Time to take stock

Exactly how did we get into this mess with the capital markets? A situation where the global stock of derivatives is over $US600 trillion, which is about twice the capital stock of the world. A situation where high frequency trading is over two thirds of the transactions on the NYSE and about the same in the stock markets of the UK and Europe. Likewise they are over half the action in foreign exchange markets and they are rapidly becoming dominant in the futures market. Andrew Haldane from the Bank of England is arguing against allowing high frequency trading — algorithms chasing algorithms chasing algorithms — from being allowed to proliferate pointing at volatility as the problem:

Speed increases the risk of feasts and famines in market liquidity. HFT [high-frequency traders] contribute to the feast through lower bid-ask spreads. But they also contribute to the famine if their liquidity provision is fickle in situations of stress.

Haldane noted that relative to gross domestic product, the equity market capitalisation of the US, Europe and Asia had not grown since 2000, suggesting that “the contribution of equity markets to economic growth … has been static”.

Little wonder, when you consider that companies are putting themselves in the hands of algorithms.

I think this conclusion, which many come to, is to some extent a blind alley. Because the volume of transactions is higher — when it is claimed that it adds liquidity this is a circular argument, like saying “the more we trade the more we trade” — it should mean that “volatility” at least on basic measures, is lower. The trades are made around normative models so they will tend to re-inforce those norms. Right up until the moment when the market does not behave with regard to norms, and then they suddenly start doing weird things, such as the so called “Flash Crash”. So it is probably correct to say that there is less volatility. It is also beside the point.

A better question is: Why do we think liquidity is a good thing?” Answer, because it facilitates trade around the exchange of information. “Information about what?” one might then ask. “The company in which the investment is being made,” is the answer. Does algorithmic trading exchange information about the performance of the company? No, it is only working off information about trading behaviour. Ergo, it may increase “liquidity” but it is not fulfilling the purpose of liquidity.

That kind of shift to traders working mostly off what traders do, rather than assessing the value of what is being traded, has become an absolute plague. It has taken over most Western financial markets. Hedging, for example, used to be all about hedging bets to protect the underling exchanges (usually wheat, or pork bellies or physical things). Now, hedging is all about reading behaviour, which then leads to other hedging strategies that are based on reading the hedging behaviour, and so on.

So the disappearing point is part of the problem. In our “anthrosphere” we are increasingly staring at each other’s navels in the financial markets, trying to make money and sustainable wealth out of ether. That is part of the problem. Regulators forgetting what the PURPOSE of financial markets is and instead just trying to stay faithful to the technical explications of that purpose, or utility. A colossal abrogation of responsibility, in other words, fuelled by thoughtlessness or intellectual laziness (Haldane is a notable exception).

But I think there is another problem. A growing mismatch in TIME between financial markets and commerce or economic activity. I can remember in the currency meltdowns of the last 20 years how the explanations in retrospect for why Russia or Thailand or Mexico  or Indonesia “deserved” what they got. They were always plausible enough, if usually circular arguments.

But then you looked at what happened to those economies that had experienced crises and the impact was completely out of alignment. In a matter of weeks, there would be a massive re-rating of the currencies. No economy changes that fast. The problems, if there were problems and sometimes it was just a trading fiction, had usually accumulated for years. After the crises, the economies would take years to recover from the shock. It seemed to me that the misalignment in time is what is fundamentally wrong with this kind of financial behaviour.

The misalignment is even more extreme with high frequency trading, where micro-seconds are the basic unit. How can the exchange of information about a stock occur in such small periods? Obviously they can’t. There is a mismatch. Money should be aligned with what it is supposed to be representing, and that includes aligned in its temporal structure. For at least two decades, that alignment has been progressively picked apart, and now it is reaching endemic proportions.

In terms of its intellectual origins, this has  a lot to do with the quasi-scientific methods used by economists and financiers. In science, time is just a dimension of space. The point of creating scientific “rules” is to say that every TIME the rule applies. Time, in other words, has to be eliminated as a problem.

Which is why science applies so poorly to human behaviour, because humans are always changing in time. It is why scientific models have extremely limited application to markets, because every time things are different — at least in their timing. For instance, I may reasonably conclude that the $A will fall, and be right because it will probably revert back t a norm. But what I need to know to make money is the time it will happen.

What one notices about all the fundamental analyses is that, while persuasive, they are extremely limited because they don’t tell you when the predicted events will occur. Those traders who sniff “the times” often do much better.

Time, in other words, cannot be eliminated from human behaviour, it is front and centre.

Which is why I would submit that the misalignment in time between financial market instruments and that which they are supposed to represent is not just extremely dangerous, it is fundamentally inhuman.

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  1. Do you remember the ultimate formula of capital accumulation: M-M’?
    Whenever the dash (the time between M and M’, which is the time of making profits) can be minimized and driven toward 0, there will be financial creativity of economic nonsenses and absurdity.

  2. Lighter Fluid

    A thought provoking piece Sell, many thanks.

    The mutual-nasal-gazing of financial markets reminds me of the Keynesian beauty contest quote:

    As a basic scientist by day, I thought I could add to the discussion of scientific ‘rules’ and human behaviour. A scientific ‘law’ only holds as long as it is true – it is a statement or principle that seems to be fundamentally true under repeated observations. Theories explain laws, and must have the ability to make predictions that can be tested. If the predictions are wrong, then the theory is false or incomplete. Laws too are falsifiable by further observations – so even at the core of science there is uncertainty.

    This is the key issue. Most honest scientists when presented with data that consistently contradicts their long-held theories or ‘laws’, will change their mind. This is because fundamentally, science is about trying to get to The Truth – scientists accept that there is an objective reality to the universe and their role is to try to get as close to a complete understanding of that reality as they can. I see it as an asymptotic process (think y=1/x as x=>infinity) – you get closer and closer to the truth the more you observe it, and you try to view it from as many aspects as you can, but there are limits and every observation has uncertainty.

    The problem with economics is that a) when shown that their fundamental assumptions are wrong, economists* have not changed their mind; b) The goal of economics has been to describe purely subjective phenomena such as “value” and “utility” as if they were purely objective; and c) this wouldn’t be a problem if economists didn’t govern how society works (or ‘should’ work as they see it).

    (*I should clarify that in the above context I mean neo-classical economists; General Equilibrium-ites, Efficient-Marketeers, CAPM-ers and the like – there are empirical economists out there, but they are rare and too-often ignored)

    Now, if you shift the goalposts, and start trying to understand how humans make decisions or behave under stress (rather than how rational entities go about the exchange of goods in a pure abstraction of reality), then yes, I think you might get some kind of objective understanding – but it may not be easily converted into maths and if you could, any valid model would be non-linear with time and highly complex. In these kind of systems, unless you can measure every variable (be it stock prices, mood, number of coffees consumed by traders, whatever) with absolute precision at a single point in time, their predictive capacity goes to zero very rapidly. This could be why HFT-ers operate on tiny fractions of seconds – their models fail over longer time-scales.

    The problem is not the application of science to human behaviour (science seeks only to understand), but a lack of appreciation for the inherent problems with modelling complex systems, based on subjective variables, under uncertain conditions. All that said though, I don’t disagree with your conclusion.

    As we become more capable of understanding complex systems, and every aspect of our society becomes increasingly complex and interconnected, we need to start thinking not just about ‘efficiency’ but of ‘robustness’.

    I see this in my day-job thinking about novel drugs that combat drug resistance, in the IT department of any business or organisation, in financial markets, the economy, government policy and planning – everywhere.

    I guess this is why I keep coming back to MB. The message is the same – don’t sacrifice robustness for short-term performance.

    PS, Apologies to all for the scroll-fest.

    • Great comment. The basic problem I see is how can you ensure robustness when you’ve got no idea on the feedbacks and nonlinearities?

      My own views are much like what I read here – keep it simple. More complex, more feedbacks, more nonlinearities, less robustness.

    • a move toward behavioural and empirical economics would be a blessing… it amazes me how much neo-classical is still the dominant doctrine

  3. WOW! To SON and Lighter Fluid. It’s 12.40 am and damned if I can think of anything constructive to add. Thanks to you both.

  4. One of Australia’s greatest minds, Robert McCredie, Lord May of
    Oxford, whose CV takes up pages, wrote a paper in “Nature” with
    Andrew Haldane in Jan or Feb 2011, titled “Systemic Risk in
    Banking Ecosystems”. The largest international banks, along with investments banks and hedge funds, in about that order,
    dominate the trade in derivatives, and the use of algorithmic
    trading. No one knows when or where the inter party linkages
    or their threat of systemic breakdown may occur . We will know quite well after the fact. For those of a technical mind, it is well
    worth a look at this important paper.

  5. MissMoneyPenny

    I still can’t fathom how people can trade in nothing. Unlike commodities andcompany stocks, derivatives don’t provide a product or service or anything that is of tangible value. Now that this trading of ‘mythical’ valued entities makes up more of the worlds wealth than actual ‘stuff’ is quite scarey. Maybe their time would be better spent writing algorithms to work out how to feed the growing world population.

    I’d better start learning how to grow my own veges for when this whole house of cards comes down.

  6. Tks Robert K, that is really worth following up. Don’t have a link, by any chance?

  7. Different China Fanboy

    Derivatives are a zero sum game. Negative sum game after transaction costs. In other words it is gambling. Shareholders would be outraged if executives funded trips to a casino by their management yet no one says anything, or at least very little, about gambling on e.g. credit risk.

    If you have an interest in the underlying then derivatives provide risk management.

    So what is needed in derivatives markets is the equivalent of an insurable interest requirement. If you have an “insurable interest” then welcome, come and hedge your risk. If you don’t, then piss off and go to the casino for your thrills.

  8. As I pointed out before, though you lot probably deleted it, the Bank of England has serially repudiated its obligation, that being the Pound Sterling, for centuries.

    Nothing out of the BoE can be considered valid.

    • That is too broad a statement.

      Just because someone or some organisation gets one thing wrong, that doesn’t mean they get everything wrong. Also, within organisations there are people with different views.

  9. El Zorro Dorado

    Capital and equity markets have been transformed into nothing more than gambling dens through the financial chickanery which is endemic in most financial institutions of today–whether it be pre-eminent in their operations or more subtle. Short-termism, HFT, push lending, exotic financial derivatives, hedging ( not for hedging risk but simply to garner a few dollars), plus the host of imaginative participatory vehicles available for individual and corporate or fund punters…all these are designed not for some ‘greater purpose’ of mobilizing and allocating capital and dealing in real risks and events. Now it is all fairy-tale stuff and the authorities and the exchanges –if one might bless them with credibility anything more than might be bestowed on a numbers runner– all take their filthy cut of lucre and look the other way…or rather lie back and think of England ( or maybe who they might entertain as a partner next). Haldane may be right in his assessments but no one will listen. There used to be a time when traders could make money by assessing risk and then taking it in an imperfect but un-manipulated market. Those days are gone…and so is the integrity of the financial sector.

  10. Great article and comments. This is scary stuff. I became very disillusioned with economics when I realised it was all about trying to fit human behaviour into some neat mathematical model, with ridiculous assumptions (and to hell with the real world). The world’s financial systems now seem to be out of touch with reality and out of control (thanks to the computerisation of trading systems). Does anyone really understand what’s going on? Is anyone in a position to stop it and return financial systems to some kind of normality?