Yves here. I had come across the speech mentioned in this post, “The Race to Zero” by Andrew Haldane of the Bank of England and decided not to write it up because I had come across it a bit late. This post will probably persuade readers that that was a bad call.
By Sell on News, a macro equities analyst. Cross posted from MacroBusiness
Exactly how did we get into this mess with the capital markets? A situation where the global stock of derivatives is over $US600 trillion, which is about twice the capital stock of the world. A situation where high frequency trading is over two thirds of the transactions on the NYSE and about the same in the stock markets of the UK and Europe. Likewise they are over half the action in foreign exchange markets and they are rapidly becoming dominant in the futures market. Andrew Haldane from the Bank of England is arguing against allowing high frequency trading — algorithms chasing algorithms chasing algorithms — from being allowed to proliferate pointing at volatility as the problem:
Speed increases the risk of feasts and famines in market liquidity. HFT [high-frequency traders] contribute to the feast through lower bid-ask spreads. But they also contribute to the famine if their liquidity provision is fickle in situations of stress.
Haldane noted that relative to gross domestic product, the equity market capitalisation of the US, Europe and Asia had not grown since 2000, suggesting that “the contribution of equity markets to economic growth … has been static”.
Little wonder, when you consider that companies are putting themselves in the hands of algorithms.
I think this conclusion, which many come to, is to some extent a blind alley. Because the volume of transactions is higher — when it is claimed that it adds liquidity this is a circular argument, like saying “the more we trade the more we trade” — it should mean that “volatility” at least on basic measures, is lower. The trades are made around normative models so they will tend to re-inforce those norms. Right up until the moment when the market does not behave with regard to norms, and then they suddenly start doing weird things, such as the so called “Flash Crash”. So it is probably correct to say that there is less volatility. It is also beside the point.
A better question is: Why do we think liquidity is a good thing?” Answer, because it facilitates trade around the exchange of information. “Information about what?” one might then ask. “The company in which the investment is being made,” is the answer. Does algorithmic trading exchange information about the performance of the company? No, it is only working off information about trading behaviour. Ergo, it may increase “liquidity” but it is not fulfilling the purpose of liquidity.
That kind of shift to traders working mostly off what traders do, rather than assessing the value of what is being traded, has become an absolute plague. It has taken over most Western financial markets. Hedging, for example, used to be all about hedging bets to protect the underling exchanges (usually wheat, or pork bellies or physical things). Now, hedging is all about reading behaviour, which then leads to other hedging strategies that are based on reading the hedging behaviour, and so on.
So the disappearing point is part of the problem. In our “anthrosphere” we are increasingly staring at each other’s navels in the financial markets, trying to make money and sustainable wealth out of ether. That is part of the problem. Regulators forgetting what the PURPOSE of financial markets is and instead just trying to stay faithful to the technical explications of that purpose, or utility. A colossal abrogation of responsibility, in other words, fuelled by thoughtlessness or intellectual laziness (Haldane is a notable exception).
But I think there is another problem. A growing mismatch in TIME between financial markets and commerce or economic activity. I can remember in the currency meltdowns of the last 20 years how the explanations in retrospect for why Russia or Thailand or Mexico or Indonesia “deserved” what they got. They were always plausible enough, if usually circular arguments.
But then you looked at what happened to those economies that had experienced crises and the impact was completely out of alignment. In a matter of weeks, there would be a massive re-rating of the currencies. No economy changes that fast. The problems, if there were problems and sometimes it was just a trading fiction, had usually accumulated for years. After the crises, the economies would take years to recover from the shock. It seemed to me that the misalignment in time is what is fundamentally wrong with this kind of financial behaviour.
The misalignment is even more extreme with high frequency trading, where micro-seconds are the basic unit. How can the exchange of information about a stock occur in such small periods? Obviously they can’t. There is a mismatch. Money should be aligned with what it is supposed to be representing, and that includes aligned in its temporal structure. For at least two decades, that alignment has been progressively picked apart, and now it is reaching endemic proportions.
In terms of its intellectual origins, this has a lot to do with the quasi-scientific methods used by economists and financiers. In science, time is just a dimension of space. The point of creating scientific “rules” is to say that every TIME the rule applies. Time, in other words, has to be eliminated as a problem.
Which is why science applies so poorly to human behaviour, because humans are always changing in time. It is why scientific models have extremely limited application to markets, because every time things are different — at least in their timing. For instance, I may reasonably conclude that the $A will fall, and be right because it will probably revert back t a norm. But what I need to know to make money is the time it will happen.
What one notices about all the fundamental analyses is that, while persuasive, they are extremely limited because they don’t tell you when the predicted events will occur. Those traders who sniff “the times” often do much better.
Time, in other words, cannot be eliminated from human behaviour, it is front and centre.
Which is why I would submit that the misalignment in time between financial market instruments and that which they are supposed to represent is not just extremely dangerous, it is fundamentally inhuman.