Sunday, 3 April 2011

High Frequency Trading and Flash Crash - Part 7: The Living Dead as the Culmination of Contradictions

In Masnavi, Rumi tells the story of a man with his donkey who checks into a mid-way inn.

In the evening, walking around the inn, the traveler comes across a group in a celebratory mood and joins them. Unbeknownst to him, they are penniless students looking for ways to finance their party. Upon learning of his possession, they scheme to sell the donkey to buy food and drink for the night. The plan is carried out while the students mischievously dance and sing to the rhythm, “donkey is gone, donkey is gone.” The man joins them. They all had a jolly good time.

In the morning, he discovers that his donkey is gone. He grabs the innkeeper and demands damages. “You, so and so, how could you let them sell my donkey without informing me?”

The innkeeper pleads innocence. “Master, I came to inform you but saw you were dancing and singing that ‘the donkey is gone.’ I thought you knew it.”

For those who have been singing efficient markets to the tune of pranksters from Chicago, I have news.

In Part 6, I mentioned that the self-destructiveness of speculative capital should not be interpreted to mean that it is suicidal; speculative capital does not seek to destroy itself. Rather, it destroys the arbitrage opportunities that give rise to it.

What happens to markets in which arbitrage opportunities are destroyed?

The answer is that they become efficient markets. The textbook definition of efficient market is precisely a market in which arbitrage is impossible. Like derivatives, hedge funds, globalization and the rise in market volatility, efficient markets are a manifestation of a force that is speculative capital.

For almost 40 years, as the rise of speculative capital impressed itself ever more vividly upon the uncritical minds of finance professors, the “theory” of Efficient Markets gradually grew to the “theory” of Rational Markets, eventually becoming the official doctrine of finance in the West.

The premise was that the markets worked themselves towards a state in which everything was in equilibrium – supply and demand, buyers and sellers, bid and asked prices. In these markets, all the information was reflected in prices and no one had an advantage over others. What is more, everyone could buy or sell with ease, quickly, and with minimum expense. Naturally, these markets did not permit arbitrage because arbitrage arose from price discrepancies. The rational markets were, by definition, free of such impurities.

What is more, this state of efficiency came from the working of the markets themselves and without any outside interference. It followed, then, that the longer and harder markets worked, the faster they became efficient. Hence, the critical role of continuous-time trading. The incessant, round-the-clock trading appeared as the logical means for taking society to this financial Nirvana.

In Vol. 1, I commented on this world view and pointed out that a system in equilibrium is a dead system. That was a theoretical statement. Thirteen years later, we have the evidence before us in the form of the U.S. equities markets. Tony Jackson of Financial Times in paper’s December 12, 2010 issue, under the heading, Behaviour of equity markets poses fundamental questions:
What are the equity markets for these days? In the developed world, at any rate, they no longer seem trusted as a store of value or a source of income. Nor are they much use at providing capital to businesses, which should be their primary function.

The quality of information they provide is, meanwhile, deteriorating.

Daily index movements are often a by-product of larger external forces. Individual stock prices tell us little, since they move in lock-step. And volume is meaningless, since may be half of it now consists of information-free “flash” trading.
So it has come to this, that the premier financial newspaper covering the markets questions whether the equity markets have any purpose at all.

Could it be that the high-frequency trading firms have rigged the game, destroying the market just to make themselves rich?

The answer is No. They, too, are struggling. In 2009, the Dutch HFT firm Optiver with 600 employees made a puny €6.3 million profit. And recall from Part 6 that the average trading profit of HFT firms is rather low; 26 largest HFT firms, trading over $30 trillion stocks annually, made a relatively modest combined $3bn a year.

One constant drag on the profit of HFT firms is the high cost of upkeep of software and hardware; they must be constantly upgraded to match the capabilities of the rivals who are engaged in the same “arms race.”

What gives, then? Why all the activity and hassle – billions of transactions a day, hundreds of millions a year in system upgrades and programming – only to generate very little profit and, in the process, harm the system to the point that it is raison d’ĂȘtre is questioned?

The answer is that that is the way markets exist under the dominance of speculative capital.

Let me elaborate.

When I speak of destruction in relation with speculative capital, the word is liable to conjure up images of physical destruction because that is what a modern citizen of the world is conditioned to imagine; that’s all he sees on TV.

Physical destruction has finality. It brings the physical aspect of the story to an end. A beach is destroyed by the sea and that is the end of the story.

Social systems are different. A social system is destroyed only when it is replaced.

Speculative capital destroys the markets by replacing their traditional set-up by one tailor-made for its own purpose.

The destruction is set in motion with the intrusion of speculative capital into a market in search of arbitrage opportunities. Speculative capital brings in trading volume and commissions, so markets are eager to accommodate it; recall the Istanbul Stock Exchange’s concessions to FH traders from Part 5.

After the market is thus “opened up”, there is no going back, even after the arbitrage opportunities are grazed. The market – now “efficient” precisely because it cannot be arbitraged – becomes conduit for the movement and expansion of speculative capital to other segments and markets. And unlike the traveler’s donkey, it does not go away. It stays put.

The critical point to bear in mind in all this is that the changes taking place on behest of speculative capital facilitate the movement of speculative capital. That is their primary purpose. To the extent that there are other effects, those effects are secondary. So, the U.S. equities markets in which specialists were responsible for market-making being replaced by HFT firms in which no one is in charge, is a mere by-product of changes taking place at the service of speculative capital. If the changes prove harmful to social institutions – and they must be harmful, as I show in Vol. 4 – that is regrettable but understandable. Markets are messy and stuff happens, which is why we have a modern expression like collateral damage. You know how the argument goes.

So, “people” are not a part of speculative capital’s calculus. People facilitate and bring about the changes demanded by speculative capital; as a thing speculative capital cannot change laws, place trades or initiate mergers between the exchanges. In spearheading these activities, people are compelled to serve the interests of speculative capital. Compelled, because how many exchange executives do you suppose could turn down the prospect of higher trading volume and more commissions? And how long would they last if they did?

In this way, people become the agents of speculative capital. “Speculative capital becomes the grammatical subject of the sentence as if it were alive”, I wrote years ago.

We have a peculiar condition in front of us, then: a dead market, in the sense that it no longer serves any purpose, being maintained by feverish activity – not respectful and measured, even if expensive, activity, as with the Pyramids, but feverish, high-tension activity of HF traders.

But the dead do not require feverish activities to stay dead. That is the province of the living.

Exactly!

The U.S. equities market under HF trading has become a living dead – that stuff of Hollywood B-movies. Please do not be dispirited by the contradiction. I wrote about it more than two years ago. Things have merely intensified.

The evidence on both sides is incontrovertible.

The market is dead because it cannot be trusted as a source of value or income, it cannot provide capital to businesses, individual stock prices move in reaction to the broader index, etc., etc. The list is a legion. You saw the indictment above.

Yet, the market is also living because it is capable of inflicting real damage on itself and others by inducing flash crash.