Sunday, 19 December 2010

High Frequency Trading and Flash Crash – 3: How the Die Was Cast

Nathan Rothschild, head of the family’s London branch, had an agent in the Battle of Waterloo. Upon seeing that the tide of the war was turning against Napoleon, the agent rode to nearby Brussels and hired a sailor for the unheard sum of 2000 francs to take him across a stormy Channel to England and his boss. With valuable intelligence at hand, Nathan rushed to the London Stock Exchange and feigned selling. The crowd followed, on the belief that Wellington had lost. After the share prices had collapsed during the selling frenzy, Nathan Rothschild began buying, making millions.

Whether this is a true story or a legend is not the point here. The point is ethics.

No, I am not talking about Nathan Rothschild. Good for him, I say. If the goyims were slaughtering one another over money, why shouldn’t a Jew make few a pounds from the mayhem?

The question of ethics pertains to the Rothschild agent. What would you say if he had used a mule instead of a horse, or had waited for a “scheduled” ferry and calmer seas?

Why, such willful delaying tactics would amount to sabotaging his mission. That would be treason, a crime punishable by death at wartime.

Imagine now, if you will, that the Rothschilds had an equally sharp rival family. We call them Rosenzweig.

The Rosenzweigs, too, considered war a man-send opportunity for making handsome profits, but they could not place an agent in Waterloo. What they did, instead, was place a jockey with a fast Arabian horse at the ferry stop on the English side. They instructed their jockey to take a peek at the open message that the Rothschild agent was carrying and rush to the Rosenzweigs with that information ahead of Rothschild’s man.

The scenario is a bit contrived (for a really contrived scenario you have to read Friedman’s “government helicopter” dropping money on the rabble), but you see where I am going with it. Would the ethical dimension of the story change if the Rothschild agent had used a steamboat instead of a sailboat, or if the Rosenzweig man had used a car instead of horse, or one of them had used a cell phone to pass the message along or traveled with the speed of electrons?

These progressively faster means of “getting there” take us in principle from Waterloo to high-frequency trading (HFT).

In principle, but not exactly. That is because in HFT, the dialectical law that the accumulation of quantitative changes results in a qualitative change kicks in and creates a situation with its own peculiarities; there is a long way from the one off stunt of an ear-to-the-ground businessman to the way HFT works in modern, decentralized exchanges. But I started from a technical angle to show that “getting there first” – because there is money to be made from speed – is the driver of both scenarios and the sole purpose of the game. The “fairness” issue – as in the HFT not being “fair” to “others” – is a fig leaf to cover the self interest of those critics of the HFT whose interests the practice threatens. Long before the rise of HFT, brokerage firms touted their fast execution capabilities – like how news organizations tout their speed in covering “breaking news” – as a competitive advantage and selling point. It was only a matter of time before competition and technology would push the speed to its physical limit. That time having arrived, we could now focus on the financial aspects of HFT.

The practical man of finance who started the stock exchanges on both sides of the Atlantic knew that bringing buyers and sellers together, the way it is done in a flea market or a bazaar, would not in itself be sufficient for creating a viable exchange. That was only the first step, a necessary but not sufficient condition.

Why and how a stock exchange is different from a flea market or a bazaar is a relatively advanced topic in economics and finance theory. The space limitations of a blog preclude me from delving into it in detail. But I cannot give the subject a short shrift because its understanding is a condition for understanding HFT. Consider what follows a compromise.

A stock (share in the UK) is a security. A security is the evidence of ownership of notional capital.

Imagine an aspiring entrepreneur who approaches 10 people and raises $100,000 from each for a venture to produce widgets. He gives a receipt to each contributor.

After the completion of the fund raising, the entrepreneur has $1,000,000 in cash. The balance sheet of his corporation (which he has set up to produce widgets) would show $1,000,000 cash under Assets and 1,000,000 under Owners Equity. Separately, each one of the 10 people have a receipt indicating that they have given the entrepreneur $100,000.

Afterwards, the entrepreneur goes to work. He rents a space ($100,000), installs tools and machinery ($500,000), buys the raw materials ($200,000) and hires workers ($100,000). He keeps $100,000 cash for operations.

After these activities, the value of his company’s assets remains unchained at $1,000,000. But the composition of assets is different. Cash is used to buy the components of the production apparatus that will create the widgets. We could say that it is converted into those components. The conversion turns:
  • The original $1,000,000 from money into capital.
  • The people who gave money into investors.
  • The receipts in investors’ hand into securities.
From here the definition of a security as the evidence of ownership of notional capital follows. Capital is notional or imaginary because it is already spent. If one of the investors has a change of heart at this point and wants his money back, he would be out of luck. The entrepreneur would remind him that his $100,000 is already spent – converted into the elements of production. What is more, it is impossible to determine which 10% of the total enterprise belongs to a particular investor. All $100,000s were combined to create a synthetic, organic whole.($100,000 cash is as much a necessary part of operations as wages and the raw material). That, of course, was the plan all along: to spend the money in a precise, purposeful manner which would make it capable of producing profit. It is to this profit that the holder of the security is entitled on a pro rata basis.

System-wide, though, the situation of the investor who wants his cash back is not hopeless. The economic system that creates stocks also creates stock exchanges precisely for that reason: for investors to sell their securities to other investors. The mechanism merely replaces the title of the ownership of the capital but otherwise leaves it undisturbed in the production process.

That is how the stock exchanges are different from a flea market or bazaar. In the latter places, the participants are consumers and producers and what is exchanged is a commodity – worked matter, generally.

In a stock exchange, the participants are capitalists. They are not buying and selling commodities but converting one form of capital into another.

The change of forms of capital signifies movement, which is the defining characteristic of capital – in the same way that breathing is the defining characteristic of live creatures. Yet, it remains unknown to professors and bankers. That is one reason for their profound and often embarrassing ignorance of events taking place around them.

Note, for example, what happens after the widgets are produced. The composition of the company’s balance sheet changes again, reflecting another change of form of the capital. Under Assets, raw material is reduced and the tools are depreciated. But there is now a new item: widget inventory. The widgets are produced and ready to be shipped.

To keep his factory working, our entrepreneur must begin a new cycle of production. He has to buy raw material, pay the rent, pay the workers and also pay the investors. But no one wants to be paid in widgets. They all want money, which means that he must sell the widgets. That is, he must convert his capital from commodity form into money form.

It is no exaggeration to say that, unless you are reading this in a remote village, everything you see around yourself is shaped by that process. A full chapter in Vol. 4 deals specifically with that topic. As a pitch for the book, but also as further background, let me quote a few paragraphs:
During production, the entrepreneur was in full command because he had paid for, and therefore, owned, everything within in the production process. Now, the sale must be affected by buyers – outsiders over whom he has no control.

It would be saying too much to say that like the Blanche DuBois character, our entrepreneur depends on the kindness of strangers to sell his widgets. No hawker of goods ever sat completely passive. Throughout the millennia, the craftsmen in the East and West have used various venues, with varying degrees of subtlety and aggressiveness, to attract buyers. The techniques in all forms revolved around a two prong strategy that is intuitively obvious to a seller: being noticed by the potential buyers and then actually “closing the sale” against the energetic pitch of competitors. The idea of bazaar that exists in one form or other in all early communities, is the practical realization of the strategy to bring all the buyers into one place, to affect what in the modern retail business is called “foot traffic.”

An entrepreneur of the 21st Century, where Capitalism reigns supreme in much of the world, must go beyond these passive measures. He has to actively seek buyers and then entice them to buy his product as opposed to the products of his competitors who claim to offer superior or cheaper alternatives.
***

Every entrepreneur begins the venture by asking probing questions about the sales prospects of the product he is planning to produce: Will it sell? Who would be the buyers? How long will they continue to buy? What price would they be willing to pay? Who are the competitors?

These are the intuitive and obvious questions. But the complexity of the modern markets demands more than an intuitive approach. It demands a systematic and methodical analysis of the markets, with the goal of turning the subjective, intuitive lesson of selling into a “science” with principles. Hence, the advent of marketing which, alongside finance, is the core subject of all the business schools.

***

Advertising is the ‘art’ of ‘effecting sales’. Note that there is no reference here to the product. Advertising is the means affecting the sales of any product. In the eyes of a salesman, houses, nuclear waste, electronic gadgets and plots of cemeteries are all products to be sold. Only the sales pitch varies, depending on the product and circumstances. In this way, in advertising, the fundamental, which is the product, becomes an incidental, to be addressed through the manipulation of the form, which is the way the product is promoted. The fundamental is the conversion into money of whatever that is being sold.

***

On the surface, “affecting sale” pertains to the product, but its target is in fact the buyer. It is the buyer who must be persuaded to part with his money in exchange for the product. What we have in “affecting sales”, therefore, is influencing the behavior of potential buyers – making them buy a product which they would not have otherwise bought. When the focus thus shifts to the buyer and the ways of influencing his behavior, it matters little whether the product serves a real need. If the advertising can create the need and persuade the customer to act on it, the goal of the exchanging product for money is accomplished.
Returning to our entrepreneur, if he cannot sell the widgets, the cycle of capital’s circulation, involving re-ordering raw material, extending the lease, keeping the workers, and distributing profits to investors, would be interrupted. That would translate to a crisis, a phenomenon whose analysis is beyond our subject. I merely note that while commodity-to-money form of capital’s transformation is the most intuitive and immediately accessible, the other forms and the ease of their transformation into one another are no less important in preserving capital’s cycle.

The practical businessmen who started the exchanges did not know these theoretical fine points but they did not have to, in the same way that a six year-old who rides bicycle need not know about the preservation of angular momentum that keeps the bicycle on two wheels.

The businessmen realized that a stock is a title and claim to future steam of incomes. Future profits being inherently uncertain, an element of speculation is always present in stock prices. At times, that aspect of stock trading could get out of hand and disrupt the “equilibrium” of the supply-demand. Under such conditions, the relation of the stock prices and the underlying physical reality of capital could be severed, as it happened in 1907’s Bankers’ Panic.

Then, J.P. Morgan prevented a collapse by ordering wholesale buying of stocks. But the crisis showed the need for a formal mechanism to stabilize the market. Markets were outgrowing the capacity of one individual or firm to control them. That experience led to the establishment of the Federal Reserve in 1913, an institution whose central mission was to act as the “lender of the last resort”.

The Fed was about lending and borrowing money. The stock exchanges needed a buyer and seller of last resort. So it came that the “specialist system” was established in the New York Stock Exchange. Each specialist was assigned a group of stocks in which he had to “make market”: bid for the shares of those who wanted to sell, and offer the shares to those who wanted to buy. Buyers and sellers could not trade with one another the way they did in a flea market. They had to go through the specialists.

Later when the Nasdaq market started, the same function was duplicated there, only in Nasdaq, the title was “market maker” and they were typically the arms of the Wall St. firms such as Goldman, Lehman and Merrill Lynch.

You can see the centrality of the specialist position and how lucrative and privileged it was. Profits were virtually guaranteed. An IBM specialist, for example, would buy the stock from A for $40.125 and sell it to B at anywhere from $40.25 to $40.625. A change in the stock had generally no impact on specialists’ profits. He could maintain the same “spread” between bid and offered prices if that stock rose to $43 or fell to $38. Assuming a daily volume of 200,000 shares, that translated to about $100,000 a day.

Sure, occasionally stocks went south and sell pressure forced the specialists and market makers to dip into their own capital and buy stocks where no other buyer was present. But these instances were few and far in between.

Far more important, the specialists could see the overall buy and sell orders for a particular stock and position themselves accordingly; they could buy for their own account if they saw a strong buy order or sell if there was a sell bias in the market. That is “front running” which has always been illegal. Occasionally a few small time brokers were charged with the practice, but it was virtually impossible to prove or enforce it in the case of specialists and market makers.

Then came the Crash of ‘87. On that fateful October day, as the unprecedented sell pressure mounted and the buyers disappeared, specialist and market makers refused to accept orders. In fact, they refused to answer the phones. And then, they walked out. They had little choice. Their capital was close to exhaustion, with no end to selling in sight. At 3pm on October 19, 1987, no one dared to buy because there was no telling how much further the stock prices could drop. The normal functioning of the market had broken down.

There is a large number of books, reports and studies on the cause of the crash of ‘87. Not a single one of them got the story right. You could not get the story right without knowing speculative capital. Quite a few mentioned “program trading” as the cause of the crash without realizing that “program trading” and its cousin, “portfolio insurance” are the particular manifestations of speculative capital. The rest offered drivel. Here is what Michael Steinhardt, a hedge fund manager who had become the all-purpose commentator on the markets, said: “The stock market is supposed to be an indicator of things to come, a discounting mechanism that is telling you of what the world is to be. All that context was shattered. In 1987, the stock-market crash was telling you nothing.”

Was he wrong! Oh, boy, was he wrong! Never was the stock market so prophetic. But how could a moneyman realize that the stock market was signaling the collapse of the stock exchange system – its destruction under the onslaught of speculative capital? That is what specialists and market makers leaving their posts signified.