Guiding Seminar 2 Flashcards
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What is Moore’s and Murphy’s law?
▪ Moore’s law in financial markets: from 1929 to 2009 the total market capitalization of the US stock market has been doubling every decade
▪ Murphy’s law: “whatever can go wrong will go wrong” (faster and with worse consequences when computers are involved)
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What is algorithmic trading? What are the benefits of AT?
Algorithmic trading (AT): the use of mathematical models, computers, and
telecommunications networks to automate the buying and selling of financial
securities (benefits: cost savings, operational efficiency, and scalability)
▪ Cheaper, enhances operational efficiency and promotes economies of scale, but
creates tighter interconnections in the financial system
▪ Regulation is outdated and its philosophy is ripe for an overhaul
▪ AT is not bad per se, but it needs to be appropriately monitored to benefit the
society at large
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What encouraged the rise of AT?
▪ The financial industry is becoming more complex over time (not less) – marginal product of more sophisticated financial technology is increasing
▪ A number of breakthroughs in quantitative modelling of financial markets: Black, Cox, Fama, Lintner, Markowitz, Merton, Miller, Modigliani, Ross, Samuelson,
Scholes, Sharpe, and others
▪ Parallel breakthroughs in computer technology – Moore’s law in technology. Storage and processing speeds have changed the way financial technology
operates
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What 5 developments fueled the popularity of AT?
1) Quantitative models in finance:
▪ Markowitz portfolio theory. The CAPM. Factor models for return estimation. The BMS options pricing model. Dynamically complete markets
2) The emergence of index funds:
▪ “passive” investing: value-weighted portfolio need not be adjusted as it automatically does so as Mcap changes; Samsonite’s pension fund: rebalancing
weights to keep the $1 investment in each stock
3) Arbitrage trading (incl. statistical arbitrage)- one human cannot monitor all possible possibilities, AT can.
▪ Even if most arbitrage opportunities are not riskless, if you can manage and quantify their risks, they become an attractive investment opportunity. Statistical
arbitrage: large arbitrage portfolios are formed to maximize expected returns while minimizing volatility
4) Automated order execution and market making:
▪ Slicing and dicing orders to execute them in the optimal (cost-efficient) manner
without moving the price too much (despite a downward-sloping demand curve)
▪ Market-making: continuously quoting prices and standing ready to buy and sell
securities at those prices so as to gain on bid–ask spreads. AT allows for more
sophisticated dynamic risk management (specify how an bid/ask should be
adjusted following bid/ask orders)
5) High-frequency trading (HFT):
▪ Trade at incredibly high frequencies and short time intervals. HFTs’ impact on
liquidity and market quality remains ambiguous: more trading can promote
liquidity, but HFTs are often accused of predatory trading that consummates
liquidity
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What are some examples of AT failure?
- Facebook IPO glitch–> too high demand, the AT had to recompute price with every new order–> created a 30 min delay
- The perfect financial storm- in the source of 33 minutes, prices os most actively traded companies crashed and recovered (Apple traded only $100,000 per share).
- BATS IPO- software bug made symbols of stock from A to BFZZ inaccessible –> IPO was canceled
- Knight Capital Group- because of a technology issue sent out erroneous orders into the market–> the company had to liquidate the position–> huge losses
- High-frequency manipulation- spoofing and layering- placing orders to create a false impression of demand/supply and later trade in the opposite direction.
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What is spoofing? Layering?
Spoofing- placing an order in a certain direction (buy/sell) to create a false impression of demand/supply for a particular security and to later trade in the
opposite direction of the initial order, profiting from the imbalance
Layering- the same but or a series of orders at different prices (?)
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What are the regulation proposals for AT?
–> Do nothing: will result in cost reductions for intermediaries, but will not address
the issue of fair and orderly markets
–> Ban AT altogether: will yield a more “fair” and orderly market, but also reduce
liquidity, efficiency, and capital formation
–> Change the definition and requirements of market makers to include HFT: will
lead to a more fair and orderly market, but will also increase the costs for
intermediaries
–> Fix time intervals between trades (market continuity): leads to reduced
immediacy. Need more analysis to evaluate the effects connected with demand for
immediacy
–> Introduce a “Tobin tax” on all transactions: will reduce trading activity, liquidity
and make hedging more costly (think option dynamic replication) and remove HFT
Moore’s Law versus Murphy’s Law: Algorithmic
Trading and Its Discontents
What are financial regulations 2.0 for the AT?
- -> Systems-engineered: should approach financial markets as complex systems composed of multiple software applications, hardware devices and human personnel
- -> Safeguards-heavy: both human and machine safeguards are necessary to ensure the safe functioning of the system
- -> Transparency-rich: should aim to make the design of financial products more transparent and accessible to regular automated audits
- -> Platform-neutral: should be designed to encourage innovation in technology and finance and should be neutral with respect to the specifics of how core computing technologies work
Towards a Political Theory of the Firm
What is Medici vicious cycle?
The ability to influence the political power increase with economic power, so does the need to do so (fear of expropriation by politics)
“Medici vicious cycle” risk: money is used to gain political power and political power is them used to make more money
Towards a Political Theory of the Firm
What are the reasons behind why the size of the average publicly listed company has tripled in the market capitalization?
▪ The size and market share of companies has increased reducing competition across conflicting interests in the same sector (more powerful vis-à-vis
consumers)
▪ The complexity of regulation has increased (easier to tilt the playing field)
▪ Demise of the antibusiness ideology that prevailed among Democrats took place
▪ The ideal state of affairs is the “goldilocks” balance between the power of the state and power of firms (otherwise, one entity will exploit the other)
▪ Network externalities (an increase in usage leads to a direct increase in the value for others)
▪ Proliferation of information-intensive goods (high fixed and low variable costs with increasing returns to scale) [winner-take-all industries]
▪ Reduced antitrust enforcement
Towards a Political Theory of the Firm
What is the goldilocks balance?
The ideal state of affairs is the “goldilocks” balance between the power of the state and power of firms (otherwise, one entity will exploit the other)
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Towards a Political Theory of the Firm
On what does the Medici vicious cycle depend on?
▪ The main source of political power:(democratic or autocratic)
▪ The conditions of the media market: key mechanism in formation of social consensus; [i.e. censorship and concentration of media ownership in the hands of few make Medici vicious cycle more likely]
▪ Electoral process (incl. electoral law and campaign financing laws): [Electoral law – who can vote, who can hold the office, how political parties can be organized]; [campaign financing – private or public?]
▪ The dominant ideology; political legitimacy (how a given jurisdiction selects a person(s) whom they entrust the passage of new laws – think formal election process vs. inheriting political power)
▪ Prosecutorial and judiciary powers: how independent these powers are from the the political and the economic powers?
Towards a Political Theory of the Firm
On what does a company’s ability depend to obtain what it wants from the political system?
1) Its ability to make credible long-term promises (future employment opportunities for politicians and regulators – think Citigroup example). Depends on the company’s longterm survival probability
2) The grip a company has on the market for specific human capital (the only game in the town – being the only employer in a town gives you a lot of lobbying power)
3) A company’s ability to wrap its self-interest in a bigger, noble idea (Fannie Mae and
the goal that every American should be able to borrow to purchase a house)
4) The control that a company has through its imagine in society by way of employment,
data ownership, media ownership, research funding, other methods
The Economic Consequences of Legal Origins
What is a legal origin? What are the possible reasons for divergance?
Legal origin (LO) is a style of social control of economic (and not only) life (English common law vs. French civil law) ▪ English law puts a greater emphasis on judicial independence and the enforcement of property rights, in part through the active use of case law (precedents) ▪ French law sets maintaining social order as its top priority and attempts to write laws and statutes that require strict enforcement rather than interpretation
Possible historical reasons for the divergence:
▪ Common law – developed because the side of lawyers and property owners wanted to limit the
crown’s ability to interfere in the markets;
▪ Civil law – rediscovered in the Middle Ages and adopted by the Catholic church. Policyimplementing, state-desired allocations. Written during the 19th century French Revolution in
Napoleon’s codes to deprive judges, who were on the losing side with royalty, of law-making
power (i.e. create a legislation that can foresee all future circumstances)
The Economic Consequences of Legal Origins
Compare the investor/ creditor protection between the common and civil law? Regulations? Judicial institutions?
LO → investor/creditor protection → economic/financial development
▪ Common law is associated with significantly better protection of creditors and outside investors,
both through rules and enforcement
LO → regulation → economic/financial development
▪ Common law is associated with less intervention in the markets/societal organization
LO → judicial institutions → contract enforcement/property rights
▪ Common law is associated with more judicial independence
Common law appears to be associated with better rules and in turn stronger financial development that leads to better economic outcomes (e.g. [arguably] faster economic growth). (Arguably because there are other confounding variables, such as human
capital)
