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What Business is Wall Street In?

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101–110 of 191 posts

Re: What Business is Wall Street In?

#101
post #73

Earlier quoted context omitted.

This really has nothing to do with retail investors. Retail is completely insignificant. Its about what the bulk of the trading is: robots trading with robots without any regard to the stocks they are trading. The big whales are the mutual funds and they have to execute their buy/sells using special techniques of spacing trades out to try to not show what they are up to. Otherwise the HFT spots it (and they usually d…

>Its about what the bulk of the trading is: robots trading with robots without any regard to the stocks they are trading. The big whales are the mutual funds and they have to execute their buy/sells using special techniques of spacing trades out to try to not show what they are up to. Otherwise the HFT spots it (and they usually do) and then front runs all of the trades, just skimming pennies off. What use are they ?…

> someone willing to buy now for $50 beats someone willing to buy a second later for $51

We have misinvested countless millions on a system which produces the wrong answer, optimizing for millisecond latencies which benefit neither companies needing capital not investors providing it.

Re: What Business is Wall Street In?

#102
Mark Cuban has touched on what is at the center of why financial regulation is so difficult: the roles, values, and differences of the primary and secondary markets.

All of Wall Street exists to do one thing: connect those with capital to those who want it.

The primary market exists to do what Wall Street is meant to do: a company or other entity wants money, an investment bank connects that company with investors, and investors hand over the money. Wall Street acts as a classic broker, executing the function it was meant to perform (match those with capital to those who want capital). For its services, it takes a cut.[1]

This part of Wall Street - the primary market - works reasonably well and there aren't many complaints about it.[2] In fact, people sometimes complain about the IPO market getting too hot, which really just means that more companies in the real economy are getting money. The biggest ongoing complaints about the primary market are that the big banks charge too much for the capital raises and that they hype up the securities. Neither is a particularly cutting complaint though, nor is either issue crippling in any way to the capital markets.[3]

This brings us to the secondary market - the stock market as most people know it. Most people never participate in the primary market (i.e. in the first sale of securities), but rather in the secondary market. Here's the core question: WHY DOES THE SECONDARY MARKET EXIST?

The secondary market serves a support function to the primary markets. It provides "liquidity" to the primary investors - that is, it gives them a reasonably easy and cheap way to offload their shares should they choose to do so. The idea is that if there's a ready secondary market for the shares, primary market investors will be more willing to participate in deals because they know they can get out quickly and cheaply if they want to, and they'll be willing to pay a higher price for the shares for the same reason. In more technical terms, the secondary market serves to increase the flow of capital to companies and lower the cost of capital for companies.

And this is where all the problems Mark Cuban is citing come in, plus all the problems that financial regulators were trying to deal with in the last regulatory push (Volcker rule, Glass-Steagall, etc.).

The main issue here is that you can't really draw much of a line between "market-making" and short-term trading. Market-making is something most people agree is a good thing - you want a healthy number of market makers competing transaction costs down and providing sufficient liquidity (again, all to serve the health of the primary markets). And short-term trading is something that most people feel is a bad thing - it creates short-term thinking in the markets, which usually flows over into the companies, so you have everybody thinking about the next quarter, which leads people to ignore longer-term and deeper issues. But both market-makers and short-term traders are just buying and selling securities - it looks exactly the same. This is why the Volcker rule is so ineffective. The rule stated that a financial firm could only have a few percent of its capital in "proprietary trading," but every trader at any financial firm knows that most of the trading (and most of the lucrative trading) happens on the market-making desks. Buy a portfolio of illiquid emerging market bonds at 70 cents on the dollar from an investor looking to offload quickly, warehouse it for a few days, and offload at 85 cents. That's market making. And it's also short-term trading. There is no difference. The trader had to make a judgment about whether he would profit on the trade - whether the price of the bonds would hold up until he could offload it, or whether he got it at enough of a discount that even a move against him wouldn't hurt him. He probably thought about whether he could hedge it while he held it or if he could somehow line up a buyer before he even bought it. A high frequency trader is technically doing the exact same thing - just buying and selling; they just get very fancy about figuring out whether they'll profit on the trade: fractional penny arbitrage opportunities, information about where the price is headed in the next half-second, etc.

The best idea I've heard in terms of tackling this specific issue is to alter the tax structure. Mark Cuban advocates this in the form of a 10 cent tax on trades held under 1 hour. Another version I've heard is to levy a similar penalty tax on any capital gains reaped on a trade held less than 3 months (i.e. taxed as income plus a penalty; right now it's just taxed as income), and to move the lowered long-term capital gains tax rate to gains on investments held for more than 2 years (right now, long-term is 1 year). This would certainly discourage short-term trading, but that would mean that it would also make trading slightly more expensive for everybody, which some people think would be a good thing in that it would make people think twice before they traded something, while others argue that it would be a terrible thing because it would hurt the smallest players (individual investors) the hardest - after all, they're the ones who feel trading costs the most in percentage terms (trading costs as a percentage of the amount they're investing).

As a final thought, while all this trading and short-term thinking seems like it hurts us in the long-term, I don't think this is where our energies should be focused in terms of regulation. Trying to get people to stop short-term trading in the market would be like trying to get people to stop going to see movies for all the violence. Sure, it'd be nice if everybody thought like Warren Buffett in the market, and it'd be great if everybody just wanted to watch Stanley Kubrick films. But the important thing is not to get people to be "better," but to ensure they can't cause much damage as they're acting on their impulses. People like violence, but we keep guns away from them. People like short-term trading, so we need to keep LEVERAGE away from them. If you limit leverage, you limit bubbles and busts. It's that simple and that difficult. Bubbles and busts will still happen because people will chase up prices of some securities and then run for the hills once prices falter, but you need to make sure they're just running and not rocketing. Leverage is that rocket - limit it, and you've got the most elegant solution to the major problems of the financial markets. Don't try to enforce good behavior; just limit the power of bad behavior.

[1] Some people complain about the size of the cut that Wall Street takes for these services. The cut is stable and large for 3 reasons: 1. There's an oligopoly at the top. 2. The risks to a failed capital raise are huge, financially and reputationally for the company raising capital, so they usually opt to go for one of the few top players (protecting the oligopoly). 3. Like most large negotiated transactions, there are higher costs of doing business (think cars and houses).

[2] In the primary markets, the area that probably poses the biggest danger to the economy and society as a whole is when it gets into non-plain-vanilla securities, i.e. stocks & bonds work just fine, but derivatives and other instruments (like some asset-backed securities in the last crisis) get a bit more tricky. But I'm going to leave those aside for now since Mark Cuban is mostly addressing trading in the stock market and plain vanilla capital raising.

[3] The costs have been pretty stable for long stretches of time without seemingly barring companies from raising capital or making the capital raise so prohibitively expensive that people don't participate. And on hyping the securities, investors know that there's a financial relationship between the company and the bank, and they're for the most part pretty aware of this and therefore do much of their own research. All the major mutual funds and hedge funds do their own research and know not to rely on bankers (to the point that many portfolio managers ask that the bankers remain silent during meetings with companies that are raising capital until the discussion gets to specific deal terms, and if the company is not raising capital but just meeting with portfolio managers or analysts, the PMs or analysts often don't even allow bankers in the meeting room but ask them to wait out in the lobby or waiting area).

Re: What Business is Wall Street In?

#103

In the past few years, I've been a fervently anti-bank corruption, often aligning myself with the occupy wall street crowd. However, unlike most people with my views, I see algorithmic trading as not a symptom of, but one of the solutions to the problems in investment banking. Maybe it's because of my background in machine learning, but I view computers as a way to reduce the amounts of arbitrage opportunities and in…

It seems to me to be naive to believe that a bunch of computers running software built by humans will compete perfectly to create a perfect market, the hypothetical "efficient market".

Instead what you would probably arrive at is an arms-race of retail investor-accessible HFT systems competing for investor dollars. That arms-race would just lead to a market even more arbitrary than the one we have now where the HFT systems are using fundamentals and at the same time learning about the trading patterns of the other systems indirectly to exploit them. Investors would be investing in the trading system instead of the real market, it would be reduced to gambling on the race instead of investing in the market.

My personal opinion is the HFT systems of today add zero value, as argued in the article. The liquidity provided by them is an illusion as they skim a cut off between the original seller and their buyer on the two ends of the trades they perform.

Re: What Business is Wall Street In?

#104
post #48

Why is there such a witch hunt against high frequency traders? I understand the brain-drain argument, but I fail to see a direct negative impact on regular investors. -High frequency traders provide liquidity enabling me to transact with slightly lower spreads. While narrow spreads may only provide a marginal benefit to the markets, how is it harming you or I? -High frequency traders hardly impact my investing decisi…

the main, reasonable complaint against HFT (at least from my perspective, besides brain-drain) is the introduction of a higher volatility. since pension funds and other institutional investors dont usually have them same well trained funds managers and sophisticated analytics, yet a much higher volume, they are usually the ones who get it in the pants. the loss might be fractional, since you are usually investing long term, yet a short fluctation (eg. 2 cents, after you started executing your orders) in prices does add up if you're investing upwards of 100 mil.

Re: What Business is Wall Street In?

#105
post #96
post #95

Earlier quoted context omitted.

My point was that external factors can have an impact on the stock price of an company in ways that previously hadn't been possible, and I cited HFT as one of those factors. You cited Knight Capital whose "internal factor [...] (apparently?) accidentally deployed a bunch of test code to production" resulted in "trading activities [that] caused a major disruption in the prices of 148 companies listed". So yes - in thi…

The share price for those 148 companies barely moved.

Yet Knight Capital's share price never recovered. Say instead of KCG it was JPM, operating without the usual risk concerns because they've got assurance from the government of support. Should investors or taxpayers be okay with such an "internal issue" destroying part of their net worth? And wouldn't a too-big-to-fail company have a broader impact on the entire market if such a think were to happen? It's kind of the whole concept behind too-big-to-fail that they would.

Re: What Business is Wall Street In?

#107

In the past few years, I've been a fervently anti-bank corruption, often aligning myself with the occupy wall street crowd. However, unlike most people with my views, I see algorithmic trading as not a symptom of, but one of the solutions to the problems in investment banking. Maybe it's because of my background in machine learning, but I view computers as a way to reduce the amounts of arbitrage opportunities and in…

> Contrary to what the article states, computers that compete against each other will tend to eliminate all short term unjustified price swings and leave only accessible prices based on real company fundamentals.

This is assuming that computers only try to extract money by going long on every stock they purchase, an incredibly ignorant view of finance.

Re: What Business is Wall Street In?

#109
post #5

It is getting increasingly difficult to just invest in companies you believe in. Like how twenty years ago you could buy a stock you believed in for like $4 by using a computer system, paying a fraction-of-a-penny spread on average, to have a trade executed in milliseconds to seconds, but now you have to talk to a human on the phone and pay a $400 commission to pay a fraction-of-an-eighth spread and have the trade ex…

seeking alpha is a sucker's bet.

Surely this can't be right. If for the only reason that, if it were a sucker's bet, then most people wouldn't take it. Especially most 'informed/rational' actors. The vast majority of the players on Wall Street, we can assume, are informed and relatively rational. Yes, they may follow the herd - but that too is a rational exercise. If you are in a building and everybody is running for the exits, it is irrational to stand still and risk being trampled.

So, the mere fact that there are countless informed/rational actors seeking alpha and - quite frankly, many do capture it - would seem to me that statement is inaccurate.

If your argument is that the odds are long, well that is more nuanced view.

There are many traders that seek a small amount of alpha, with no leverage, and make a reasonable return annually - enough to support say 1 - 2 employees. But, there are many others that do the same with a larger capital base and capture enough to support larger organizations.

Seeking bets with long odds is, quite frequently, not a sucker's bet - because the mainstream view of that bet is that it is a sucker's bet. Mainstream adoption of that view, actually - non-intuitively - turns the bet into a prudent bet. The whole be greedy when everybody is fearful bit.

The same can be said of founders wanting to build the next Facebook - you might argue it is a sucker's bet, but the outcomes aren't as rare as it may seem.

Re: What Business is Wall Street In?

#110

In the past few years, I've been a fervently anti-bank corruption, often aligning myself with the occupy wall street crowd. However, unlike most people with my views, I see algorithmic trading as not a symptom of, but one of the solutions to the problems in investment banking. Maybe it's because of my background in machine learning, but I view computers as a way to reduce the amounts of arbitrage opportunities and in…

> This can all be proven by something called the efficient market hypothesis.

Of course, the efficient market hypothesis is basically an unproven assumption.

The general gist of it is obviously somewhat reasonable, but you have to be extremely careful what kind of statements you really believe.

Just to make two obvious examples: the strongest form of EMH claims that asset prices reflect even hidden information. That cannot possibly be true, because the circle of people with access to that hidden information most likely does not have enough money / market power to affect a shift of sufficient size.

The other example: slightly weaker forms of EMH still claim that prices adjust immediately to new information. That cannot possibly be true either, because traders simply aren't that fast. HFTs typically cannot afford to put so much money into affecting big price shifts, and other traders are slower. Besides, it's clearly falsified empirically: if this form of the EMH were true, stock prices would look like step functions, and they don't.

Another argument against EMH is complexity theoretic: one can most likely show that if EMH were true, the market would solve NP-hard problems efficiently (I remember seeing a line of work that attempted to show such a thing, though obviously the modeling is very messy).

Now you might argue that EMH still somehow approximates the real world. Maybe. But small errors can add up, so you have to be really careful in your thinking.

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