The history of the markets is actually quite long and probably would make a good History Channel show. However we know that mankind has traded things of all kinds basically in their attempt to improve their living conditions and also acquire the necessities of a healthy and fruitful life.
I believe that a free market system is the best method for reaching these goals for all people. The reason is simply that it gives everyone the opportunity to participate and trade their goods and services to the benefit of all.
But there is always a caveat. That is that not all things are always put to their proper uses. In fact you may even go as far to say that many times the proper use of our knowledge to the benefit of society is not the goal. When this is not the goal and the sole focus becomes profit not only does it become a self serving act but an act that may actually hurt in general all mankind.
This is the premise of my presentation today. I will by using the imagery of the story of Dr. Frankenstein and his monster expose to you the story of a global economy which was humming along fine but was actually deeply troubled. I will open your eyes to the how and why.
What are the purposes of the market per se? The markets exist for a place where people can exchange items of value. So we have the stock exchange, the commodities exchange and many other similar venues such as EBay now in the virtual world where values changes hands daily and moment to moment.
The stock exchange’s principal and original function is to raise capital for business ventures by enticing others to invest in their company and taking the risk of failure. For this the investor is rewarded with earning and or a higher share price for their investment if the venture is successful.
The second and probably more important part of this exchange of value lies in the creation of new business enterprise which will offer goods and or services and this in turn will create jobs and ancillary to it even more opportunity to supply those in the successful business enterprise. Hence this exchange of value is both fruitful for the investor and for the greater economy as well.
The commodities markets exist for a similar purpose. The future pricing model on the exchange came to be for the primary function of enabling the producers of a commodity to have a better venue of price discovery where they are to sell their goods. In the market we have the speculator which is a form of investor as well, that by taking the risk in buying or selling a commodity, may or may not be rewarded. But their function is an important and necessary part of the exchange that provides the liquidity. Liquidity means that the producer will always have pricing for their commodities or goods, even if there are no active consumers at any given time.
Now like all of life there are often those who may take unjust advantage of market participants. Usually the damages caused by these injustices are not catastrophic. But regrettably when they are, it hurts more than just the people party to these transactions.
For the purpose of this presentation I will focus on the marketplace in the USA currently being the world’s largest economy, even though recent outcomes have had global ramifications.
Since the beginning of the subprime crisis and the collapse of Lehman Brothers much has been written about the devastating decisions that allowed the players on Wall Street to go unchecked. Government actions were taken to reduce regulation at a point when they were actually most needed. But is or was this the crux of the problem? Where does the blame actually lay? As if it could be laid at any one industry, company or person.
Still to prevent the repeat of past offenses we need to understand what happened and the market conditions that enabled situations to blossom to this point of international disgrace.
The everyday person invests their earnings into mutual funds and various other portfolio products hoping to have a nest egg when they retire. Other than that we may have some private investors with the resources to invest directly and do the research to properly position themselves on the buy side of the market. Even doing so not one of these investors ever dreamed that in a matter of a few months their retirement accounts could lose 50% or greater of value as we had seen in 2008. So what caused this?
They say that money is the root of all evil, but this is not true because it is not money but greed. The two do not always go hand in hand but are often interrelated. Greed or avarice; is the inordinate desire to acquire more material goods or power than one needs or deserves.
Now I firmly believe that when someone creates or devises something that provides a service or good to the market then payment is justified and their wealth was or is justified such as Bill Gates the inventor of BASIC the first easily programmable language for computers and founder of Microsoft.
There are many other examples of wealthy individuals whose real activity does create value not just for them but for the world at large. In other words they are real producers. But in this world there exist a situation, where a certain class of so-called investors in my esteem, become what I call takers.
Takers are people whether a corporation, government or individuals that sole purpose seems to be to take value from the market. This value is not earned but literally taken from the rest of the participants in the marketplace.
In the book Frankenstein by Mary Shelley the good doctor describes his desire such: “I had desired it with an ardor that far exceeded moderation but now that I had finished, the beauty of the dream vanished, and the breathless horror and disgust filled my heart.”
Is this possibly the way some quants felt at the reaction of their systems to market anomalies? Did they not have the same dread upon seeing the devastation they caused in 2008?
What are quants? “Quant” is the short term for Quantitative Analyst. These are men and women and that have pledged their lives to the study of math and been hired to apply their skills to analyze the market trend and price moves to make money. There are many different titles and varieties of firms that use quants in this world; micro funds, CTA, mutual funds and High frequency trading firms.
Unlike Dr. Frankenstein most quants are numbers people and are directed by their company or trading division on the application of their skills. Still these are what we call Quant firms. These firms over the years have grown in size considerably but at the same time had also almost destroyed the financial landscape.
It all began with a quant by the name of Ed Thorp who in the early 1960s wrote a book about his discovery of how to beat the system using his mathematical skills. This book was called Beat the Dealer (and I happened to check Amazon and they are offering the paperback for $10.40 new). The book would become the primer for most of the quants that we know of today.
Many are names that are commonly read in the financial section such as Goldman Sachs, who by the way everyone loves to hate, and other banks. There are Citadel Investment, Renaissance Technologies, and Applied Quantitative Research to name a few. These people spend their lives researching and analyzing the mathematical structure of the market place for the sole purpose to remove value at the least risk possible.
Do they create jobs and industry? Could not these genius mathematicians employ their hands to a greater calling? Could their skills not have been used to study in details the flaws in the inequitable distribution of goods and wealth? Could they also study the dysfunction in the market to heal them and not to render them wider?
Now I am not condemning them because they do take some risk in the market place which adds value. However because of the low interest rate environment and the credit the banks have provided these businesses it has given them an inordinate amount of leverage which in return has given them greater market presence and power.
In my view the combination of the power of leveraged capital is a significant factor that gives these parties an unjust advantage. The use of quantitative study to remove value gives them an even stronger position but anyone can hire them, couldn’t they? But then again anyone can hire a hit man too. But there is one more piece to this puzzle that I haven’t even mentioned yet. That is technology.
Combine those two factors with technology and now we have the recipe for a big Gorilla in the room. Now of course there are other Gorillas in the room but does that make the market fair for the general investor? Do not these new advances place a quandary in front of legislators?
In reality the bottom line is yes. But what the solutions and answers are to these dilemmas are much more difficult to come by.
The evolution of the market place is a very important factor that we must review to understand what did and did not work in the old system and the same for the new systems.
How many people here remember the movie Trading Places with Eddie Murphy and Dan Aykroyd? If you recall that was a system that was called open outcry. This particular ring was on New York Cotton Exchange where at the time they also traded Orange juice.
In open outcry an exchange would have brokers in the ring, that by the way were also partners in many cases, making prices all day long. A customer would call his broker, the broker would then call to the floor and the order would be entered into the ring.
Before it hit the floor, if the customer had signed an agreement permitting this, the broker would be able to cross the trade against orders he had in his hand or books. In many cases though, the order would need to hit the floor to be executed. But when the order got into the brokers hand he could see the size and depth of the orders and may do something that was considered illegal up until the closing of the ring or pit. He may front run the order.
Front running the order simply means because of the beforehand information he is able to possibly get himself a price ahead of the customer that may move the market in a certain direction and he may be able to garner profit just from being ahead of the trade.
Of course this was unethical and was closely watched for in the ring. But still we can’t say that it never happened.
But these brokers that stood in the ring are the ones that offered the constant liquidity to the market. It was their job to shout out the orders to the ring and take the best bid or offer to fill the customer. It sort of had the noise of an auction house but with higher stakes and faster movement because each order would eventually get executed.
Now there would also be orders that sit in the hands of the broker. They could be day orders or GTC orders. GTC orders meant good ‘til canceled. And in all cases they were some form of limit orders. Limit orders are orders that are executed when the limit price hits and triggers the order into action. In most cases becoming a market order. Market orders are those which are to be executed immediately at the current price. Then there were also other types of limit orders such as Stop orders, MOC or MOO and other various items. Another advantage that a broker may have had was to know in advance if his order book leaned more towards buy or sell side. Of course this could be an advantage if your customers are right or a disadvantage if they are clueless and totally wrong. Because if you trade basis your book you had no idea of what cross section of traders you had in the market place. In most cases it was only interesting as a reference and for the broker to be prepared if the market moved into the direction where their book was heavy, the up or down side.
The professional traders rarely would leave orders working with their brokers. Hedge funds and banks are particularly secretive and would not want reading their orders to tip off anyone of their possible position.
Then of course there were many different brokerage firms that would handle orders so you can see that the flow and the direction was not easily transparent to the market. So in the days of open outcry, communication was very important and learning who was buying or selling, the size of the orders and the pricing levels where they may be triggered. Usually a trader would get this color from their floor brokers trying to use that information to their advantage if it was relevant.
There has always been rankling of market manipulation and many times those accusations during open outcry were directed at the floor brokers. In the early 1900s an infamous broker Benjamin Hutchinson, known for cornering the wheat market, put it best when he said; “Ethics, the word has a curious rattle, its meaning is hardly known in business today. Yet no one has accused me of violating any laws….what I have done may likewise be tried by anyone who wishes to risk his fortune. The field is open to all.”
The stock exchange is a little different. We all remember seeing the exchange on the news but how many remember the ticker tape? Honestly I remember it but it is more like a hazy fuzzy thing in the back of my mind. Brokers use to have machines that received the prices from the exchange via teletype. It was a rather slow moving thing. Eventually it evolved to the information terminals like Reuters and Bloomberg.
Sure the stock market can be exciting at times but back in the old days of real buy and hold activity there was a lot more stability. This stability in the market place was brought about by the system of how the exchange operated.
On the New York Stock Exchange each stock was quoted by a person named a specialist. This specialist would get paid a commission on executed orders in the specific stock he handled, for the reason that his responsibility was to always make a price for his specific stock. Unlike the commodities exchange where the gold ring was filled with dozens of brokers adding liquidity to the market, on the big board it was one person or group that made sure there was always a price.
For the fun of it we will call this guy Stan. I don’t know why but when I think of stocks, Stan from Reliable silver comes to mind. Anyway, so let’s say Stan was responsible for Exxon, IBM, and Citigroup. Runners from other brokers would run over to Stan all day long to get a price to buy or sell their stock. Stan was required to always show a price. In precious metals we call that a market maker. It sounds like a great business and it was.
But on Black Monday in 1987 when they had to still make prices as the market just kept crashing through panes and panes of breaking glass bottoms fortunes were lost and so were some minds.
So still if Stan survived that one he went on to make a good living and had many of the advantages of the commodities floor brokers and made the market fluid, visible and kept it manageable.
Then we had of course NASDAQ I believe one of the first electronic stock exchanges. It was slow moving, growing and aspired to become the Electronic NYSE. But even after joining with the London Stock Exchange it never reached that plateau. Still the exchange became an important factor and changed the way business had been done.
So you see there was an old world way about it. It was human beings directly interacting with each other. Many rules were placed in and around the markets to protect investors from sharks and for the most part things ran pretty smoothly.
But likewise though a system may be flawed, when devising a new system do we throw out the old completely to set up the new? Like the young Doctor Frankenstein and his avarice for knowledge and the power of creation, we will learn that even brilliant minds can create something that may not be the solution to the age old problems, or even at the least a better mousetrap.
Most of the widely used exchanges were also mutual companies prior to 2000. This means that the owners were the persons who actually worked on the exchanges. It was this private ownership that kept the business secure and viable for over a century. So it was very difficult for persons, even though they saw the world evolving around them, to accept the fact that things would need to change.
In Leo Melamed’s book “For Crying Out Loud” he tells the story of the evolution of the CME the difficulties he had convincing members to allow electronic trading in any format. Over the rather long period of time it took from the original Globex system with its side by side with open outcry trading, to the new silent computer world of the new age which was about fifteen years of battle, the members fought and dragged their feet.
In the end as convincing a promoter of new technology as he was it wasn’t until the threat of a European invasion and loss of market share that the members finally swayed. The CME would go public, devouring many of the other exchanges to become the big behemoth in the commodities world it is today.
The same can also be said of the New York Stock Exchange when they went public as they bought other exchanges. As they bought Archipelago which was an electronic exchange which had already taken over the Pacific Stock Exchange. The NASDAQ bought both the Boston and Philadelphia Exchanges to grow their business. Both groups expanded overseas as well with other purchases. Eventually the evolution continued as they merged with European counterparts to assume their new identities of today.
Of course the NASDAQ had an easier time migrating to all electronic as this was their primary business from the beginning. But the changes in the market place and the advent of them becoming public companies change their view of the world. Instead of making money from having stocks listed that would have activity. They focused on groups that would create volume in the listings they have. The program trading was the best customer and the highest volume of activity to be had was to come from a specific group which we call these days High Frequency Traders. Many are also highly leverage funds and pay huge commissions.
The exchanges came up with a new concept. It is called collocation. Co-Location means that they would allow these very active trading companies to have their computers on the same site that theirs are for a fee. This fee of let’s say 50,000 USD a month for the access was a pittance for the service they would get.
The ability to have their machines on location increased their speed by seconds and it also gave them a first look at the orders as they come in. It sounds innocuous but they are able to see the order before it is out in the open. In other words they can execute even before anyone has seen it. The bids and offers may never hit the screen.
This simple fact, in reality, is that it is exclusionary. What was once a real open exchange, where bids and offers were seen by the brokers and customers on screens, has now become a marketplace where specially designated companies with deep pockets can buy their way into better placement. The age old adage of knowledge is power still stands true to this day and that beforehand knowledge is worth big bucks.
This brings me to good old Dr. Frankenstein again. When you read the original story you come to realize a very interesting thing about the good Doctor. He was full of pride. His pride blinded him from seeing the truth of his pursuit. He believed he already knew the truth and so anyone or thing outside his own personal point of view was restricted. He would not allow himself to be accessible to the outside world while he pursued the creation of what would later be known as the Frankenstein Monster.
At the point where his creation comes to life and he believes he has given rise to a monstrosity, he says of himself the following ““A Selfish pursuit had cramped and narrowed me.” Wow! Now the guy gets a clue is what I thought while I was reading the book. He goes onto abandon the creation which was given birth to by his own disordered intellectual greed. The monster is left to its own devices and destroys his family and world. But was “it” the monster or was he the monster?
This is why Frankenstein so vividly reminds me of what we are living through in recent years. It first started back in the early years of program trading during Black Monday when Portfolio Insurance programs kicked in. Every time the market would go lower their programs would have them sell more on the futures market as a hedge. This would move the price lower and force the cash markets to trigger the bicycle wheel much like a chain to the pedal. On that day program trading represented more than 30% of the market. On the following day’s open the stock market was down 22 percent wiping out several years worth of GDP. This was a simple lesson in life; liquidity and reality are two different things. Even when a market is liquid in times of adverse movement the liquidity may dry up.
The head of our trading desk, Gerry Dawson, has term for that he calls it going “roach”. If you are from this country and you are close to 50 you should remember a television commercial from the 1980s by a pesticide firm for their roach killer called “Roach Motel”. Followed by their simple phrase “roaches check in but they don’t check out.” That line tells it all when we are talking about liquidity in the market place.
But that would not be the last market to go roach. How many people here remember Long Term Capital Management? It was in the late 1990s that we had another blow up. This time it was highly leveraged money combined with liquidity issues in the Russian Bond market that would cause this firm’s ruin. But they were a Macro fund so what does that have to do with anything I am talking about? Simply put just like Dr. Frankenstein their arrogance, self pride and greed blinded them to the reality of the situation.
Long Term Capital would cause a devastating disaster in the financial markets and take a major Swiss bank with it. However for some reason, I do not understand why, the financial markets shrugged it off without looking for a solution. As if this were only some strange anomalies, never to be seen again.
In fact the financial markets would come under less vigilance instead of more in the wake of this tsunami.
It was in 2007 that the Regulation NMS (National Market System) came to being. The SEC in its wisdom saw fit to change the controls and take them away from the exchanges due to the new technological advances. Its benign and actually just intentions to have all stock orders filled at the best possible price no matter which exchange they were listed on sounds like valiant cause. However in the move to create better transparency it actually created a system where the orders may be executed without ever hitting an exchange. Simply put if the broker received an order to sell 100 shares at 50 and across all the different electronic exchanges the best bid in the market was 50.01 they could fill the order by having their system out bid the market by 50.011. Hence this now became the best order in the market. They also get to keep all the commission.
But do you realize how this is done? This is done through the mastermind of computer programming advances. It is the High Frequency Trading that increased the profitability of the exchanges but at the same time has endangered the merit system that has been in existence for all these years. Now a new class of investor has an edge over everyone else.
These firms take advantage of their high speed and collocation. They have split seconds of sneak peeks. They get to calculate instantly and jump in between trades constantly both in stocks and commodities. The transparency that was sought actually became a permit to front running orders. But still even as many in the marketplace complained their voices were not heard because the case was made that these program traders made the market liquid.
Then on Thursday, May 6, 2010 at 2:30 pm, a massive crash occurred on the stock markets. It was called the Flash Crash or some like to call it Fat Finger Thursday. But fingers had nothing to do with this. The stock market dropped 1,000 points in a few minutes triggered by algorithmic traders and their high frequency machines. It was sale pressure from large volume that put such undue stress on the market that High Frequency traders pulled out their bids causing the market to go roach and the execution of the orders that were not price sensitive just kept moving lower like a submarine sinking to the bottom as there was no ground to stop it. After which it became obvious that the case for these trading systems supporting the market was untenable.
The SEC of course since has been working on this issue. It has become apparent that what happened was only logical. The panic selling that often happens in the heat of things happened faster, because the computers still programmed by people, just react thousands of times faster using the same thinking.
That day some stocks were driven as low as ZERO! In the book Crapshoot Investing by Jim McTague he mentions one stock, Accenture, an international company with over $22 billion in revenue saw its share trade down to a penny from $41. This price move tumbled their market capitalization which in essence caused investors and employees to be robbed of millions. This was to be another black eye in a series of disfiguring occurrences in recent history for Wall Street and their markets which would bring about renewed distrust of the entire exchange system.
Prior to the change of regulations there used to be stops or circuit breakers that would have prohibited such an occurrence from happening. These regulations which have since disappeared were actually put into effect following the Black Monday crash. Why is it that we keep removing regulations that were meant to protect the investor and also the integrity of the market? Again simply put the high volume business is so profitable and their political power so strong that they are able to influence regulatory parties involved. At one point when the SEC looked into the influence of the HFT on the market place they came out with a statement that paraphrased the different trading company’s slogan of the importance of the liquidity they add to the market.
The program traders have many ways to fish for money in the market, flash orders, pinging, and flipping among a few. They take pennies out which add up to millions of dollars of profit for these firms and an invisible tax burden for the economy at large. Still there are no laws forbidding it. But the biggest burden is when they finally blow up.
In all these different scenarios there is one legitimate concern. It is the fact that these businesses presume they have the solution. They believe they know truths of the world. Their arrogance leads to their demise. In 1987 it was the Portfolio Insurance Programs that knew it all, in 1997 it was Long Term Capital who were the gods, in 2001 it was Enron and in 2008 it was Lehman Bros and Bear Stearns who had all the answers and to this day we still feel the repercussions of these firms and their unbridled investment structures.
In a direct quote from Leo Melamed’s Book he writes; “Participants find inventive ways to cash in, only to be caught in unsuspecting savage traps. Rogue traders unearth ingenious techniques to deceive or cheat as traditional controls are found antiquated or woefully inadequate. Market regulators, along with business managers, seem helpless and off guard.
What shall the world do? Condemn the events that produced the turbulence? Curse the reality of the present? Outlaw the markets? Restrict price movement? Ban futures? All of the above? We can neither expunge the history that brought us to this fate nor prevent its ultimate resolve. We must be prudent and vigilant. We must set standards, benchmarks, and especially internal controls. We must heed the lessons we have learned and adopt the prescriptions that are warranted.”
This is so true, but so hard to do in the world where bipartisan politics and especially self interest are always at the heart of the problem. How do we breed selflessness and concern for the general welfare of all people and the markets? It is not in giving courses on ethics it is in extolling the virtues of sacrifice. But in a world where we put people on a pedestal because of material wealth instead of elevating those who have loved greatest I fear the world will always be burdened with corruption. But I hold out hope and believe that we can always improve and if we leave our markets just a little better so that our future generations can live with more peace and harmony than that of our own, then we have accomplished something.
The character Dr. Frankenstein wrote a poem describing his dread of the monster he had created and it goes like this.
“Like one who, on a lonely road,
Doth walk in fear and dread,
And having once turned round,
Walks on, and turns no more his head,
Because he knows a frightful fiend
Doth close behind him tread”
I read you this poem as a warning. Though all seems calm now unless we take regulatory action that will protect investors and the integrity of the markets we may be as he walking with a monster of a problem not too far behind us.
By the way don’t get me wrong I am totally pro-technology with caveats of course.
Special thanks to my brothers, Javier, Carlos and Eddie without whose valuable insight into the markets I would be missing many aspects
Also special thanks to Patricia Cauley of the CME who planted the seed.
Bibliography:
McTague, Jim. Crapshoot Investing. Upper Saddle River, NJ
Pearson Education Inc (FT Press), 2011
Melamed, Leo. For Crying Out Loud, Hoboken, NJ
John Wiley & Sons, Inc., 2009
Patterson, Scott. The Quants, New York, NY
Crown Publishing Group, 2010
Geisst, Charles R. Hoboken, NJ
John Wiley & Sons, Inc. 2002
Bookstaber, Richard. Hoboken, NJ
John Wiley & Sons, Inc. 2007
Thursday, June 30, 2011
Subscribe to:
Posts (Atom)