The paradox of efficiency - Robot trading

High Frequency Trading strategies which use robots to trade is the result of a process of financial development and its quest for efficiency. But we begin to see the limits of this development which lead sometimes to contradictions, such as the "Hathaway effect”. The theory is still to be proven, but the bluntly put (from the FT):

if Ms Hathaway is in the news, Warren Buffett’s Berkshire Hathaway stock jumps too.

Mr Mirvish, the blogger who spotted the trend

pointed the finger at confused robotraders – the complex algorithms that execute 70 per cent of stock trades, sometimes by scanning news stories for trends.

A tale of two trials

The trial of Raj Rajaratnam, a billionaire hedge fund manager, for insider-trading has just begun. This trial strike at the heart of corporate America, for Rajaratnam was getting information from a managing director of McKinsey, Anil Kumar. As if finance, and especially hedge funds - the villain of financial sectors in the eyes of the public - needed more bad publicity to hit rock bottom. 

Zingales thinks that for the industry to avoid being associated with the growing list of rogue traders, legitimate hedge funds should proactively disclose their past trades that are at least two years old. That suggestion prompted a reply from Stone Street Advisors, invoking hedge funds's "trade secrets" to argue that Zingales should get out of his office a bit more. I think the interesting point is that trading strategies, which HF fear could be reverse engineer, are elaborated in the perpetual quest of some kind of modern philosophical stone: the Alfa. Patterson's book on Quants gives a good account of that quest and its sociological underpinning. That being said, I think the bottom line is that some think it's naive to expect disclosure from hedge funds, because HF view their trading strategies as intellectual property.  It would be akin to ask pharmaceutical companies to be allow generic drug. Which they do ! and the period of time protecting their Intellectual Property (IP) cannot enter the line of arguments, because, as Zingales reminds us, the life of most trading strategies is very short.  The IP card cannot be played here. The benefit of invention, a common good, is usually the rational to protect, temporarily, Intellectual Property. So after all, so what ? if other investors can reverse engineer strategies that are more than two year old. It is not like everybody has benefited of the marvelous inventions of financial engineering.

The other trial ended up in a ruling of the German Federal Court of Justice against Deutsche Bank and in favor of Ille Papier-Service. 24 pending cases are still to come. The Court considered the structured product which took a bet on interested-rate spread - with 4 % of commission in it - sold by DB to that company as inappropriate. The complexity of these products and the trials that follow highlight a fundamental question: who are the financial sectors to serve (or to screw) ? SME's don't (and shouldn't) have the necessary financial literacy to fully understand these financial products, whose structures are so complex that it can hide large commissions and make their market value so hard to establish, that we begin to see intermediaries appearing between issuers such as DB and customer. It seems financial engineering has not been beneficial to SME's either.

"Markets like totalitarian regimes"

Said Blackrock's Larry Fink who manages over $3 trillion, the world's biggest asset manager. This is the perfect example of a view that dismisses institutions and are bound to see totalitarian regimes as the only answer to confusion and uncertainty.

Because, yes, markets don't like confusion and uncertainty, but concluding that, therefore, markets like totalitarian governments, is firstly, logically incorrect, secondly, missing an entire world of social technologies to cope with uncertainty. 

And to quote, Mike Krieger: "Even if markets did like totalitarian governments, HUMANS DON'T".

London Vs Geneva

Regulation is not always what counts most.

What is Wall Street for ?

Felix Salmon looks at the falling number of publicly listed companies on US major domestic exchanges and sees a dangerous trend eventually leading to make stock markets irrelevant for the economy.

Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money.

This echoes an old debate about whether bank-based or market-based systems allocate capital more efficiently and one that should be revisited in the light of these past decades' financial innovation and its consequences.

 

The persistence of habits and stock exchange mergers

The Deutsche Börse and the NYSE/Euronext are negotiating a merger. The Economist noted a paradox which shows that it is hard to overcome differences in regulatory practices and that social structures of financial markets are not easily wiped off:

The reality is that the exchange business is unusually unglobal. Securities and derivatives are traded, by and large, in long-standing silos, with their own regulations, laws, working hours and critical mass of big, savvy market participants, who may not all be based in the same country but who share the same rules of engagement. Even if practical, the utility of being able to trade everything, everywhere, all the time is not clear.

The complexity of stock markets

The Nasdaq has been hacked. First the flash crash and now this: 

Hackers have repeatedly penetrated the computer network of the company that runs the Nasdaq Stock Market during the past year, and federal investigators are trying to identify the perpetrators and their purpose, according to people familiar with the matter.

Tyler Durden takes a retrospective look at its recent development and conclude that this stock market is nothing but a "daylight fraud":

The one exchange to first legalize frontrunning aka Flash Trading, to actively promote churning via HFT erection-inducing liquidity rebates in stocks and options, to create novel and ingenious ways to skirt Rule 611, and, most recently, to overtake the NYSE as host for greatest number of fraudulent Chinese reverse-mergers, the Nasdaq has never kept a secret that it cares far more about its clients than the investing public.

This shows just how critical and complex financial markets have become. They are viewed by officials as part of the basic infrastructure, like power companies or air-traffic-control operations. On the other hand, the SEC does not have the budget to regulate it like it should be (which does not excuse its staff downloading midget-porn). And wait, if stock markets like the Nasdaq are of strategic importance,  then the debate about how to regulate it should be viewed in this light as well. It boils down to how to manage complex financial system - algo trades and HFT are under scrutiny - so that investors and the public do not begin to think financial systems are big ponzi schemes.