Diary of a Financier

Monetary Innovation: How Triangle Trade Relates to High Frequency Trading

In Idiosyncrasy on Wed 14 Mar 2012 at 08:10

I am currently reading the latest edition of Manias, Panics, and Crashes by Charles Kindleberger and Robert Aliber. In a chapter entitled “Fueling the Flames: the Expansion of Credit,” the authors discuss the geneses for credit expansion, among them financial innovation vis a vis the monetary evolution:

“In many cases the expansion of credit resulted from the development of substitutes for more traditional monies. In the United States in the first part of the nineteenth century, the innovation was bills of exchange… replaced silver in the triangular trade among the United States, China, and Britain… The institutional innovation was that American merchants sent bills of exchange that specified payment in the British pound for China’s imports; the Chinese then shipped these bills to Britain to finance their trade deficit. The transactions costs involved in making cross-border payments using bills of exchange are much smaller than those that involved the shipment of silver.”

My mind drew parallels between this 19th century financial innovation and the modern digitalization of currency. Consider all the money that changes hands electronically, as opposed to physically, nowadays. The convenience has enabled such fluidity in our economic affairs. Yet, it reminds me of the Blackberry paradox I often reference: the first businessmen to use a smartphone enjoyed competitive advantages from having ‘their office follow them everywhere they went.’ Eventually, smartphones permeated the main-stream, leveling the competitive landscape such that nobody enjoyed relative advantages of the technology any longer. Ironically, if they’ve accomplished anything, Blackberries have left us with the boundless work day, and of a sudden ‘our office following us everywhere we went’ has become tarnish where there once was a sheen of efficiency. Similarly, the benefits from greater “fluidity of economic affairs” erode quickly once system-wide adoption razes those competitive advantages belonging to first-to-market users.

I do not oppose the developed world’s migration to an electronic monetary system. I consider it the natural, logical progression toward modernization. I do, however, want to shine a spotlight on the “opportunists” who seek to lever the liberties of the new regime. Whenever the rules or the playing-field change, someone stays one step ahead. Some are benefactors; others malefactors. Some are your Apple (AAPL) visionaries; others your Tour de France dopers.

To that end, I crossed an article of interest this weekend over at Business Insider, “How The Stock Market Resembles The Heart Rate Of A Dying Patient.” The author, Ashvin Pandurangi, discusses the stock market’s fractal structure historically showing deterministic chaos, culminating recently with uncharacteristically persistent volatility that resembles the EKG of a heart-attack victim:

“We see this dynamic clearly displayed in the cardiovascular system of humans – a healthy and stable heart is characterized by a chaotic beat interval pattern, while the heart of a person in ventricular fibrillation has collapsed into much more regular intervals.”

20120312-010602.jpg

In that vein, Mr. Pandurangi segues to a discussion about the flight of the retail investor at the haste of High Frequency Trading (HFT). He cites Australian economist Steve Keen, who observes:

Similar to the healthy human heartbeat, the market achieves aggregate stability when investors have variable time horizons and expectations for their investments. In contrast, a speculative bubble is formed when many investors share the same expectations, imitating each other’s decisions to buy, and a market crash occurs when they all “rush for the exit” at the same time. [Slide 36]

The relatively large drop for the day trader is basically a non-event for the weekly trader’s technical/fundamental outlook, so the latter can buy the dip and provide stabilizing liquidity to the market. [Slides 38-39]

The market once derived stability from the mix of different investors’ different time horizons. For one reason or another, mom & pop have left the game and took the long-term buy & hold segment with them, leaving high-frequency trading (HFT) robots relatively alone in markets to trade on short-term (millisecond) horizons with one-another.

Closing the loop of this entry, recall the currency innovations employed in the 19th century triangle trade. Today’s migration toward electronic currency exchange has enabled the HFT rise of the machines. Digital dollars allow HFTs to trade multiples of their capitalization intraday. (Trading as their own broker, HFTs don’t need settlement requirements to satisfy regulators. As long as all trades settle within T+3, they only need to settle-up net balances. So, in one day, a robot capitalized by only $10mm is permitted to trade $1b worth of liquid volume in SPY, assuming he can pay for the net position, if any, resulting from his buys/sells.) This would not be possible were the conventional process of trade settlement physical, as opposed to electronic; the HFTer would have to shell out gross sums for his trades, likely dipping into margin with Reg T limitations.

While I’m not convinced HFT is solely responsible for this market’s unprecedented volatility, I am confident that it has contributed more than its share. I don’t condemn the HFT opportunists just because they provide dubious social utility (after all, in an existential sense, what social utility does an iPhone offer?). Rather, I hope to contain them for their potential to distort and devour their host. In my opinion, they are one of many unintended consequences of monetary innovation. My intention herein was to make the historical connection to a prior analogue of monetary innovation. My message: Never underestimate the fate that begins with an innocent flap of a butterfly’s wings.

–Romeo

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  1. […] imitating one another.  Not to cloud short-term bullishness with gloom, but these kinds of markets always […]

  2. […] correlation drops, etc. See also: How the stock market resembles the heart beat of a dying patient https://thebuttonwoodtree.wordpress.com/2012/03/14/monetary-innovation-how-triangle-trade-relates-to-… #Hedge fund […]

  3. […] improvement over yesteryear’s floor traders taking 25 cent commissions–it’s the structural stability of our markets that’s troubling. The structural integrity of our financial markets has been […]

  4. […] avg <5% range; extreme 10% [Previously: Bubble indicators, Vol is not a timing mechanism, How the stock market resembles the heartbeat of a dying patient, From mediocristan to extremistan & Price controls never work] $VIX #Unconventional […]

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