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September 1, 2009

Unfair at Any Speed

We are all bad guys. After reading the opinion pages in The New York Times over the past few weeks, I have been forced to confront the sad truth: that trading profitably is a morally questionable enterprise that is damaging to society. My awakening began when I read a recent Times column by Nobel laureate Paul Krugman, who commented that much of today's trading is a "socially useless" activity, as opposed to a higher calling, like say, writing opinion pieces. He ripped apart traders for the crime of making money "mainly by outsmarting other investors, rather than by directing resources to where they're needed." Dr. Krugman proposed pay restrictions and higher taxes as the solution to curbing trading activities that serve no "useful purpose."

Next up was an opinion piece by Paul Wilmott, the quantitative researcher and hedge fund manager, who launched an attack specifically on high-frequency trading, calling it a "morally suspect financial minefield." The two articles in concert led to a fresh explosion of anti-Wall Street sentiment among the general public, leading to dozens more newspaper articles, CNBC interviews, calls for new regulation from politicians and thousands of angry blogs and chat-room rants demanding trader blood.

In trying to decide whether I should join the angry masses on the march, or maybe turn and run from them, I first needed to understand who they were going after. Did I personally know any of these financial miscreants? Was it possible that I had seemingly mild-mannered clients who were really serial portfolio killers? Was I unknowingly aiding and abetting morally suspect DELL flipping? Fortunately, Professor Krugman outlined a clear definition that differentiates good from bad trading. He defines good and useful speculation as trading based on publicly available information, as opposed to damaging speculation, which is based on information not available to the public at large. So far, so good--who could argue in favor of insider trading? My conscience remained clear.

 

Menace to Society

But I became a little worried when I realized how low the professor sets the bar for non-public information. He's not talking about Gordon Gekko learning about the impending takeover at Blue Star Airlines. Far from that, Dr. Krugman first cites high-frequency traders, who by processing public information faster than the next trader, are damaging society. The implicit argument is that since not everyone has "superfast" computers, the information that high-frequency traders are reading from the public tape is still essentially non-public until everyone has had time to read and digest it. It's a good point--why should a trader have an advantage over his competition just because his broker splurged on a nitrogen-cooled tungsten-coated nanochip processor? Shouldn't algorithm providers be polite and wait until the old-school broker with the paper ticker tape and the Atari 800 catches up?

Mixed into this market morality maelstrom was the simultaneous controversy over so-called "flash" orders. "Flash" refers to orders that exchanges post for a fraction of a second to subscribers of their data feed before sending to another exchange. The order type now appears to be rapidly on the way to the ash heap of trading history, joining other failed ideas like OptiMark and specialists. I was happy to hear of the impending demise of flash, as I had always felt there were significant problems with the concept. Flash orders are allowed to virtually lock the market, violating the spirit of Regulation NMS and weakening the concept of a national market system. More importantly, choosing to flash orders seems like a dubious trading strategy, since leaking your intentions prior to trading could result in another trader running ahead.

 

Public Data Feed

Despite the many actual flaws of flash orders, opponents repeatedly stated an incorrect argument: that flashes represent non-public information. This is simply not true--anyone can subscribe to the exchange data feeds and anyone can read the flash quotes. Believe it or not, you don't need to be a member of a privileged cabal to get these, and you don't even need to know a secret handshake. You just subscribe to the exchange's public data feed--getting the flash quotes doesn't even cost extra.

So, while flash orders are bad market structure for a number of reasons, let's separate the issue from Professor Krugman's "non-public information" argument, since the opportunity to get these quotes is publicly available. Which reduces his argument to the self-created unfairness that results from some traders improving their equipment while others don't. If as a result of a technology investment you can respond to market data faster than most, you have turned yourself into an insider, and your profits are now ill-gotten gains. Now this was logic I could grasp: High-speed computers are basically like those polyurethane swimsuits that were just banned. The Olympics ought to be about the fastest swimmer, not the most expensive swimsuit. Why shouldn't the game of trading be the same? Let's permanently freeze trading technology where it was in, say, 2003, and then let the best man win.

Confident that I now understood both the problem and the solution, I was taken by surprise by Dr. Krugman's second example of a damaging trader of no social value: Andrew J. Hall. Mr. Hall, the legendary trader from Citigroup's Phibro unit, could be considered the antithesis of a high-frequency trader. Whereas high frequency traders think in milliseconds, he is known to think in years. A March 2008 profile of Mr. Hall in MoneyWeek magazine stated, "Trading may be the wrong word to describe what Hall does best; he makes very large long-term bets, and sits back." This is when I realized I needed some serious re-education. My head was spinning--I had thought Professor Krugman said I could like the fast swimmers, and just hate the fast swimsuits. Why be against Mr. Hall, a guy who appears capable of making money armed with a rotary telephone and a No. 2 pencil?

 

Black Hats

And then, just as I grew distraught that I would never be able to determine who the bad guys are, it suddenly dawned on me. The bad guys in this Wall Street story aren't limited to 1985-style insider traders, or 1987-style program traders, or 1993-style SOES bandits, or 1999-style day traders or even to today's high-frequency traders. I now understood that any trader who spends more money on data, or invests more in analysis, or is simply smarter than most, eventually comes to possess thoughts and trading ideas that others don't have access to. As soon as those thoughts are formed, whether in the silicon of unfairly large machines, or in the carbon of unfairly large brains, the thoughts become non-public information that other traders don't have. And according to a Nobel Prize-winning economist, trading on non-public information is not investing, it's outsmarting.

So the jig is up. Trade poorly and you will not last long in this business. Trade well and success itself proves you are guilty of outsmarting others and damaging our society. You see, we are all bad guys.

 

 

Dan Mathisson, a Managing Director and the Head of Advanced Execution Services (AES) at Credit Suisse, is a Traders Magazine columnist. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

 

(c) 2009 Traders Magazine and SourceMedia, Inc. All Rights Reserved.

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