Like a lot of Wall Street types, I think of the financial industry as split between the buy-side and the sell-side. Both sides of the industry have undergone radical changes over the past eighteen months of crisis.
Much more change is coming. We've come through the phase of tearing down ways of understanding our business that have held for decades. We haven't yet begun to approach the question of what will replace those ways.
The buy-side exists in order to use financial raw materials (primarily debt securities) for the purpose of constructing and marketing a range of products known generically as retirement. The sell-side exists in order to match people who have capital with people who use capital, to discount risk, and therefore to provide the finance needed for a modern economy.
But over the several recent decades in which the theories of modern portfolio management have come to dominate the practice of finance, a different objective has come to the fore, on both the buy-side and the sell-side: seeking alpha.
Intuitively, alpha is a return on investment activity that exceeds, on a risk-adjusted basis, the expected return on the market as a whole. The goal of finance has become to "beat the market." But modern finance is based on a set of mathematical theories which assume that beating the market is impossible over long periods. (If you accept that markets process information efficiently, then the market, which definitionally possesses more information than any individual, will always win.)
Much more change is coming. We've come through the phase of tearing down ways of understanding our business that have held for decades. We haven't yet begun to approach the question of what will replace those ways.
The buy-side exists in order to use financial raw materials (primarily debt securities) for the purpose of constructing and marketing a range of products known generically as retirement. The sell-side exists in order to match people who have capital with people who use capital, to discount risk, and therefore to provide the finance needed for a modern economy.
But over the several recent decades in which the theories of modern portfolio management have come to dominate the practice of finance, a different objective has come to the fore, on both the buy-side and the sell-side: seeking alpha.
Intuitively, alpha is a return on investment activity that exceeds, on a risk-adjusted basis, the expected return on the market as a whole. The goal of finance has become to "beat the market." But modern finance is based on a set of mathematical theories which assume that beating the market is impossible over long periods. (If you accept that markets process information efficiently, then the market, which definitionally possesses more information than any individual, will always win.)
The buy-side, the world of hedge funds, pensions, insurance companies, university endowments and other institutional investors, sought alpha in a wide range of synthetic, ("exotic") securities. The idea was that, by employing the latest clever tools and techniques, it would be possible to dial up investment yields slightly, or dial down risk slightly, across an investment portfolio, and thus produce slightly better outcomes.
But the basic raw material for all of these synthetic securities still was debt, the age-old substance that has been the cornerstone of finance since our ancestors lived in trees. The alpha-seekers believed quite sincerely that you could repackage debt in ways that would produce a higher return for a given risk level, and the equations suggested this was indeed the case.
What happened in reality, as all the world now knows, is that you can't make risk disappear. Instead, you can only move it from place to place. Since it was no longer being carried (and hedged) in investor portfolios, the excess risk found its way, like water flowing downhill, into the financial system itself.
The buy-side will need to transition back to an older understanding of how to construct portfolios which are used to fund retirement and to match other liabilities like the construction of public works. Unfortunately, because we've all been burned now by the reach for higher returns, less usage will be made of tools that actually are beneficial (including leverage and securitization), and overall returns will be below capacity. It will be years before we have this figured out. And in the meantime, regulators will be adding to the uncertainty (and thus lowering returns) by taking years to decide which already-obsolete activities they will outlaw.
Now the sell-side (what is what the public generally think of when they hear the term "Wall Street") also managed to get their fingers burned quite badly, as the buy side was searching for alpha in all the wrong places. The sell-side made the classic drug-dealer's mistake: they started using their own product. This caused the death of Bear Stearns and a substantial weakening in Merrill Lynch, Citigroup, and many others.
But the sell-side has another disease, which is still in full flower and has not yet caused apparent problems. (Not that are visible to the regulators and the public yet, anyway.)
The sell-side is addicted to algorithmic trading. This is the modern version of front-running, or what replaced front-running as markets became more electronic and more efficient. (Many people, including regulators, imagine that electronic markets are more transparent. They're not. When you can get off-the-shelf software to "shred" a one-million share order to buy or sell some stock into hundreds of little pieces, there's less transparency, not more.)
The objective of profiting from slight, evanescent price disparities across many markets has transformed the structure of financial markets across the world. The most prized commodity now is liquidity, the ability to execute buy and sell orders anywhere in the world, in large size, at speeds measured in milliseconds.
Trading is like pornography in one important way. The two of them together are the drivers for much if not most of the innovation in information technology and communications. Wall Street is now obsessed with "low-latency networks," which are all about making it possible to execute ever more trades, in ever more venues, at ever-increasing dollar amounts, in ever less time.
The trade which you see printed in any given market (let's say, for example, that it's an order to buy one billion dollars' worth of some off-the-run Treasury note), is almost certainly part of a much more complex trading strategy. It has no standalone meaning. The fact of the trade itself, and of the price at which it was done, is only meaningful in the context of what the trader was trying to accomplish with multiple trades executed simultaneously in different markets. And his strategy is very far from transparent.
Algorithmic trading makes up an overwhelming proportion of total trading, perhaps as much as 85%. And this activity, which is designed to capture very small price differences as they appear and disappear like quantum froth, dominates the traditional purpose of trading, which is to discover the prices and value of real-world investments.
Therefore, algo-trading extracts a certain, and very significant, amount of value from capital markets. This is value that otherwise would have been applied directly to the provision of capital for industrial activity. Capital markets are parasitizing themselves. How might you go about quantifying the degree of parasitism? Well, it probably correlates well with the trading-desk profits of Wall Street firms and boutique quant shops.
What's the upside? High levels of trading make markets more liquid, and this is an undeniable benefit for people, like mutual funds, that often must execute very large trades.
But I'm not convinced. Someone needs to do a relative-value calculation. Pervasive, high-volume trading adds a large noise component (excess volatility) to market prices, taken over the very short term. It's quite possible, and I think quite likely, that the value which this subtracts from the economy is quantitively larger than the liquidity benefits it provides.
If that turns out to be the case, then as a matter of policy, you would want to shut down most prop-trading. That could easily be done by applying a tax of a fraction of a basis point to every trade.
If we end up doing that (which, as far as I know, only I am talking about), then Wall Street will need to come up with a totally different way of making money.
Who knows, someone might revive the idea of traditional investment banking, such as was practiced 100 years ago. Discount risk, and match the providers of capital with the consumers of capital. And maybe that would lead us back to a future of healthy, sustainable economic growth.
But the basic raw material for all of these synthetic securities still was debt, the age-old substance that has been the cornerstone of finance since our ancestors lived in trees. The alpha-seekers believed quite sincerely that you could repackage debt in ways that would produce a higher return for a given risk level, and the equations suggested this was indeed the case.
What happened in reality, as all the world now knows, is that you can't make risk disappear. Instead, you can only move it from place to place. Since it was no longer being carried (and hedged) in investor portfolios, the excess risk found its way, like water flowing downhill, into the financial system itself.
The buy-side will need to transition back to an older understanding of how to construct portfolios which are used to fund retirement and to match other liabilities like the construction of public works. Unfortunately, because we've all been burned now by the reach for higher returns, less usage will be made of tools that actually are beneficial (including leverage and securitization), and overall returns will be below capacity. It will be years before we have this figured out. And in the meantime, regulators will be adding to the uncertainty (and thus lowering returns) by taking years to decide which already-obsolete activities they will outlaw.
Now the sell-side (what is what the public generally think of when they hear the term "Wall Street") also managed to get their fingers burned quite badly, as the buy side was searching for alpha in all the wrong places. The sell-side made the classic drug-dealer's mistake: they started using their own product. This caused the death of Bear Stearns and a substantial weakening in Merrill Lynch, Citigroup, and many others.
But the sell-side has another disease, which is still in full flower and has not yet caused apparent problems. (Not that are visible to the regulators and the public yet, anyway.)
The sell-side is addicted to algorithmic trading. This is the modern version of front-running, or what replaced front-running as markets became more electronic and more efficient. (Many people, including regulators, imagine that electronic markets are more transparent. They're not. When you can get off-the-shelf software to "shred" a one-million share order to buy or sell some stock into hundreds of little pieces, there's less transparency, not more.)
The objective of profiting from slight, evanescent price disparities across many markets has transformed the structure of financial markets across the world. The most prized commodity now is liquidity, the ability to execute buy and sell orders anywhere in the world, in large size, at speeds measured in milliseconds.
Trading is like pornography in one important way. The two of them together are the drivers for much if not most of the innovation in information technology and communications. Wall Street is now obsessed with "low-latency networks," which are all about making it possible to execute ever more trades, in ever more venues, at ever-increasing dollar amounts, in ever less time.
The trade which you see printed in any given market (let's say, for example, that it's an order to buy one billion dollars' worth of some off-the-run Treasury note), is almost certainly part of a much more complex trading strategy. It has no standalone meaning. The fact of the trade itself, and of the price at which it was done, is only meaningful in the context of what the trader was trying to accomplish with multiple trades executed simultaneously in different markets. And his strategy is very far from transparent.
Algorithmic trading makes up an overwhelming proportion of total trading, perhaps as much as 85%. And this activity, which is designed to capture very small price differences as they appear and disappear like quantum froth, dominates the traditional purpose of trading, which is to discover the prices and value of real-world investments.
Therefore, algo-trading extracts a certain, and very significant, amount of value from capital markets. This is value that otherwise would have been applied directly to the provision of capital for industrial activity. Capital markets are parasitizing themselves. How might you go about quantifying the degree of parasitism? Well, it probably correlates well with the trading-desk profits of Wall Street firms and boutique quant shops.
What's the upside? High levels of trading make markets more liquid, and this is an undeniable benefit for people, like mutual funds, that often must execute very large trades.
But I'm not convinced. Someone needs to do a relative-value calculation. Pervasive, high-volume trading adds a large noise component (excess volatility) to market prices, taken over the very short term. It's quite possible, and I think quite likely, that the value which this subtracts from the economy is quantitively larger than the liquidity benefits it provides.
If that turns out to be the case, then as a matter of policy, you would want to shut down most prop-trading. That could easily be done by applying a tax of a fraction of a basis point to every trade.
If we end up doing that (which, as far as I know, only I am talking about), then Wall Street will need to come up with a totally different way of making money.
Who knows, someone might revive the idea of traditional investment banking, such as was practiced 100 years ago. Discount risk, and match the providers of capital with the consumers of capital. And maybe that would lead us back to a future of healthy, sustainable economic growth.
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