Monday, May 10, 2010

The future of finance?

My schedule has not permitted me to post anything fully-developed for quite a while, but tonight I have a few multimedia treats for you, building off of the news themes of recent weeks.

First off, "Quants, The Alchemists of Wall Street."  A film made about the mathematical geniuses who created the models that have been largely running the financial world for a number of years now.  While that may not sound like the most interesting subject matter, I highly recommend taking 45 minutes and watching the film, there's lots to learn:



I thought this was an interesting little film as it stood, however the second half takes a surprisingly prescient turn in that the interviewees (or "quants," short for "quantitative thinkers," I assume) begin to discuss "high frequency trading," a term that sprang into the wider international consciousness following last Thursday's as-yet-unexplained 1,000 point drop in the Dow.  The idea of high frequency trading (or HFT) is that arrays of computers are set up to catch any variations in a stock's price that exceed or fall below certain parameters, or that follow Google search terms and will buy or sell stocks based on what's "hot" on Google at that moment.  Those parameters are set by mathematical models created by quants.

There are a host of scary implications that result from high frequency trading (not least of which is that these computers essentially set up parallel market structures that operate outside of public scrutiny) however there is a somewhat more mundane detail that the film raised that I'd like to focus on.

One of the quants notes that the NYSE is going to be (or perhaps already has by this point) setting up a warehouse in New Jersey that will house huge arrays of computers, each belonging to the various financial firms, where they will engage in further HFT.  The idea is that the computers will be closer to the NYSE than before, and therefore they will have a faster data connection to the stock market.  A further implication is that certain firms will get "privileged" connections that will afford them a tenth of a second advantage over the other firms; how those firms are chosen, be it through lottery or through financial transactions with the NYSE (read: bribes), is unclear.

There are certain industries in the world that are capital-intensive, in the sense that those industries required a large amount of resources, be it money, physical inputs, or large areas of land, to operate.  Steel is a capital-intensive industry, as is telecommunications, which requires the development of a significant amount of infrastructure to operate.  Clearly the world of finance is a capital-intensive industry, as a firm generally requires large amounts of money to operate, however "boutique firms" have always existed that were able to operate with smaller amounts of cash.  With this impending shift to a computer- and geographically-dominated business model, I wonder if finance is becoming more capital-intensive too?

Consider that if you're a small player, you're going to be forever outmaneuvered by the big firms who have prime locations for the fastest connections for their computer servers in New Jersey, plus offices full of top-quality quants figuring out the most accurate (or at least, the least wrong) algorithms that are then fed into the computer systems constantly.  How is a small firm supposed to compete against that?  This sort of situation can only lead to further consolidation of the financial sector into fewer firms controlling more of the wealth in this country.  As I discussed in my previous post, further consolidation of wealth is a very bad thing indeed.
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And now for something only slightly different...

A further interesting implication of the film was the concept put forth by a couple of the quants that economists in recent years have begun to regard themselves as "scientists;" that their models predicting financial market movements and concepts were "laws" that would be proven correct no matter the circumstances.  This, despite the fact that economics has, since its inception, been considered to be one of the social sciences, these economists who were running the world of finance believed themselves to be masters of the financial universe.

There is a small problem with the underpinnings of these economists' views of the world, however: humans are messy.  To the extent that any sort of "science" is based on looking at human behavior in the aggregate there will always be room for inputs that simply break one's perfectly-calibrated model of the world.  So to the extent that finance is based off of the actions of many individual stock traders and firms run by financiers, perhaps it, too, should be considered a social science?  At least the world of theoretical finance, such as the world in which these quants operated should be, as they're modeling human actions in the aggregate, much in the same way that economists do.  Therefore, as even the quants recognize in the film, their models may not have failed, but the ways that the models were used and manipulated by the non-quant stock traders to make money is at least one part of what contributed to the financial meltdown in 2008.  Humans are unpredictable, and while it's a valiant effort to try to model human behavior, the more I read and the more I learn, the more futile, ultimately, I think it may be.  Just a small observation...

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Finally tonight, the terrible, terrible story of what happens when the financial markets run out of subprime mortgages to invest in: they turn to "commodities."  Commodities markets trade derivatives of actual, physical goods, such as corn/maize futures, oil futures, or gold.  I don't wish to get into how the derivatives contracts work (partly because this post is already long enough and partly due to the fact that they're bloody complicated) but suffice it to say that firms betting on the futures markets can drive the prices of commodities up in a way that is completely unrelated to the underlying supply and demand fundamentals of that commodity.  Witness the continued high price of oil despite the fact that oil consumption is the lowest its been in years (see the link above for more on that).

These effects can be devastating for the poor and middle classes around the world, and sadly, the financial reform bills currently being debated in the Senate may do little to nothing to halt the devastation.

For Rounds 2 and 3 of the feature films tonight, I bring you an interview with Indian economist Jayati Ghosh, who explains to us that when finance gets its hands on the very food you seek to feed your family with, prices often will go up, to everyone's detriment.  This interview will infuriate you, and you'll want to yell at your computer screen "how can humans be so immoral as to create food bubbles and starve the poor???"  Well having seen "Quants" now, and gaining a bit of access into the mind of the modern financial mathematician, I can see, to an extent, how that might happen.  When you're dealing only in abstract numbers, looking for the most promising market to invest in, with no concept of the fact that your actions will increase the price of corn to be used for tortillas in the slums of Mexico, then it's very easy to buy into that bubble.  Does modern finance add any social value to our society?  It's really hard to tell these days, but I guarantee I'll come back to that theme.

Part 1:


Part 2:


I have been working on more complex postings having to do with the nature of the financial/political nexus that has developed and subsumed our political life in this country, and I hope to post those soon.  Furthermore, the oil spill in the Gulf of Mexico and the Greek debt crisis are all fodder for future postings, if there's time...

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