Posts Tagged ‘2009’
High Frequency Trading
Tags: 2009, Economics, High Frequency Trading, Stock Exchange, Wall Street
A world that lives 0.03 seconds ahead of you
A non-descript building
In Jersey City, just across the Hudson River, stands an unmarked building hidden in the urban jungle. Although inconspicuous from the outside, it boosts strong security on the inside with many checkpoints, mantraps and high-tech identity verification.
If you would get past all the security, you could enter the main section of the building: a dark room, full of giant unmarked cages, vigorously buzzing away. Looking down one corridor, it stretches for a hundred yards. The entire complex is the size of 3 football fields. It is cold in here, powerful ventilators are droning away, sucking up all the heat.
Processing financial data
If you owned one of these cages, you could enter it, and find yourself surrounded by a vast array of computers. Here, you can identify yourself using the biometric hand scanner. You would then be allowed to access the activity of these machines: 10’s of thousands of shares are traded by these machines every second. Sold, bought, and resold. But why? And why here?
Rise of the Machines
The purpose of this immense facility is so that computers can be close to each other, minimizing the distance that information has to travel. As a result, shares can be sold ever faster. (This is called co-location.)
Each computer can process a transaction in a micro-second or less, a millionth of a second. In other words, each computer can process 400,000 transactions per second.
People aren’t needed here.
These computers trade on the stock markets, and it is estimated that 13% of all shares in America are traded here. That makes it the third largest stock market in the world, bigger than the London stock exchange. 21 Billion dollars were traded here last year alone.
And none of this was here 2 years ago.
Electronic spies that beat time and space
Are we being manipulated?
These computers are set up to detect all activity in the market. As soon as a regular share trader tries to make a transaction, the computers detect it, using something that in the jargon of the trade is called a ‘high-frequency algorithm’. Because the computers are so close to the center of trading, they can cut ahead of the sale. They issue and cancel the sale almost simultaneously, bullying slower investors to giving up profits. The computer will do this all day long, in a systematic way, making money out of the original trader’s intention.
“It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange. “Markets need liquidity, and high-frequency traders provide opportunities for other investors to buy and sell.”
Even if they make a modest loss in the process, they still profit. They benefit from the competition between stock exchanges that pay small fees (called liquidity rebates, usually a quarter of a percent of a share) collected by the biggest and most active traders. Spread over millions of trades each day, these small fees amount to huge sums of money.
The problem is that these trades simply happen for the sake of the trade (because of the payout made for the act of the trade). That means that the trader doesn’t take a position, or rather is on either side of the trade, effectively taking opposing positions regardless of market intelligence. As a result, it skews the markets and makes them opaque. The investors argue that they provide liquidity to the market by being on either side, but the controversy is that the way they do this creates murky prices, undermines the fundamental principles of the exchange and under extreme circumstances (which happen often) leads to volatility or at the very least badly informed decisions that destabilize the markets.
In the last 2 years, this type of non-human trading has risen to almost 70% of all share transactions in America.
The billions of dollars these ‘predatory traders’ earn are directly at the expense of such traders as pension fund managers. It spies on what they do, reads their movements on the stock market and instantly runs ahead of their activity, undercutting their selling behavior.
Is knowing information 0.03 milliseconds in advance of everyone else still insider knowledge?
Making money, but adding value?
Legally speaking, this is not insider trading. Insider trading is the practice of trading based on non-public information. It has been made illegal, because it gives the trader an ‘unfair advantage’ and the power to ‘disrupt the markets’ and ‘game the system’.
The big firms who run these computer programs claim that they are not engaged in insider trading, that they simply trade faster. In truth, they can read your actions, and cut ahead of you by a millisecond, and make the trade in your place, then sell it back to you at inflated prices.
These companies are making huge sums of money based on innovative technology that costs billions to put in place. But isn’t that the American way?
To understand how this changes society as a whole, it is important to remember how the stock exchange came into being.
Making capital available to trade
Stock exchanges were set up to raise new shareholder capital for growing companies. Regulations were put in place to lower cost and offer a fair and equitable capital system which has the confidence of all participants because everybody has a fair chance of participating in the market. In order to keep this system viable, practices such as insider trading were made illegal, so that investors would remain in the stock exchanges and trade in a transparent ways. As a result, a large number of people poured their money in stock exchanges, investing in the future of business. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. Their intention was to open markets to all of us, so that we could participate armed with nothing more but a desktop computer and a new idea. But what happened was very different: 1% of the richest banks started building super computers, and they were perfected in the last few years. They positioned them close to marketplaces like the New York Stock Exchange and actually are aimed at driving prices up for those very people who the new regulations intended to involve.
How We Ate Your Lunch - A Case Study
On July 15th 2009, Intel had reported high earnings the night before. Investors quickly realized that as a result of Intel’s success, Broadcom, a semiconductor company, would be in a strong position. Traders should be investing in Broadcom shares. But they faced a conundrum: buying large number of shares would alert the markets and drive up prices. So they divided their orders in smaller batches, ducking and diving as they went on their business. The markets opened, and shares started trading at $26.20
The orders were being issued, in small and cloaked forms. This is where the high-frequency sellers kicked in: their computers saw a pattern. They managed to be faster than the traders by 30 milliseconds (0.03 seconds) and executed what is known as flash orders. Their computers started buying Broadcom shares and then resold them to the investors who placed the orders in the first place, but at the higher price of $26.39.
What happened was that the high-frequency computers saw the movement in the market, executed a sale faster than the traders could and then resold these trades to the traders at a higher value. This practice rakes in huge profits every day.
That world is changing
The former executive vice-President of the NASDAQ is wary of the new system of ‘High-frequency trading’. He warns that it undermines the very purpose of a stock exchange: raising capital for growing companies. Instead, the large profits from High-frequency Trading have led big investment funds to focus on the shares of the biggest companies where shares are plentiful. As a result, the feeding capital for the future of the US, the new growth companies, is cut off. This means less growth, innovation and jobs.
Instead of speculating on future innovation, all money is currently caught up in a gaming system that simply analyzes movements in the shares of the largest companies, and artificially creates value and trade without these companies actually offering equal amounts of innovation or improvement of service to justify this.
The former executive Vice-President of the NASDAQ is warning that this practice is undermining the US economy and undercuts the integrity of the markets.
“You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient,” said Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques. “But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”
Fighting back: Dark Pools
There already has been a growing backlash. Companies now increasingly trade in ‘dark pools’, away from the stock markets and their High-frequency Trading Algorithms. Dark pools are currently estimated at 30% of the trading market.
A dark pool is essence a place where a willing buyer meets a willing seller in a closed room, and makes a non-public deal. This means that the actors are making decisions disconnected from the rest of the market, and that makes it very hard to understand the value of the buy. In effect, without assistance of the market, the buyer and seller are throwing their hat at the actual value of the trade and it could be argued that trades in the dark pools throws this part of the market back hundreds of years and all the instabilities that come with that. Fair enough, the buyer and seller are highly educated, but they are NOT an island.
The greatest innovation in financial systems was to have all actors participating in the price formation process, a price that reflects the business is being done and insures transparency by treating all buyers and sellers equally. Today however, markets are less transparent than 40 years ago.
This has consequences. The more trade happens in dark pools (and it is constantly increasing) the more it undermines the system of pricing in general, because your prices don’t reflect a sufficiently large enough part of the market. Many people are making their decisions on current prices; if these prices don’t actually reflect actual value as well as they can, this can lead to unexpected upheavals, booms and busts and volatile markets.
Can you spare some change?
All of this is now part of a larger debate on how to regulate markets: how do we reduce banks appetite in trading and increase its appetite for traditional banking: taking in deposits, giving out loans, raising share finance for growing businesses. But with such big profits available in what is essentially casino trading and the current system in America of legally buying the votes of Senators through lobbyists, it is unclear this growing profitable instability in the markets can be tamed before a new crash occurs.
And all the while, it is draining liquidity from the markets just as the economy needs it most, lavishly pouring money on the established businesses while cutting off funding from growing industries, and in effect, the future of America.
Tags: 2009, Economics, High Frequency Trading, Stock Exchange, Wall Street
A Historical Perspective on Health Care
Tags: 2009, America, Health Care, History, Politics
Health Care Reform
The American health care system is entering reform as most systems in the world are facing intense pressure. As a result, it cannot turn to any model as a shining beacon, but will have to get its hands dirty trying to find a solution fit for a 21st Century world, where life spans are longer, birth rate in developing worlds decline and expenditure must be curbed. And that’s just naming the most obvious problems.
So what are the lessons America must learn?
The idea for health care insurance (see latest news on Health Care Reform) at its conception was a simple one: illness in a population is not the norm, most people are healthy most of the time. But sometimes disaster strikes, we don’t know when and don’t know who it will strike. Economies of scale can deal with this: if everybody pays a fee to an account, that pays out when disaster happens, everyone is covered.
Economies of scale also suggest that the bigger the group you include, the better you can predict risk and therefore the lower a fee you charge everyone. Simply put, take a group of 10 people and it is hard to predict how many of them will face some serious illness in their lifetime. 100 people, predictions work a tiny little better. The more you increase that number, the more predictable the model becomes.
That further brings a challenge to a Free Market model: economic models predict that where perfect competition exists, the consumer will pay bottom prices for the best and most innovative services. But health care doesn’t work in a perfect competition model: it would be too fragmented and wouldn’t be able to benefit from the economies of scale that allow it to actually be effective. As a result, health care insurance must be provided by oligopolies or monopolies (in some European countries there exists a free market solution where many insurers must compete to sell their services to a single buyer: the government. This can easily be called an inverted monopoly: the government has monopoly on demand. A perfect example of this is the Swiss health insurance model. Do read this, it’s a very interesting compromise.)
Most developed countries opted for the welfare state. This model isn’t popular because of socialistic reasons, but because of economies of scale. It is simply cheaper for one insurer to provide health care insurance than 10 insurers, due to the economies of scale.
There is however one massive problem with this model in the developed world. It works great when the majority of your population is young and vital.
Take Japan as an example. Its ‘welfare state’ was so successful that by the 1970s life expectancy in Japan had become the longest in the world. So the population was rapidly aging, and to exacerbate the problem, birth rate was falling. In effect, the ratio between old and young got to be the steepest in the world: 21% of its population was over 65, and it is projected that if the current trends prevail, 50% of the population will be pensioners by 2044. These trends have brought the Japanese welfare state to its knees. The problem is so formidable, the population so old on average, that even private insurers cannot present any solutions to Japan’s challenge. Life insurance companies have been fighting for their lives after the stock market crash of 1990, and 3 of its largest insurers failed.
So Japan acts as an omen: in the West, our population is following a similar trend, one where the population noticeably ages. Where the welfare system could be saved by the arrival of a large number of newborns, birth rate in the developed world is less than impressive and immigration isn’t bucking the trend.
As a result, countries in the developed world are looking for a privatized solution to be added to the national insurance model. When there is less money to go around, the money has to work harder. Perhaps private investment companies can help.
Take Chile as an example: brokers invest the pension contributions of Chilean workers in their own stock market. This has wielded impressive results: the annual rate of return on the Personal Retirement Accounts is more than 10%, thanks to an extremely healthy stock market that has risen by a factor of 18 since 1987.
Of course, this model, as all other models has its problems: not everyone in the system has a full-time job and the self-employed don’t have to contribute which leaves a substantial part of the population without coverage. The administrative and fiscal cost of the system are also deemed too high.
It remains however ironic that this type of radical reform did not originate in the heartland of free market economics: America, but instead was executed in Chile.
Reform in America is unavoidable. America’s hospitals vary in great degrees from state-of-the-art to challenged at best, but none can be called cheap (see the World Health Organization Report). For those who need treatment before retirement, the need a private insurance policy. It is estimated that 47 million Americans don’t have one, partly due to the structure of the system: such policies tend to be available only to those in regular, formal employment – any other scheme has a prohibitive price ticket attached to it.
[Cartoon courtesy of Seppo Leinonen. Be sure to check out his other great cartoons!]
The ultimate result is a welfare system that is not comprehensive, marginally redistributive (compared to European systems) but costs a whole heap more. Public health expenditures hover around 7% GDP while private health care is equivalent to 8.5% (in addition!)
In America, over the next 40 years, life expectancy is to rise even more, and the number of the population over the age of 65 will rise from 12% to 21%. However, according to the the 2006 Retirement Confidence Survey , only 60% of American workers say they save for retirement and just 40% has actually calculated how much they should be saving. The average worker plans to retire at the age of 65, but actually retires at 62. All these miscalculations require the tax payer to cough up one way or the other. Currently 36 million retirees receives a total of $21,000 each in Social Security, Medicare and Medicaid. According to one projection, left alone the cost of Medicare alone will account for 24% of all federal income tax by 2019.
Reform is necessary, and the government hopes to cooperate closely with private insurers. But leaving health care to private insurers is not entirely without risk either, considering the fragmented mosaic of responsibilities that often offers an opt-out for insurers.
Hurricane Katrina forced the myth of the well-oiled American welfare state to collapse for even the most ardent of believers. Those who choose to remain ignorant had no choice but to recognize that the current insurance models no longer cover the risks.
In the aftermath of Hurricane Katrina 1.75 million property and casualty claims were made to the sum of an estimated $41 billion. In America, private insurance companies offer protection against wind damage, and the federal government offers protection against flooding. As a result, the assessors sent out by the insurance companies were not sent to fairly assess the damage, but instead to visit properties and find reasons why damage could be due to flooding and not wind. The objective was to limit the amount of claims that would have to be paid out. At the time, insurance companies were portrayed as evil, but this is merely human nature, men are not angels driven by altruism, but driven to thrive and survive. The insurance companies acted in a predictable fashion, and ultimately it was the system that failed, because it allowed for ambiguity, vagueness and shied away from a comprehensive solution, instead leaving in place a fragmented, ‘puzzled’ system.
The same dangers lurk in the modern health care system, as a recent, perhaps slightly alarmist documentary of PBS suggests on health care in America. A fragmented system of insurers, whose company goals are to increase the bottom line year by year (and have done so more than 400% between 2000 and 2007), a system complex enough that it can often avert responsibility at crucial moments but works just well enough on the surface for people to still want to rely on it, while in the background gobbling up so much of America’s GDP and costing employers so much that it actually threatens America’s future in the world…
The challenge for the Obama administration is formidable…
Tags: 2009, America, Health Care, History, Politics