. It's one of the most important and favorable cases for business in a very long time”.
The majority decision was written by Antonin Scalia, the justice who, in a formal legal meeting, opined that the fictional TV character Jack Bauer of “24” who tortured people should go free because he “saved Los Angeles”.

AT&T Mobility, the defendant in the case, said in the statement that the decision was “a victory for consumers”.

So it goes. If you read my earlier post, Functionaries Passed off as Revolutionaries, you would see that I was expecting the decision.

Someone like Antonin Scalia is nothing if not predictable.

Epilogue: Lost in Conversation

Why would you stay up all night to see the sunrise? Every day, sun rises at an exact moment. You only have to get up a minute before the designated time to see it; no need for staying up all night.

Why would you then strain yourself to analyze the utterances of a central banker for clues to his future actions? Those, too, have an almost mechanical predictability. The old joker of the economics officialdom, Milton Friedman, gave away the game when he suggested replacing the Fed with a computer.

Yet, the “Fed watchers” – Fed watchers! What asses they must be! – come running whenever a Fed chairman opens his mouth. Alan Greenspan played them, constantly casting fake pearls before the real swines in market, media and academia and letting them munch on the drivel he had just delivered.

All this is by way of saying that Bernanke’s comments require no analysis. What he would/could say is scripted. All the time. Let me take you to the highlights of his Wednesday news conference to show what I mean. It neatly ties in with what I said in Lost in Conversation.

The New York Times tried to frame the central issue confronting the Fed as the question of balance between unemployment and inflation.
The questions reflected the difficulty of the choices the Fed now faces. Some reporters pressed Mr. Bernanke to explain why he was not more concerned about inflation. Others asked why he was not more concerned about unemployment
But there has never being a question of a choice, as the Chairman made clear:
“While it is very, very important to help the economy create jobs and help to support the recovery, I think every central banker understands that keeping inflation low is absolutely essential to a successful economy, and we will do what we can to make sure that happens,” he [Bernanke] said.
So no matter how many times Ben Bernanke modifies very with very, his job is nipping inflation in the bud.

But why this pre-occupation – obsession, really – with inflation; and obsession is the word:
Mr. Bernanke cautioned that if the economy did falter, it could prove difficult for the central bank to provide fresh support because of growing inflationary pressure ... “Inflation is getting higher. It’s not clear that we can get substantial improvement in payrolls” without creating a considerable risk of a dangerous rise in inflation.
Read the last sentence one more time, that begins with “inflation is getting higher”. Bernanke can substantially improve the payrolls if he so chooses, but he is not sure he can do that without the risk of dangerous rise in the inflation. So he would not do that, because he earlier said that his main mission is fighting inflation.

This inflation thing must be a real scrooge then. How else to explain that its containment trumps fighting joblessness. Right?

If you are like the blue collar residents of Queens, you probably half-agree with that statement and the Fed chairman, seeing the price of gas at about $4.20 and food prices up almost 20%. Yeah, someone has to do something about that. It's crazy.

But as we saw in the previous post, food and energy prices are not of concern to Bernanke. He does not even consider them in calculating the "core inflation". Better yet, his actions are the very cause of food and energy price rises. (Oil is heavily taxed in Europe, and food has its complex politics so a direct comparison is difficult. But the rise in the price of oil in Europe has been less than half of the U.S. A better, “unadulterated” measure is gold, which has risen by almost 35% in the U.S. in the past year but actually fallen by 2.5% when expressed in euro.) So in dealing with that inflation, you are on your own. Here is the proof from the newspaper of the record:
Critics of the Fed’s position on inflation argue that higher commodity prices will push up the price of other goods and services. But Mr. Bernanke and his allies consider it more likely that the higher prices will force Americans to reduce consumption, because wages are not rising and therefore Americans do not have more money to spend. As demand drops, they say, the price of food, oil and other commodities will also fall.
Got that?

The “critics” want the Fed to inflict pain on the populace immediately. The Fed argues that there is no need to rush and the pain will come in due time. That is what the contention is all about, a matter of when and not if.

Then what is Bernanke talking about when he talks about the inflation?

As I said, the “inflation” for him is the measure of the industrial capacity. Go back to the quote above, starting with "inflation is getting higher" and you will see this. He talks about “improvement in payrolls”. By that, he means improvement in employment, i.e., a decrease in unemployment or joblessness. Who calls improvement in employment the improvement in payrolls? Why, those who have payrolls, i.e., hired workers. Bernanke is talking from their viewpoint. That's the only viewpoint he has.

Let me explain.

Suppose traffic in a highway is 50% of its capacity. Under this condition, there is no “traffic”. Should a car develop a mechanical difficulty or brake to avoid a pothole, the traffic will flow unimpeded.

If the traffic flow rises to the 90%, the cars would still move freely. But now, if a car develops a mechanical problem, it would create a traffic jam. With 90% of the capacity full, there is no avoiding backlog when one lane is substantially slowed down.

If the highway is full to 100% capacity, braking by one car for a few seconds will crated miles-long backups, the familiar situation in roads leading to beaches during the summer.

Replace highway capacity with the industrial capacity and traffic jam/slowdown with the increase in labor wages and you have the function of the Fed as an entity which is designated to keep the traffic flowing smoothly.

If you have a plan that can employ 100 workers and you currently employ only 50 – because there is not sufficient demand for all you can produce – your payroll can “improve”. That is, you have room to hire more workers.

If your payroll goes up to 95 workers – “improves”, in Bernanke’s parlance – you are operating at close to capacity. After that, any demand for hiring more workers would translate to demand by workers for higher wages. The Fed’s “core inflation” measures that condition; its main function is to prevent that situation from developing.

The Fed does other things too. We cannot childishly view it as a one-trick pony. But what I just said ultimately trumps all other considerations.

The Fed cannot, in the sense of not being allowed to, slowdown economic activity by raising interest rates. That nonsense is for college textbooks and the “Fed watchers”. If Bernanke did anything that remotely affected the bottom line of corporations, his head would be handed over to him. The Fed would go the way of the American buffalo – or Fannie and Freddie.