The Grand Illusion
I recently discovered that the cable company Hibernia Atlantic is spending $300 million to construct and lay a new transatlantic cable between London and New York [New Scientist, 1 October]. Why? In order to cut 6 milliseconds from the 65 millisecond transit time in order to get more investment trading firms to use their cable. For 6 milliseconds? That’s apparently a comparative age when computers can execute millions of instructions in a microsecond, and London traders must think that those 6 milliseconds will make a significant difference in the prices paid and/or received.
And they may well. Along the same lines, a broker acquaintance of mine pointed out that New York City real estate closest to the New York Stock Exchange computers commands exorbitant rents and prices for exactly the same reason… but I find the whole idea totally appalling – not so much an additional data cable, but the rationale for its use. Human beings can’t process much of anything in 6 milliseconds so that the speed advantage is only useful to computers using trading algorithms. As I’ve noted earlier, the use of programmed and computer trading has led to a shift in the rationale behind trading to almost total reliance on technical patterns, which, in turn, has led to increased volatility in trading. Faster algorithmic trading can only increase that volatility, and, regardless of those who deny it, can also only increase the possibility of yet another “flash crash” like that of May 2010, and, even if the new “circuit-breakers”cut in and work as designed, the results will still disrupt trading significantly and likely penalize the minority of traders without superspeed computers.
Philosophically speaking, the support for building such a cable also reinforces the existing and continually growing reliance on maximizing short-term profits and minimizing longer-term concerns, as if we don’t already have a society that isn’t excessively short-term. You might even call it the institutionalization of business thrill-seeking and attention-deficit-disorder. This millisecond counts; what happens next year isn’t my concern. Let my kids or grandkids worry about what happens in ten or twenty years.
And one of the problems is that this culture is so institutionalized that any executive who questions it essentially destroys his or her future. All you have to do is look at those who did before the last meltdown.
Yes, the same geniuses who pioneered such great innovations as no-credentials-check-mortgages, misleadingly “guaranteed” securitized mortgages, banking deregulation, fees-for-everything-banking, and million dollar bonuses for crashing the economy are now going to spend a mere hundreds of millions to find another way to take advantage of their competitors… without a single thought about the implications and ramifications.
Isn’t the free market wonderful?
If I know gold is going up 6ms before everyone else, I can buy some from someone else at a lower price. Then I can turn around and sell it for the price I knew it would reach. The same applies when it goes down, so I make money either way. So yes, there’s a clear competitive advantage if I’m dealing in a large number of commodities.
Some bankers do think about the implications and ramifications of their work. But as you point out, you either have a job or you don’t. And with large student loans to repay, many of them really don’t have that much of a choice.
If you want to stop it, you need regulation to make many of the things you decry to be illegal. You need proper enforcement of those regulations, ensuring individual punishment (jail time, not a fine). You need to break the banks up so that they aren’t too big to fail. You need to stop the influence of money on politics/government. And you probably need to get rid of student loans. Or, we could just ban usury (making money off money) as we used to, although that probably now also means banning capitalism.
Or… we could just place far higher taxes on extremely short-term capital gains, and disallow capital losses on securities held less than, say, a month. That way, you don’t ban anything, but you force the short-term traders to pay a higher price for the effects of their “greed.”
Just disallow the capital losses. That too provides revenue by decreasing write-offs (although the problem is too much spending, not a lack of revenue; so I’m opposed to almost any increase in revenue unless it’s offset by a decrease somewhere else; I want to see massive spending cuts, instead – even the the point of affecting things I’d rather not see cut, like NASA and DoD). And by taking away the write-off for short-term losses without punitively taxing short-term gains, rather than discouraging short-term holding entirely, you still let the money be mobile (not entirely a bad thing in a number of ways) while at the same time increase the risk of making losing choices. Maybe it makes sense to allow an actual gambler to write off losses up to the amount of their winnings, but it makes no sense to allow an _investor_ to write off short-term losses. Since most short-term trades are probably either made by amateurs that are in effect addicts, or by fund traders, that should be enough to discourage the promotion of amateur short-term trading (which is nearly a con anyway, most people would lose their shirt given the fees), and would put pressure on the funds to be more careful.
Even if one flat out banned holding something for less than some minimum period of time, all it would do is cause the automated trading to be rewritten; because whenever the trade would be legal and profitable or in a some situations would at least minimize loss, the advantage would still remain with something that can react faster than any mere human.
What might interest me more would be something that would ensure a reasonable diversity of automated trading programs, so that somewhat as with human traders, you’d have some variation of cutoffs and priorities of action and so on, so that not everything would be doing exactly the same thing at the same time. I think that the problem with automated trading is not so much the short-term aspect as it is that it acts as an amplifier of relatively few individual strategies, rather than as a spread of thousands or millions of different but not entirely dissimilar strategies (there being some bounds within which all reasonable strategies would tend to fall). To some extent I would suppose that competition achieves that. But funds already reduce massively the number of strategies in play, pooling thousands or millions of individual investors behind the strategy of a single individual or a very small group. Under absolutely no circumstances should two funds use the same parameters and algorithms for automated trading; and if automation-assisted individual trades offer tools, they should only offer very broad don’t-lose-your-shirt settings as a default, and leave the rest up to the individual to select, even if in simple mode only via a few fine-grained selections. Four settings each with 256 values possible multiplies out to over four billion slightly different behaviors; perhaps enough to help buffer the shock effect of automated trading.
Short-term isn’t good because the connection between investment and productive use of invested funds breaks down (although some short term is perhaps useful as an indicator). But that’s really a very different problem than the reduced diversity of strategies due to either funds or automated trading.
Placing far taxes on extremely short-term capital gains, and disallowing capital losses on securities held less than, say, a month would reduce high frequency trading. It might also affect the liquidity of the markets, making people less willing to hold certain kinds of assets because they would fear not being able to sell them, thereby reducing those assets’ value.
It would not affect the subprime mortgage problem that caused the recession: the derivatives were bought by pension funds since they were “AAA”. Nor would it affect the fact governments bailed out the debts of the banks, and are now having their own sovereign debt crises. Nor would it affect the fact banks control most of the transnationals, and therefore can bully politicians into helping them, while creating market panics.
So no, taxing extremely short-term gains does not solve the problem, only part of it.
You have a source on that “derivatives…since they were ‘AAA'”? I can’t understand how a derivative can be better than that from which it derived, and loans made on the premise that requiring ability to pay under less than ideal conditions should be abandoned as discriminatory, cannot possibly be AAA in any sane world.
There’s lots of blame to go around. The lack of separation between banks and investment houses has to have encouraged this, as well as the long-time emphasis on short term profits to the neglect of long-term stability. But both regulations passed and repealed, and pressures to engage in less than sensible behavior, that led to this, are on the government. The private side simply does what it can under the prevailing conditions, if sometimes with a willful blindness to consequences.
Re: “AAA” derivatives. Yes, they are called CDOs and pension funds were not allowed to invest in anything but AAA securities. Google “CDO AAA pension”. Eg:
http://en.wikipedia.org/wiki/High-yield_debt
http://www.investopedia.com/articles/07/subprime-overview.asp#axzz1bwvtlEv5
The trick is simple. Buy tons of low quality mortgages. Bundle them up into an “investment vehicle”, otherwise known as a debt which is associated with a bunch of people paying interest. Investors buy this debt to collect the interest the debtors will be paying each month. Split the investment vehicle into tranches. Every month you get a chunk of cash from the debtors. You pay people who invested in the first tranche first. They are most likely to get paid, but get a lower rate of return since the investment is less risky. Investors in the second tranche get paid if anything is left from the first tranche (and get a higher rate of return since they took more risk), and so on. Now the “magic of wall street”: ASSUME the debtors are INDEPENDENT — the likelihood of one defaulting on his mortgage does not affect the likelihood of another defaulting on his mortgage. If you do this, you can always divide up the investment vehicles such that the first tranche has a very low probability of default. So low that it qualifies as a AAA investment that can be sold to a pension fund.
The problem is … obviously … that the probability of debtors defaulting is NOT independent. A recession, mass unemployment, foreclosures and people underwater with their mortgages makes many debtors default simultaneously. Doh!
You are correct that lack of enforcement and repeal of regulation is to blame. BUT the reason for that lack of enforcement is regulatory capture in some form or another. If I want to be elected, I need corporate contributions, so I don’t anger my corporate donors. If I’m a bright student I can go work for Wall Street and make money or I can go to the SEC, not make any money and be frustrated… but if I’m not too bright I have a job waiting for me at the SEC. So when the SEC tries to regulate industry, they find it hard to understand the math the investment bankers are throwing at them. If I am at the SEC and I make no enemies, I may get a nice job in Wall Street later as recompense for helping out. Etc, etc, etc. Thinking the problem is government or corporations makes no sense. Corporations cannot exist without government to enforce contracts, and protect them. But Government is effectively more beholden to corporations than to the people — for instance check how many laws are written by lobbyists. The problem is Government AND Corporations, not one or the other.
Here is an amusing example. GM lobbies against the US increasing fuel efficiency standards for cars. It’s cheaper than doing the research and developing new cars. Toyota also lobbies against the US increasing fuel efficiency standards for cars, although it has already done the research and sells the most fuel efficient cars. Why does Toyota do this? Because it knows that if GM were to be forced to make fuel efficient cars, Toyota would lose a competitive advantage in the US and in Europe. Regulations are made, not for the benefit of the US population or US national security, but for the competitive needs of corporations or of the very rich. And many politicians are cheap investments ($25k here, $25k there versus millions of dollars worth of R&D).
FWIW, GM actually does make some cars that are (for their category) fuel efficient. The LS-1 engine and successors are a rather impressive small-block V8; my ’02 Trans Am could exceed 160MPH if my nerves could, but at more reasonable speeds gets nearly 30MPG highway. In sixth gear at sleepy speeds like 55MPH, it’s little more than idling.
I see the lobbying a little differently. If I were running a business, I wouldn’t want to be told anything more than to be honest with my customers; _if_ I choose to have my products evaluated, have them evaluated according to standards and make no substantive claims about the product that can’t be backed up. That’s it. Don’t tell me whether to put money into safety vs fuel economy vs profits vs paying off smelly unions vs anything else. Seller be honest, buyer beware. The moment you tell me how to run my business, I’ll be telling you to tell me only what I want to do anyway…and probably to do worse to my competitors. Self-defense, pure and simple. To minimize lobbying, minimize anything worth lobbying _for_: regulations, government contracts, tax breaks OR shelter from punitive taxes, etc. A _few_ (compared to what we have) regulations and government contracts are necessary; using the tax system to reward or discourage behavior is not. _Everything_ has unintended consequences. The least intervention will have the least of those, and the most obvious. What brings politicians down? Not the shady things they do, but the cover-up. Do as little as possible, and do it as transparently as possible.
ALL power over others is evil. But those who offer to solve every problem are the worst. Those who at least _know_ that their use of power is also evil and seek to do the least harm with it, should be re-elected, once. The rest should never be elected at all.
(note: it’d be a cold day before I’d run a business, esp. in a climate where the paperwork will eat you alive. I want to be making something or fixing something, I don’t want to be jumping through hoops for idiots that never made anything other than obstacles in their lives, and I’m not sure that I want to spend too much time dealing with customers many of which aren’t that much better than the politicians.)
@R.Hamilton: The point of regulations is to define and enforce “be honest”.
I’ve found this week’s developments in Greece to be fascinating as it shows again that the mechanism (short term capital gains) is not the issue.
As long as politicians and banks only consider their short term interests, this will continue. In the case of Greece, 40% of the assets of some German and French banks are tied up in Greek debt. The French and German banks obviously didn’t want to lose that money and put pressure on their governments to bail Greece out. However, it turns out that 4 times that amount is guaranteed by Credit Default Swaps (the things that brought AIG down). No European bank other than Barclays and Deutsche Bank would issue such CDSs… the risk is too high. No it was the largest banks (mostly US banks + Barclays + Deutsche Bank) that did because they thought they could twist their governments’ arms to force Greece not to default. And guess what, they were right. The “voluntary 50% haircut” rather than an enforced “50% haircut” was the result of mainly US pressure.
Democracy is clearly secondary as has been shown by the George Papandreou’s withdrawn referendum. The referendum made sense politically: ask people whether they want to stay in the Euro and suffer another decade or two of austerity/privatisation of public assets OR whether they want to leave. If they choose to stay, they shut up and go back to work. If they choose to leave, they suffer a massive devaluation, but may eventually dig themselves out of it like Iceland which defaulted and is now doing much better. Either way it reduces the likelihood of social disintegration or a military coup (the last military dictatorship in Greece was in 1976). But George Papandreou has been forced to withdraw this idea and the bankers have won again. So much for democracy.
It’s quite clear that democracy will always lose against too-big-to-fails. So we either break up the banks or we revert to a new feudalism.
For those that are interested please check out the link below to a TED talk I found fascinating on the same topic as LEM’s comments.
http://www.ted.com/talks/kevin_slavin_how_algorithms_shape_our_world.html
Well said.
As a slightly ironic corrollary to your last point:
In the UK, a recent investigation into lobbying and special interest groups was postponed until 2013 – after intensive lobbying.