- Speculative capital, capital engaged in arbitrage, dominates the financial markets. (See Vol. 1 for how and why).
- Arbitrage is simultaneously buying (low) and selling (high) two different “targets” to lock in a riskless profit.
- Buying X low and selling Y high raises the price of X and lowers the price of Y, narrowing their difference and reducing the potential profit for the next round of arbitrage.
- To compensate for shrinking spread, speculative capital increases its size and piles up on the leverage, with the result that spreads shrink even further – and faster. From there, the defining characteristic of speculative capital follows:
- Speculative capital is self destructive. It eliminates the opportunities that give rise to it.
- Let us be precise: Speculative capital eliminates only those opportunities that it actively exploits. That follows from arbitrage the way conclusion follows from premise. But speculative capital is not suicidal! It ferociously defends and preserves itself as the best man-made science-fiction monster ever could, precisely because it uses man to that end. So while destroying the arbitrage opportunities in one place, like expanding matter that creates space, expanding speculative capital at the same time creates opportunities elsewhere. Speculative capital is the quintessence of dialectics.
- The more recent opportunities tend to be more difficult to exploit because they: i) do not immediately stand out and must be uncovered; ii) generally involve several markets and jurisdictions where simultaneous execution of trades poses operational challenge; and iii) demand relatively larger capital by virtue of (i) and (ii).
- They are also riskier. It is risk management 101 that the more pieces a system has, the higher the chances of its breakdown. (Boeing engineers know that, too. A 747 has 5 million pieces. A 787, when it is finally delivered, will have 3 million.) It is one thing to buy a currency low in New York and sell it high in London. It is a different thing altogether to short Treasuries in the US and use the proceeds to create an equivalent option position on some equity index in Japan. In the latter example, if the source of funding dries up, the strategy would unravel. That is what happened in the market meltdown of 2008.
- What would you do, then, if you were speculative capital – by definition the fountain of riskless profit – in the face of such increasing risk?
- Why, you’d discover HFT.
Or, rediscover, as HFT is the adaptation to the new circumstances of old ways.
Here is the game plan. When a fund places an order to buy say, 100 thousand shares of a stock, the order has to be broadcast to reach the “market”. Before it reaches the market, we intercept it – like the “Rosenzweigs’ agent” – and get ahead of trade, buying as many shares as we could. After the order reaches the market, it would push the share price higher, by however small an amount. We then sell it for a profit. The profit would be razor thin and about a fraction of a penny. But as every retailer knows, we make up for low margin by volume, by repeating the process tens of millions of times a day. We do the same with the sell orders, only we sell instead of buying.
At its core, HFT is the old fashioned front running, that reliable strategy of pit traders and market makers when everything else had failed.
But as a dialectical entity, speculative capital never uses the opportunities it finds in their historical mode for long. Rather, it transforms them into a qualitatively higher mode, a synthesis which contains the older form but is something different from it.
In HFT, this transformation takes the form of the replacement of men by capital.
In the Rothschild story, the focus was on the man. Front running, too, has always been the story of unscrupulous traders and brokers.
In HFT, the individual is taken out of the picture. He is replaced by speculative capital. Speculative capital becomes the grammatical subject of the sentence as if it were alive: speculative capital engages in HF trading.
The transformation is liberating. In the old days, a broker could be charged with front running. In HFT, the idea becomes ludicrous. Surely you are not suggesting that the law should apply to a thing? That's how the modern economics is “value-free”.
But speculative capital is not a single entity. Nor does it have a command and control center. It is, rather, the sum total of all capitals engaged in arbitrage, spread among thousands of hedge funds and proprietary trading positions across the globe. At times, a large portion of this mass acts in unison, something that crack Wall Street researchers have recently noticed and dubbed “risk on, risk off”.
At other times, its different segments compete with, and go against, each other.
Only a small fraction of speculative capital is devoted to HFT – only so much that the relatively small field can absorb. And the return from HF trading is very low. A Kellogg Ph.D. dissertation concluded that 26 firms which control 75% of the HFT make about $3 billion annually on $30 trillion trading volume. Such low returns are expected from a business model which constantly squeezes the spreads.
Still, other segments of finance capital consider the interception of their orders and shaving off of even a fraction of a penny from their profits a flagrant robbery. (The business is actually that competitive.) They refuse to be robbed, and take actions to “protect” themselves. And what could be the defense against faster predators who feed on intercepting one's orders? Why, not showing the orders altogether. Hence the rise of private exchanges, dark pools and internal settlement mechanisms, all of which come into being so that large trades would be executed privately and out of sight of prying eyes.
The rise of these private exchanges and mechanisms diminish the role of the “market” and get in the way of “price discovery”, that leitmotiv of every clerk and scribe who taught business and finance in a Western university. (The above links give only a bland and bloodless description of private exchanges and dark pools. Still, the purpose of these new “developments” comes across. In internal settlement, a broker matches my order for buying 100 IBM shares with your order selling 100 IBM shares internally without transmitting them into the exchange. Again, the volume and price information is distorted.)
The ignorant, pompous academics who envisioned continuous-time finance considered it the crown jewel of their intellectual achievement. In addition to technical breakthroughs such as option valuation – and they got that one wrong too – two critical, ideologically empowering conclusions seemed to follow from it.
One was the participation of the populace in trading. Continuous-time finance meant continuous-time trading. And how could continuous, incessant trading be possible without the mass participation of the people – just like a highway that could be crowded only if everyone with a car is on it! That was the true spirit of democracy and the proof that free markets would strengthen democracy, and vice versa. Three cheers for markets and democracy, everyone.
And democracy was profitable, too, which is what mattered in the final analysis. This second benefit of continuous-trading came from price discovery. Everyone knew – the non-believers were directed to the “works” of Milton Friedman and Paul Samuelson – that the more frequent the trades in a market, the more transparent and efficient the prices. Naturally then, as these masters and their followers had shown, markets in democracies offered the best price to buyers and sellers. One only had to compare the liquidity and smooth movement of wheat futures prices in the Chicago Board of Trade with the arduous and time-consuming haggling over the price of goats in an Ulan Bator Friday market to be convinced of all self-evident truth.
That capital has a tendency to concentrate – a tendency that was well-known to even laymen as early as the mid 19th Century and the reason for the passage of many anti-trust and anti-monopoly laws – was never considered. It never crossed the minds of the luminaries of finance to examine the meaning of their discovery or put it in the context of the larger economic activities.
I pointed out in Vol. 1 that continuous time finance corresponds to continuous turnover of capital, “a notion so utterly absurd as to be insane.” And added later about continuous-compounding, a logical by-product of continuous-time finance: “Continuous compounding is the vision of a Shylock gone mad.”
Notice the words I used in 1998: mad, absurd, insane.
So, how are things now? What has in point of fact come to pass?
Two short news items will suffice for the answer. The first one pertains to the concentration of capital, from the Financial Times, Jul 29, 2009:
The Tabb Group, a consultancy, recently estimated that high-frequency trading accounts for as much as 73 per cent of the US daily equity volume, up from 30 per cent in 2005. Tabb estimates these players, some of the largest of which are hedge funds such as Citadel, D.E.Shaw and Renaissance Technologies, represent about 2 per cent of the 20,000 or so trading companies operating in the US markets.There you have it: about 75% of the daily equities trading volume in the US is HFT. The order for this trading volume comes from just 2% of all the trading firms.
As for destruction of the market, let us hear it from an insider (Financial Times November 8, 2010):
“Most of the world views our market structure as a joke,” said Larry Leibowitz, chief operating officer at NYSE Euronext... “Our market is too fragmented. The challenge is, how much competition is too much competitions,” he said.I don’t know Larry Leibowitz, but based on 8 words – Larry Leibowitz, chief operating officer at NYSE Euronext – I could write a 10,000 word treatise on him! And so could you. Imagine the number of times he must have been a keynote speaker talking about the merits of entrepreneurship.
Yet, there he is, the COO of an exchange, of all places, criticizing competition, of all things.
Larry, you hypocritical ass, we hardly knew ya!
But of course I am being unfair; too hard on Larry. Competition is the form under which the self-destruction of speculative capital appears to businessmen. That's how it manifests itself and impresses itself upon their minds. (The increasing instances of flagrant contradictions that you see – Tony Blair teaching religious tolerance, for example, or European Socialist government drastically cutting social services – are the result of the inability of businessmen and their minions in the government to comprehend their surroundings. In its advanced stage, speculative capital makes its working difficult to comprehend. For the first time ever, businessman becomes out of his element in the business environment. I will have more to say on this in Vol. 4.)
This doctor calls the patient: “I have good news and bad news.”
“Ok, doc, let’s hear them,” says the patient.
“The good news is that you’ve got 24 hours to live!”
“Gee, doc, is that your good news? Then what’s your bad news?”
“The bad news”, says the doctor, ”is that I forgot to call you yesterday.”
I have good news and bad news for Larry.
The good news is that soon no one will consider the US market structure a joke because everyone will have a similar structure. Everyone will go the way of the Turks and the Istanbul Stock Exchange.
The bad news is that the destruction is still in its early stages. Many markets have yet to be brought into the orbit of the HFT. Only then will the full scale of undoing become apparent. And that will come with the inevitability of night following day. Otherwise speculative capital would not be speculative capital. And that could not be!
I have not yet finished with the subject.