Simple Truths about High Frequency Trading

The interest in High Frequency Trading, of HFT for short, comes from how it combines finance, technology and secrecy. The press around the subject has increased dramatically as Michael Lewis has been promoting his new book on the topic, Flash Boys.  A chapter appeared in the NYTimes that is well worth the read. Discussions around the issue made CNBC's daytime market coverage look very similar to Fox News (because of the yelling and screaming, not because of any right wing agenda).  In the midst of this uproar, the high frequency trading firm Virtu has delayed their IPO.

Michael Lewis is a good author, but he likes to tell narrative stories with good guys and bad guys. And as Tyler Cowen once said, "As a simple rule of thumb, just imagine every time you’re telling a good vs. evil story, you’re basically lowering your IQ by ten points or more."  So without getting into some of the more esoteric details, what's really going on?

1. The market has always needed intermediaries, the people who help connect buyers and sellers when they don't want to buy and sell at exactly the same time. These intermediaries need to make money. Without some money being paid to liquidity providers there will be no liquidity.

2. As floor traders have been replaced by computers running algorithms, spreads have narrowed. Investors spend significantly less money getting into and out of positions compared to 10 or 15 years ago.

3. HFT firms attempt to front run large traders. Any market intermediary needs to try to get out of the way of big buyers after the shares they have offered to buy or sell have been taken because if they didn't they would go out of business very quickly. But HFT set ups allow them to pretend there is are more shares available to be bought or sold in the market than there actually is which can be quite frustrating for those trying to execute large trades.

4. Googling "backing away" shows that intermediaries have been causing issues well before they consisted of the population labelled as "high frequency traders".

5. The ones losing the most money from high frequency traders are those attempting to trade large amounts of stock on the market. These are institutions such as mutual funds, pension funds and hedge funds.

6. While the situation remains annoying to institutions, HFT volumes and profits have actually been falling over the past few years. 

Wall Street rips people off all the time, but there seems to be more of an outrage when the people making money are outsiders and the people losing money are closer to being insiders. 

HFT firms have been the best customers of many of the exchanges - they pay high fees to get their servers situated next to the exchange and provide large amounts of volume to the exchange. In an effort to increase their profits from HFT traders many of the exchanges have implemented some trading rules that benefit HFTs at the expense of other traders on the exchange. Michael Lewis's story explains how some large institutional traders have figured out how they are being taken advantage of and are turning to people such as the IEX Group (The "good guys" in his book) in order to trade without having to worry about people gaming the system. 

Exchanges are going to have to reevaluate their own systems and make them more favorable to institutions that engage in relatively simplistic trading if they want to be profitable in the long run. (Part of this also involves setting up incentives for market makers which reduce the probability of future flash crashes, but that's a much more complicated subject).

If you are a retail investor, the hubbub over HFT shouldn't matter that much to you. You are getting better execution than you ever did under a system managed by human market makers. HFT traders are small parasites that have outcompeted bigger parasites. Overall they've been a net benefit to the ecosystem.  

And it is worth keeping in mind that the impact of HFT firms is small compared to other financial players. The only surprising thing about revelations that many large banks have been manipulating numbers they trade in both the interest rate and foreign exchange markets is that they finally got caught. And the additional 0.1% market impact that HFT firms might cause on large trades is very small when compared to the 5.1% average commission that Real Estate brokers take in on every transaction they make.  The HFT story is smaller than it looks. 

Thoughts on Current Events

Facebook continues shopping with its overvalued stock: 

Facebook most recently bought Oculus Rift. The key here is that the purchase of both WhatsApp and Oculus Rift only make sense if Facebook plans on eventually ignoring the wishes of the founders. WhatsApp founders don't want ads and Oculus Rift founders don't want Facebook integration. It doesn't have to happen now, but if Facebook doesn't decide to spin out those companies then in three to five years there is no way that Facebook integration and ads aren't on both of those products.  Facebook is an important stock to watch, as any long term underperformance would be a strong signal that investors are falling out of love with tech.

Corrupt US Politicians:

 Leland Yee, the Californian State Senator who was in the running to be California's next Secretary of State, is really corrupt. The surprising part about the corruption is the small scale nature of it. Campaign debt of less than $75,000 was apparently enough to get him to participate in a gun running scheme. This might have been the tip of the iceberg and he could have been making a lot more money, but if corruption occurs for such low amounts of money then this is one of the best arguments for libertarianism I've seen in a long time. Corrupt politicians do less damage when they have less power.

Putin and Crimea:

The interesting thing about Russia's takeover of Crimea is that given Crimea's history and large russian population, Russia could have taken it back without force if they wanted to. One way to interpret this situation is that when their puppet, Viktor Yanukovych, got overthrown Putin wanted to make a statement. Others say that Putin is creating an "us versus them" situation to distract from the corruption that is being revealed about the set up for the Sochi Olympics. However, given that both Russia and the rest of the world would face short term pain if the situation escalated further it is unlikely to do so in the near term.

Too Good to Question

The Federal Reserver Bank of New York posted about their study that confirms many people's biases about moral hazard and large financial institutions. The question is "Do “Too-Big-to-Fail” Banks Take On More Risk?" and the answer is yes.  The basic idea is that higher government support leads to riskier loan portfolios, which indicates to many people that Too Big To Fail (TBTF) banks were abusing their positions by loading up on risk.

I'm sure TBTF banks have taken on more risk - I believe moral hazard exists in the financial system. But I am not sure this study should give anyone more confidence on this issue.

After controlling for many variables, the study found that on average eight months after an increase in the perceived government support as measured by Fitch's "Support Rating Floor" the bank would have more impaired loans around eight months later (and vice versa). 

This is using data from March 2007 through August 2013, so the time period covered both the financial crisis and the european sovereign debt crisis. Given that, which explanation is more likely?

1. The average bank goes out and makes riskier loans after getting government support.

2. A negative economic shock created a scenario where government indicated support rating floors are needed. Banks who more obviously needed help got it first. Because problems in banks balance sheets show up slowly, it took a while for the banks that got support to admit that more of their loans were impaired. Support goes away when it isn't needed and slowly the loans are found to be performing better.

3. Only after a bank is assured that it is getting more government support (this happens only after the support has been promised for some time) do the banks feel comfortable marking down part of their loan portfolio. 

4. Banks that take over ailing financial institutions become TBTF and get boosts in support levels. After taking over troubled institutions, they find that many of those loans end up impaired.

The analysis controlled for quarter year fixed effects among other things, so the simplistic "Oh they were just pricing in the timeline of the crisis" argument doesn't quite work.  But even so points 2, 3 and 4 seem far more likely than the first scenario. In their paper the NY Fed researchers claim that because tier 1 capital ratios didn't decrease then their interpretation of moral hazard is more likely to be correct, but this doesn't account for the capital raising that occurred during the crisis.

Thinking of it from another perspective, it's likely that the age of the impaired assets are greater than eight months - the banks didn't rush out to make or buy bad loans just because they got some more perceived support. The relationship between changes in the support floor an subsequent changes in the bank's portfolio are both related to the bank being in trouble and this isn't adequately captured by the other variables. It is far from certain that the story played out as neatly as people would like it to play out.

There is moral hazard and many banks have abused their positions a TBTF, but studies that confirm everyone's biases should be examined even more closely than usual. 

10,000 Hours of Non-Deliberate Practice

Deliberate practice is a very important.  When learning a skill, breaking down ideas into small pieces and mastering those segments can lead to competency and expertise if the process is repeated properly over a long enough period of time. 

Many people will put in the hours but will not actively engage in practice. This phenomena is everywhere, but it is most easily found in video games.  One account of players actively not learning can be found in a blog about StarCraft 2 on TeamLiquid.  In this account, the author (a player who was ranked among the top 85% percentile of all players) plays a strategy that has a counter so simple an absolutely new player could easily be coached to beat it via simple instructions. Most people he starts out playing it against do beat him, so he soon ends up playing in a league with the bottom 35% of players. Soon he starts winning about 50% of his matches with a strategy that is very simple to beat.

The mindset of the players who have been playing for a long time and are still really bad at an activity is interesting. Some of them have played for many years, and perhaps if you include their original StarCraft experience they might soon be candidates for the 10,000 hours needed to develop true expertise. And yet this is a group of people who have put in tons of time but have remained generally incompetent. It doesn't make them stupid, but they are definitely suffering from some forms of cognitive bias. Besides the relative immaturity of the players involved (both the author and his opponents), a few things stand out:

1. The losing player blames the game, claiming imbalance where none exists.
2. They declare that the player was not playing fairly. In Starcraft, "cheese" is what other games call cheap.  In both cases, the player tries to add extra rules to the game that their opponent isn't necessarily going to follow. This is a little reminiscent of investors creating structured products and claiming that they never expected housing markets to be correlated on a national level during the 2008 financial crisis.
3. They don't look up how to beat the specific strategy and apply the technique. Even more surprising is that some of the players who lost to the author had actually read his blog in which he describes quite clearly how to defeat the strategy.
4. Perhaps the most important factor is that most of the players who have been stuck at their level for a long don't conceive their actions in clear and defined plans. They act on feelings and find it hard to explain why they did what they did when thinking about the game they just played.

The importance of a plan is learned in many ways, but I was first exposed to it through chess.  Middle game rule #1 of the Thirty Rules of Chess* is probably the most broadly applicable rules of the thirty rules.

M1. Have all your moves fit into definite plans.

Rules of Planning:
a) A plan must be suggested by some feature in the position.
b) A plan must be based on sound strategic principles.
c) A plan must be flexible,
d) Concrete and,
e) Short.

Evaluating a Position:
a) Material
b) Pawn structure
c) Piece mobility
d) King safety
e) Enemy threats

Without a clear reason behind actions, in a chess game, a video game or in any activity requiring strategy, there is little room for significant improvement. Playing without a plan or a way to determine whether you are doing well or not is just as bad. 

So if you want to avoid 10,000 hours of non-deliberate practice, making sure that actions are formulated around plans with ways to determine whether or not the plan worked is a necessary start. 


*Reuben Fine's 30 rules of chess aren't really rules - they are more like suggestions that should be followed about 80% of the time by the average club level player.

Rent Seekers Fighting Back

Rent Seeking is using political lobbying to increase one's share of existing wealth without creating additional wealth. In many cases, the rent seeker actively prevents new wealth from being created in order to protect their share. The obvious example of rent seekers are patent trolls, but more recently other rent seekers have been in the news.

Car dealerships are a great example of the rent seeking class. Politically influential on a local and state level, car dealerships have after a long history lobbied for and gotten laws that force manufacturers to sell through them rather than directly to the consumer. There isn't a Walmart or Costco of cars because of laws designed to protect dealerships. These laws prevent manufacturers from significantly changing the terms of their relationships with their dealers and requires that they use essentially the same business model that existed before the information age. The Big Three automakers don't just have to contend with a larger union workforce than foreign competitors, they also have to keep doing business through many more of their inefficient existing relationships thanks to car dealership franchise laws that force manufacturers to continue to renew their contracts with dealerships*. This legal monopoly that the dealers have results in a transfer of wealth from consumers and manufacturers to the dealerships. For more detail on this subject, see this paper State Franchise Laws, Dealer Terminations, and the Auto Crisis.

These rent seekers recently won a victory in New Jersey when Tesla's direct sales to consumers were banned. Tesla had no previous existing relationship with dealers, and the existing law does not have provisions to handle a car company selling directly to consumers without giving a cut to some politically connected middlemen so Tesla sales were banned in the state. The mentality of the rent seekers is captured perfectly in this article on The Verge.

"This Musk guy, he wants all the profits for himself," says Tom Dougherty, a 25-year veteran of the business who now works in sales at the BMW dealership in upscale Princeton, New Jersey. "They wanted to go direct, which means no sales force. That’s cutting out a lot of people. No way that’s gonna fly."

Go back to the definition of rent seeking - these dealers think it is perfectly normal for them to insert themselves into a transaction between two parties that have no relationship to them, Tesla and the consumer, and take a cut from that transaction. It would be more efficient in the long run to pay the dealerships and sales people to find new jobs than it would be to continue having them and any future employees muck up the automobile transaction process with their legally protected inefficient local monopolies.

Another group of rent seekers are the owners of taxi medallions. Taxi's are protected from the pressures of a competitive market by a policy that grants them a legal monopoly as long as they operate in a specific manner. Taxi's can't compete on price, and they lobby for restrictions in the number of medallions issued so they weren't forced to compete very much on service quality either. That changed when Uber, Lyft and Sidecar started turning anyone with a car and spare time into potential competitors to taxis.

But a few days ago taxi companies won a victory in Seattle when they restricted the above companies to only having 150 cars active at a time. This limitation will make it very difficult for consumers to efficiently use the services of these companies.

It's unfortunate that rent seekers are winning these battles - whenever rent seekers win it means that innovation is delayed and consumers are inconvenienced. All of this happens so that parasites like Tom at the dealership and taxi medallion owners can claim a share of wealth that they are only getting because better people are being kept from performing the same job. 


*Ironically, during the auto bailout bankruptcy reorganization many Republicans remained either blissfully or willfully ignorant about how car dealerships are inefficient legal monopolies backed by the government. Their continued existence has very little to do with free markets.

Adult as a Term of Approval

C.S. Lewis was a fantasy author, and he has a great quote regarding his critics who worried about adults liking stories that are considered childish. 

Critics who treat 'adult' as a term of approval, instead of as a merely descriptive term, cannot be adult themselves. To be concerned about being grown up, to admire the grown up because it is grown up, to blush at the suspicion of being childish; these things are the marks of childhood and adolescence. And in childhood and adolescence they are, in moderation, healthy symptoms. Young things ought to want to grow. But to carry on into middle life or even into early manhood this concern about being adult is a mark of really arrested development. When I was ten, I read fairy tales in secret and would have been ashamed if I had been found doing so. Now that I am fifty I read them openly. When I became a man I put away childish things, including the fear of childishness and the desire to be very grown up.

In searching for the context of the quote, I came across the excellent essay On Three Ways of Writing for Children. Towards the end he makes the point about how realistic fantasies can be much more dangerous than obvious fantasies.

The dangerous fantasy is always superficially realistic. The real victim of wishful reverie does not batten on the Odyssey, The Tempest, or The Worm Ouroboros: he (or she) prefers stories about millionaires, irresistible beauties, posh hotels, palm beaches and bedroom scenes—things that really might happen, that ought to happen, that would have happened if the reader had had a fair chance. For, as I say, there are two kinds of longing. The one is an askesis, a spiritual exercise, and the other is a disease. 

In other words, 50 Shades of Grey represents a far more dangerous fantasy than Game of Thrones. And C.S. Lewis was saying this before the time of reality TV.

Assorted Links

1. Counterintuitively, test prep actually helps minorities.  Perhaps a less politically correct interpretation of SAT research more generally is that it highlights how general intelligence factors and conscientiousness are heritable. These traits are correlated with both higher income and outperformance on standardized tests. 

2. Rent seekers win a round in New Jersey. If there is economic activity going on around automobiles in New Jersey, the dealerships want their cut even though they aren't adding any value. Many of these dealership owners are presumably Republicans, so this is an example of rent seekers in the "free market" party winning a round.

3. Technological adaptation favors the very young.

4. Risk aversion or approval seeking behavior by college women. The politically correct explanation is that it is the males who are overconfident. 

Random Links

1. Tracking the Ukrainian conflict - live. (Hat Tip: Garry)  The best way to pressure Russia seems to be to use the Magnitsky Act against any high profile Russians affiliated with Russia's invasion. Additionally, here are some interesting thoughts on how much US credibility actually matters in foreign affairs.

2. The perils of excess information.

"Once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his or her estimates. Additional information does, however, lead the analyst to become more confident in the judgment, to the point of overconfidence."

This creates an interesting problem for asset managers who should know all of the risks to their portfolio but for whom overconfidence can be quite dangerous.

3. The French do seem to be more forgiving of personal indiscretions. After this poll I could see DSK entering politics yet again.

4. Scott Sumner on Abenomics. 

Finance Related Links

1. A valuation expert thinks about What's App from a valuation and from a trading perspective. 

Damodaran's trading perspective of looking at cost per user sounds plausible, but I wonder if the calculation was as simple as "Facebook messenger is going to be worth X% of the company in the future. Buying Whatsapp at least doubles Facebook's chance of dominating the message space, and X > 22% so it is worth paying almost 11% of the company for Whatsapp."  Also, from a valuation perspective Facebook doesn't have to monetize users more than 1 dollar a year in the short term, they can keep Whatsapp's promise to be ad free for 5 years and only later start aggressively monetizing a greater user base.


He's trying to teach the idea of margin of safety, a long term perspective and investing in what you know, but it's interesting that in doing so he is highlighting investments that definitely underperformed Berkshire's book value as a whole. The farm is worth 5 times the amount it was bought in 1986, Berkshire stock is up over 5000% since 1987.  The actual calculation is more complicated than that since the farm gave off earnings in the meantime, but the difference is still quite notable.

3. MTGOX, the original bitcoin exchange, is down right now. 

It could be that they are insolvent or they are just particularly incompetent, but it is probably a combination of both.  The coins on the exchange, which could not leave MTGOX custody, were trading at less than 30% of the value of bitcoin on other exchanges.  It would be amusing, but highly illegal, if they were actually buying these discounted coins and arbitraging the difference on other exchanges to make it back to solvency.

Facebook is Buying Continued Relevance

When Facebook was going public they bought Instagram for around a billion dollars. Instagram was succeeding at something Facebook was trying to do - get teens to engage with a photo-sharing and social network app on mobile. Facebook paid about 1% of its market capitalization to own this emerging company. Later data revealed that it was definitely a good move - people really like Instagram.
   
More recently, they paid a lot more for Whatsapp, a messaging app founded in 2009. They paid $16 billion, or $19 billion dollars when restricted shares that will paid out as retention bonuses are included. That works out to over 10% of Facebook's current market capitalization.  Whatsapp was starting to beat Facebook in the messaging space - in most of the developed world outside of Japan and Korea Facebook and Whatsapp are the number one and number two messaging apps (It's unclear if counting Apple's iMessage as a separate app would change the math significantly).

There is no question that owning the messaging and mobile photo sharing spaces is what Facebook needs to do. And the mobile messaging space in particular appears to be very profitable. Line has been monetizing their user base quite well recently. But the big question is whether or not these nascent competitors that Facebook bought will continue to dominate the market for the foreseeable future.  

Zynga tried to implement the strategy that Facebook is applying when they bought Omgpop, the company behind the popular app Draw Something. Zynga wanted to get a foothold in the mobile gaming space but found out that success was not repeatable. While the analogy is worrying considering Zynga's subsequent troubles, Facebook is in a signficantly better position. With Whatsapp the network effects are stronger and there is no pressure for Whatsapp to create any other hits - they just have to outcompete other messaging apps and monetize their current business. 

But if consumers move on to other methods of communication in a few years, Facebook will have to buy the new competitor in the space if they are unable to innovate successfully. The social space is adapting to new technologies and is changing much more quickly than other areas. If Facebook needs to continue to buy competitors to keep their mindshare with consumers constant they will dilute their shareholders before they are able to deliver significant value. They might also start to attract the attention of the FTC.

One thing that this acquisition highlights is just how technology companies are threatened by the changing technology landscape. An investor who is bullish on technological innovation should be wary when buying the current technological incumbents - these incumbents risk either be outcompeted by new entrants or having to buy them at inflated prices.