Tag: trading


By James Kwak

One of the criticism’s of Michael Lewis’s book is that he gets his moral wrong. High-frequency trading doesn’t hurt the little guy, as Lewis claims; instead, it hurts the big guy. The explanation is this: people sitting at their desks buying 100 shares of Apple are getting the current ask, so mainly they care about volume and tight bid-ask spreads. Institutional investors, buy contrast, want to buy and sell huge blocks of shares, and they don’t want the price to move in the process; they are the ones being front-run by the HFTs. Felix Salmon pointed this out, and it’s the subject of an op-ed by Philip Delves Broughton today.

What this leaves out is the question of who ends up being harmed. To figure that out, you have to ask whose money we’re talking about when we say “institutional investor.” If it’s SAC Capital, meaning Steven Cohen’s money, then who cares? But most ordinary people invest—if they are lucky enough to have money to invest—through mutual funds (401(k) plans, for example, are largely invested in mutual funds), and those funds are among the “institutional investors” losing money to HFTs. Another big chunk of institutional money belongs to pension funds. In this case, if the pension fund does poorly, the money may come out of its corporate sponsor in the form of increased contributions—or it may come out of beneficiaries and taxpayers in the form of a bankrupt plan shifting its obligations to the PBGC. Then there are insurance companies: in that case, losses from trading affect shareholders, but if they are systemic across the industry they end up as higher premiums for consumers.

This is not to say that the institutional investors are warm and cuddly and are just passive victims in all of this. I’ve spilled enough ink inveighing against active asset managers, and Salmon points out that the buy side bears its share of blame for being careless with other people’s money. At the end of the day, if HFT harms other people in the markets, it’s just a fraternal spat among capital, and doesn’t affect the fundamental divide in the post-Piketty world. Until a poorly-tested algorithm goes berserk and freezes the financial system, that is.

Random Variation

By James Kwak

As I previously wrote on this blog, one of my professors at Yale, Ian Ayres, asked his class on empirical law and economics if we could think of any issue on which we had changed our mind because of an empirical study. For most people, it’s hard. We like to think that we form our views based on evidence, but in fact we view the evidence selectively to confirm our preexisting views.

I used to believe that no one could beat the market: in other words, that anyone who did beat the market was solely the beneficiary of random variation (a winner in Burton Malkiel’s coin-tossing tournament). I no longer believe this. I’ve seen too many studies that indicate that the distribution of risk-adjusted returns cannot be explained by dumb luck alone; most of the unexplained outcomes are at the negative end of the distribution, but there are also too many at the positive end. Besides, it makes sense: the idea that markets perfectly incorporate all available information sounds too much like magic to be true.

But that doesn’t mean that everyone who beats the market is actually good at what he does, even if that person gets a $100 million annual bonus. That person would be Andy Hall, the commodities trader who stirred up controversy when he apparently earned a $100 million bonus at Citigroup—in 2008, of all years. (That was a year with huge volatility in the commodities markets.)

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“Telling a lie does not make you guilty of a federal crime”

By James Kwak

That’s what Jesse Litvak’s lawyer said at the start of his trial earlier today. And technically speaking, it’s true. If you’re trying to sell a bond to a client, and during the course of the conversation you say you can bench press 250 pounds when you can only bench 150, that’s not a federal crime. But if you lie about a material aspect of the bond and the client relies on your lie in buying the bond, that’s another story.

Litvak’s case is (barely) in the news because it has a financial crisis connection; some of the buy-side clients he is alleged to have defrauded were investment funds financed by the infamous Public-Private Investment Program (PPIP) set up in 2009 using TARP money, and hence one of the counts against Litvak is TARP-related fraud. But it bears on a much more widespread, and much more important feature of over-the-counter (OTC) securities markets.

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Masters or Trend-Followers of the Universe?

By James Kwak

There is an image that underlies the theory of efficient markets. The image is of a pack of hyper-intelligent, hyper-competitive, voracious traders (working at hedge funds, at bank prop trading desks, in their basements, whatever), relentless scouring the markets for pricing inefficiencies and pouncing on them, trading them out of existence before moving on to the next one. The archetype is the quantitative trading desk at Salomon Brothers in the late 1980s, led by John Meriweather, exploiting arbitrage opportunities between on-the-run and off-the-run Treasury bonds. In finance theory, these sharks are contrasted with the “noise traders” who don’t know what they’re doing, and the question is whether the noise traders are enough to upset market efficiency.

But how good are the sharks anyway? That’s the question that came to my mind on reading the Economist‘s summary of a paper by Lauren Cohen, Christopher Malloy, and Karl Diether on stock market responses to legislation affecting specific industries. They found that you could make money by buying stocks of companies likely to be helped by new bills, and you could identify those companies from the voting records of senators and the incidence of keywords in the bill text.

“The mystery,” according to the Economist, “is why the broader market is so slow to recognise the effect of legislation.” That’s the classic way of thinking about the problem. Shouldn’t the hedges have figured this out already? But this isn’t the only case. A recent column by Lucian Bebchuk reminded me of another example: Up until the 1990s, you could have made money by buying stocks of companies with good corporate governance practices and shorting those of companies with poor practices.

These are patterns that were discovered by academics, who have limited research budgets and little financial incentive involved. (Academic prestige counts for something, but, according to theory at least, not as much as the billions of dollars in fees brought in by top hedge funds.) How come they were discovered by Bridgewater and Renaissance and all of those guys who have huge piles of money to invest in research?

One possibility is that Renaissance has discovered this and other trading strategies and has figured out a way to milk them without making the arbitrage opportunity go away entirely. The other possibility is that the sharks really aren’t so terrifying and ruthless as popularly believed, and instead they just stumble around copying each other to try to reduce their variance from the competition.

Or more likely it’s some combination of the two. A handful of firms come up with their own superior trading strategies, but most simply copy whatever they hear other people are doing. That’s why the corporate governance anomaly seems to have been traded away, and why everyone is doing high-frequency trading these days. The problem is that most investors’ money is going to the followers, which is why they are getting low returns and high costs. But it’s good for the entire industry that laypeople are in such undeserved awe of hedge fund managers as a class.

When It Pays To Be Wrong

By James Kwak

Last week I wrote an Atlantic column about the fundamental reasons why big banks are always screwing up. In particular, given the effects of leverage and the short-term incentive structure, it pays to have lousy risk management systems, and it pays for frontline traders to evade those systems—even for the CEO, in the short term.

Today the Wall Street Journal reports evidence that the London Whale was told by his boss to boost the valuations of his trades; according to inside sources, “the favorable valuations might have been aimed at giving the losing trades time to recover and avoid setting off potential alarms at the bank.”

This is clear evidence for the too big to manage hypothesis: not only traders but heads of trading desks manipulating marks to take risks that the bank as a whole might crack down on. But we’ve known for decades that rogue traders (Nick Leeson, Jérôme Kerviel) are out there. The question is why bank managers don’t do a better job putting in place systems and processes to detect them. The most plausible answer is that they don’t want to because, in the short term, they have the exact same incentives as those traders: they like the risk and the higher expected returns it generates. It’s only when things blow up that they act all shocked.

Pack of Fools

By James Kwak

“I thought that I was writing a period piece about the 1980s in America, when a great nation lost its financial mind. I expected readers of the future would be appalled that, back in 1986, the CEO of Salomon Brothers, John Gutfreund, was paid $3.1 million as he ran the business into the ground. . . . I expected them to be shocked that, once upon a time on Wall Street, the CEOs had only the vaguest idea of the complicated risks their bond traders were running.

“And that’s pretty much how I imagined it; what I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, ‘How quaint.'”

That’s Michael Lewis in The Big Short (p. xiv), looking back on Liar’s Poker.

“Looking back, however, Salomon seems so . . . small. When the Business Week story was written, it had $68 billion in assets and $2.8 billion in shareholders’ equity. It expected to earn $1.1 billion in operating profits for all of 1985. The next year, Gutfreund earned $3.2 million. At the time, those numbers seemed extravagant. Today? Not so much.”

That’s the third paragraph of Chapter 3 of 13 Bankers. (This was a complete coincidence; I didn’t see The Big Short until it came out, and I have no reason to think that Lewis saw a draft of our book.)

I actually did not rush out to buy The Big Short, even though Michael Lewis is a great storyteller. I figured I knew the story already; Gregory Zuckerman’s The Greatest Trade Ever covered some of the same ground and some of the same characters, and I already knew plenty about CDOs, credit default swaps, and synthetic CDOs. But I’m very glad I read it, and not just because it’s a fun read.

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Radio Stories

I spend a lot of time in the car driving to and from school, so I end up listening to a lot of podcasts (mainly This American Life, Radio Lab, Fresh Air, and Planet Money). I was catching up recently and wanted to point out a few highlights.

Last week on Fresh Air, Terry Gross interviewed Scott Patterson, author of The Quants, and Ed Thorp, mathematician,  inventor of blackjack card counting (or, at least, the first person to publish his methods), and, according to the book, also the inventor of the market-neutral hedge fund. These are some of Thorp’s comments (around 24:20):

“As far as you can tell now, how are quants being used on Wall Street? Are these mathematical models being relied on as heavily now after the stock market crash as they were before?”

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Who Should Hide Behind the Regulatory Shield?

This guest post was contributed by Ilya Podolyako, a recent graduate of the Yale Law School, where he was co-chair of the Progressive Law and Economic Policy reading group with James Kwak.

The development of the news coverage of high-frequency trading has been quite interesting. The story started out with a criminal complaint that Goldman Sachs lodged against Sergey Aleynikov, a former employee who allegedly stole some secret computer code from the Goldman network before departing for a new job in Chicago. Incidentally, Mr. Aleynikov appeared to be headed to Teza Technologies, a company recently started by Mikhail Malyshev, who had previously been in charge of high frequency and algorithmic trading at Citadel, a Chicago-based hybrid fund. Immediately after the report leaked, Citadel began investigating Mr. Malyshev’s departure and filed a lawsuit to prevent him from getting his nascent business off the ground. From these facts, some reporters inferred that the surprisingly public maneuvers of two notoriously secretive finance giants vis-à-vis seemingly routine personnel matters showed that Aleynikov had tapped into the gold mine of precious proprietary trading software.

That was two weeks ago. At this point, the story has crescendoed. The New York Times ran a report on high frequency trading. The Economist published a piece on the same topic. Senator Schumer (D-NY) requested that the SEC investigate the matter and the agency acquiesced.

The cynical perspective on these events is that both Schumer’s and Mary Schapiro’s moves with respect to algorithmic trading show that the issue is a red herring. As the argument goes, neither of these actors would touch the practice if it actually underpinned Goldman’s record profits or Citadel’s outstanding performance in 2004-2006. If, however, banning the practice would eliminate a few small hedge funds and create the appearance of revising market frameworks without threatening the big players (a regulatory brush fire of sorts), high-frequency trading would form the perfect political target.

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