I think the point is that they actually don't solve any practical problems in liquidity or price discovery.
Does anyone on earth care about the price of lumber within even a 24 hour window? Why should we care about a sub second window? We don't. Wall Street refers to the high frequency game as "taking the dumb money". I call it "ripping off the value investors who actually serve a role in the economy".
Finance serves an important function in the economy, routing money to where it's needed. Are they doing a better job of that now than they were in 1985? Not really. So why are they extracting 10X the money in bonuses and profits?
Wall Street refers to the high frequency game as "taking the dumb money".
This is a rather strange thing for them to say, since it's usually the smart money types complaining about HFT.
It used to be that mutual/pension funds and other institutional investors could hide their big trades in noise - the market would adjust slowly, and other people (retail investors, smaller shops, assorted other suckers) would absorb the price impact of the trades. Now they are complaining they can't do this anymore.
Well, you know a lot more about HFT than I do, I just know that I've heard several people refer to their trading practices as taking the dumb money, including a one-guy algo shop that sounded similar to how you've described your work.
At the end of the day though, I'm still stuck on my 1985 story -- compensation, profits, bonuses, etc have skyrocketed since then. But what good have all the newfangled instruments done for the rest of the economy? Doesn't seem like much. So is it just rent-seeking?
EDIT: RE: hiding the big trades in noise. What's wrong with that? Why should they have to develop a special HFT algorithm in order to simply move shares around without getting their lunch eaten? This is exactly the kind of value extraction I'm talking about. HFT shops have now created a huge expense for these retail shops that didn't exist before.. are the financial markets functioning better as a result? No, they're just sucking more money out as transaction costs.
Corporations can now protect themselves from all sorts of risks which weren't possible before using swaps and future instruments.
Innovations in debt financing drove the huge economic growth of the last two decades. Mobile phone technology would never have taken off if cellphone companies couldn't have used debt financing to build huge cell tower infrastructures.
CMOs for all the problems they caused, did allow for a huge increase in home ownership. For every default there are dozens of paid-up home owners who could never have afforded to buy a house otherwise.
Electronic Government bond auctions have driven down the cost of government borrowing, leading to lower taxes.
Forex costs have dropped massively. Look at your laptop. It's likely that during the manufacture dozens of countries were involved and likely hundreds of currency transactions. You paid less for your laptop because of a decade of innovation in the FX markets.
Comp/bonuses went up for some. It went to zero for many others. In 1985, banks had armies of line workers processing trades, managed by officers making decent money. The average comp at a bank might be the average of 1 officer and 100-500 low level line workers. It would be better than other office jobs, but not great.
In 2010, the officer specs out business requirements after talking to traders and regulators, sends the high level work to IT and the CRUD apps to Bangalore. 475 of the 500 line workers have been replaced by a data center in Nutley, NJ, 5 remain in the US handling cash wires and other time-zone sensitive work, and 20 work via email out of an office park in Pune.
For obvious reasons, the average comp of 1 officer + 3 IT guys + 5 US line workers is going to be far higher than the average comp of 500 grunts + 1 officer.
Additionally, for many reasons (IT being one of the biggest ones), it's also vastly easier today to strike out on your own than ever before. In 1985, if you wanted to quit and start a hedge fund, it was tough. Today, a hedge fund can be operated by 3-4 guys + servers. Banks are forced to pay their traders enough money to prevent them from quitting and doing exactly this.
(Remind you of another high comp industry, with established players giving out big comp packages to retain talent?)
Edit (in response to your edit): RE: hiding the big trades in noise. What's wrong with that? Why should they have to develop a special HFT algorithm in order to simply move shares around without getting their lunch eaten? This is exactly the kind of value extraction I'm talking about. HFT shops have now created a huge expense for these retail shops that didn't exist before..
When you make a large trade, there will be a price impact. This is unavoidable - if you are selling millions of shares, supply went up, and price must drop.
In 1985, institutional investors (not retail investors) tried to make sure that other people (their counterparties) suffered the price impact. They would sell shares at full price, retail investors (i.e., my Mom) would buy from them, and then shares would go down once the market figured out supply dramatically increased.
In 2010, some HFT shops will sell to my Mom at a favorable price, and then buy from the institutional investor after prices go down. This benefits the HFT shop and retail investors at the expense of the institutional investor. I'm not saying this is good or bad, I'm saying it benefits "dumb money" (little guys who can't afford to rent an algorithm) at the expense of "smart money" (Goldman, Vanguard, Calpers Pension Fund).
[edit2: just a disclaimer - specific numbers/cities should not be taken as precise. The data center might be in Jersey City or Brooklyn, Pune might be Cebu or even Baltimore, and there might have been 250 or 1000 line workers rather than 500.]
This is an awesome convo BTW, thanks for providing all the detail about the industry.
Regarding our high comp industry vs theirs.. we've reinvented the world at least twice since 1985, and like I said, I haven't seen a reinvention of finance in any positive way. If they're that much more efficient now (and I agree that they are along the lines you're saying), where are the savings for the rest of the economy? I'm all about the TD Ameritrades of the world where I can do an $8 trade, that's providing value and they deserve every penny they earn. But it seems like most of the hedge funds are just playing games to extract money from less sophisticated investors.
Regarding your average comp comparison -- that's fine, I'm all about profiting from efficienbut what about the aggregate comp? Is that higher, too?
Regarding our high comp industry vs theirs.. we've reinvented the world at least twice since 1985, and like I said, I haven't seen a reinvention of finance in any positive way.
In almost every financial service that existed in 1985, margins have been cut to the bone (the main exceptions being M&A and IPO services). The commission on stock trades is now $0-8, it used to be $150, as you note.
When businesses need futures/options (mainly for hedging purposes), they often just buy them on the open market rather than contacting a GS/MS/JPM rep and paying through the nose for the privilege.
Regarding hedge funds/private equity, Warren Buffet and others have commented that there are very few hidden gems left, particularly gems detectable by financial/technical analysis. I.e., good businesses are getting more investment.
Regarding your average comp comparison -- that's fine, I'm all about profiting from efficienbut what about the aggregate comp? Is that higher, too?
It's a good question. Top traders get more, but they also tend to earn more. Good IT is certainly vastly cheaper than armies of line workers, and HFT is cheaper than human market makers. More financial services are provided today - my understanding is that credit cards were hardly pervasive in 1985, and no one would cell you a phone on quasi-credit like they do today.
I have absolutely no idea and I'd be very skeptical of anyone who claims to know.
I'm not sure about subsecond windows, but 24 hour windows certainly matter. Say you're planning on making a big order of lumber for your mill and you're ordering from a market with zero speculation so the prices jump up and down with the supplier's inventory. It makes a lot of sense then to wait a few days (during which your machines and workers are idle) to get the best price possible. I'm not going to say that high frequency trading serves a useful purpose, but to me that looks like a zero-sum struggle between Wall Street firms for profits that Wall Street deserves for doing its thing on a minute to minute or hour to hour level.
Ok, fine, downgrade 24 hours to 1 hour. Nobody cares about those prices within 1 hour. We've had markets that operate within 1 hour for over a century.
What did all the "innovation" actually produce? I know Wall St is making more money but are they providing more value?
High speed trading is only relevant to the competition between market makers and other short term speculators. It has no effect on long term speculators/hedgers/etc.
If you want to trade right now, you will pay a few cents/share for the privilege (this is the spread). If my company was fastest, we sit at the top of the order queue, and we will receive those few cents/share. If GS was faster, they get the pennies. Either way, you trade right now. And if I decide to cut in line by offering a better price, you trade right now for less.
Does anyone on earth care about the price of lumber within even a 24 hour window? Why should we care about a sub second window? We don't. Wall Street refers to the high frequency game as "taking the dumb money". I call it "ripping off the value investors who actually serve a role in the economy".
Finance serves an important function in the economy, routing money to where it's needed. Are they doing a better job of that now than they were in 1985? Not really. So why are they extracting 10X the money in bonuses and profits?