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The Age of Microsecond Trading

Mashing-up two-unrelated topics. Let me know if I’ve been successful, or failed miserably, in the comments below.

Topic #1: Chinese Walnuts as Dutch Tulips: Economists, finance, and market professionals the world have all reminisced at some point about the story of the first market bubble: that of the Dutch Tulip. While I can’t yet endorse the book I’m perusing that refreshed my memory on this subject (Pricing the Future), I can say two things about it: (1) It accurately depicts multiple historical markets in which bubbles were created, and (2) It will probably make people who don’t enjoy economics/markets want to dunk their head in a pool of rum (and no, I do not mean you will want be drinking blue-colored fishbowls). Of primary import is the quintessential example of the tulip bubble perpetrated by nearly the entire Dutch population around 1637, and how tulips sold for nearly “ten times the income of a skilled craftsman,” (Szpiro, Pricing the Future).

Reuters recently reported that many Chinese investors, in what can be marginally viewed as a “flight to safety” (Gold in the US, walnuts in China…), are now investing in massive quantities of money in walnuts…up to $31,000! A quick check of the CIA Factbook revealed that the per capita gross national income of China is $4,260 (2010). While $31,000 may not be the norm, this is still 7.28 times the per capita gross national income! It doesn’t take a genius to see a walnut bubble is coming (I don’t think I ever imagined that those words would make their way onto this blog).

Topic #2: An article I received today talked about how the Institute for Supply Management (“ISM”) recently contracted with Reuters to reveal its manufacturing data in a new way (manufacturing data is a key indicator of economic health). Accordingly, they’ll now be revealing information via two feeds: one to the business wire, from which normal individuals get their information, and a second streamlined version via a “low-latency” feed that may be accessed many proprietary trading firms with exceptional resources and IT deployment. The article reasons that those individuals will thus be able to trade on the news faster. As I stated before, I am a capitalist at heart. Progress is made at the expense of the firm that cannot compete, as it should be (note that I did NOT say at the expense of people). In this mindset, the slower less-capable firms are phased out, and the faster more capable firms enjoy success. It is only when there is so little societal value that this process of progress should be discussed (a whole separate argument entirely).

Mash-Up: Are these quantitative traders similar in any way, shape, or form, to those who trade tulips? It would appear that outside the context of trading occurring in a marketplace, the answer is no. The connection, however, lies in the premise that all financial innovators are similar. Innovated instruments are meant, when created, to serve as risk management tools. The product itself is irrelevant, whether it is for walnut trading, tulip trading, or credit-default swaps (yes, that is a 2008 bubble reference). Inevitable in market economies are the bubbles created by a continued frenzied purchasing and increased valuation of a specific risk management tool, and the popularity of such a product. In 1637, it was forward contracts on tulips. In today’s society, it might be tech stocks (Dot-Com bubble in 2000, or swaps on high risk mortgage insurance in a saturated housing market in 2007-2008).

You will, more than likely, not be inventing a financial risk management tool. Trading on tulips appears to be more passe than Saved by the Bell: The College Years. Inventing new financial instruments, however, is not. The point is this: the big boys will always have the resources and tools in place to obtain the profit first. In a sense, it’s important…this is the way to introduce a valued commodity to society (i.e. valued risk management tools..there was some value to CDS’ prior to their implosion…and its why the trade today). However, it’s also why there is an uproar about a firm creating financial instruments, and then betting against them. Markets are products of societal sentiment. When you create a product, you know better than anyone the makeup and inputs to that product. The problem is, the masses do not. A firm (say, Goldman Sachs) can trade faster than you, innovate faster than you, and get information faster than you. And yes, sometimes they created the instrument in itself (Note: trading and purposefully screwing your customers is NOT what I am discussing; that activity is patently illegal). There is a knowledge edge that these firms employ. And they deserve to profit from that. What they don’t deserve, is to profit at the expense and misleading of others (and is the reason the fines exist from 2008). It’s undoubtedly a fine line that will require more light.

What’s the solution to this fine line that firms employ? Like everything here at QJ, make them answer to the free market. Stop them from utilizing your money on deposit as collateral for these trades. They will likely make smaller bets if they have to risk their own money; big bets for big profits are easy when its not your own money and the public has to subsidize your loss. Ahhhh Moral Hazard.

The bottom line is this: bubbles are bubbles are bubbles. If you are hearing about a new wave of investing in something for simple income gain, there are more than likely two outcomes (1) You get in and get out with your marginal (or sometimes atypical) profits before the bubble bursts, or (2) You are the sucker opposite whom everyone else is profiting because you’re “following the trend”. Traders will always profit, and some will always lose. Just make sure you’re not on the wrong end of a trade.

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