Home > finance, modeling, rant > What does a really efficient market look like?

What does a really efficient market look like?

December 23, 2013

The raison d’être of hedge funds is to make the markets efficient. Or at least that’s one of the raisons d’être, the others being 1) to get rich and 2) to leave early on Fridays in the summer (resp. winter) to get a jump on traffic to the Hamptons (resp. ski area, possibly in Kashmir).

And although having efficient markets sounds like a great thing, it makes sense to ask what that would look like from the perspective of a non-insider.

This recent Wall Street Journal article on high-tech snooping does a pretty good job setting the tone here. First, the kind of thing they’re doing:

Genscape is at the vanguard of a growing industry that employs sophisticated surveillance and data-crunching technology to supply traders with nonpublic information about topics including oil supplies, electric-power production, retail traffic and crop yields.

Next, who they’re doing it for:

The techniques, which are perfectly legal, represent the latest advance in the longtime Wall Street practice of searching for every possible trading advantage. But the high cost of much of the new information—Genscape’s oil-supply report costs $90,000 a year—means that some forms of trading are becoming even more the province of firms with substantial resources.

Let’s put these two things together from the perspective of the public. The market is getting information from hidden cameras and sensors, and all that information is being fed to “the market” via proprietary hedge funds via channels we will never tap into. The end result is that the prices of commodities are being adjusted to real-world events more and more quickly, but these are events that are not truly known to the real world.

[Aside: I’m going to try to avoid talking about the “true price” of things like gas, because I think that’s pretty much a fool’s errand. In any case, let me just say that, in addition to the potentially realtime sensor information that goes into a commodity’s price, we also have people trading on it because they are adjusting their exposure to some other historically correlated or anti-correlated instrument, or because they’ve decided to liquidate their books, or because they’ve decided the Fed has changed its macroeconomic policy, or because Spain needs to deal with its bank problems, or because someone wants to take money out of the market to rent their summer house in the Hamptons. In other words, I’m not ready to argue that we’re getting close to the “true price” of gas here. It’s just tradable information like any other.]

I am now prepared, as you hopefully are as well, to question what good this all does for people like us, who are not privy to the kind of expensive information required to make these trades. From our perspective, nothing happens, the price fluctuates, and the market is deemed efficient. Is this actually an improvement over the alternative version where something happens, and then the price adjusts? It’s an expensive arms race, taking up vast resources, where things have only become more opaque.

How vast are those resources? Having worked in finance, I know the answer is a shit-ton, if it is profitable in a short-term edgy kind of way. Just as those guys dug a hole through mountains to make the connection between New York to Chicago a few nanoseconds faster, they will go to any length to get the newest info on the market, as long as it is deemed to have a profitable edge in some time frame – i.e. the amount of time it will take a flood of competitors to do the same thing.

Just as there’s a kind of false myth that most of the web is porn, I’d like to perpetuate a new somewhat false myth that most data gathering and mining happens for the benefit of trading. And if that’s false now, let’s talk about it again in 100 years, when the market for celebrities is mature, and you can make money shorting a bad marriage.

Categories: finance, modeling, rant
  1. glovideoglovideo
    December 23, 2013 at 10:53 am

    Cathy, you should be writing for the Wall Street Journal, NY Times and a raft of magazines.


  2. RomBea
    December 23, 2013 at 2:22 pm

    This “high-tech snooping” reminds of the corporate espionage that former intelligence officers do for corporations. Corporations hire ex-CIA, FBI, NSA, and even ex-KGB officers to spy on other corporations. They can even can hire active duty US intelligence officers.

    Listen to this Democracy Now interview with the Politico reporter who wrote a book on it. It will blow you away. There’s a note about corporate espionage that occurred during the financial crisis as well.


  3. December 23, 2013 at 3:34 pm

    The “speed game” in both public and private information has existed for as long as centralized trading locations have existed.

    Let’s not forget that news of foreign wars used to be delivered by official courier on horse-back to trading bourses. Wealthy families with faster horses were able to receive this information days in advance. You could make the same argument questioning the public good back then as you do now.

    However, the historical record shows that any single step in the speed game can not be exploited for too long as more firms enter that trade. This is what is meant by market efficiency. In most cases, whatever exploit was being made eventually becomes a public good (granted it’s long after the cash cow stage).

    If this methodology is legal but we think it should be illegal, that is a completely different scenario.


    Also to correct: the chicago to new york line was a few milliseconds difference, not nanoseconds. And they had a really hard time getting anyone to buy on that line. Their business model has changed several times since they started. This suggests that very few firms are actually making money on the chicago-nyc basis trade.


  4. revuluri
    December 23, 2013 at 5:10 pm

    Another take on the same events:

    My utilitarian perspective is that critiques I hear often – that “this kind of thing is ok, since it must pay for itself or they wouldn’t be doing it” or alternatively, that “they probably pay away all their edge and it’s just the technologists who make out in the end” – may seem reasonable in the abstract but are actually inconsistent with the facts, in particular (a) negative externalities for investors (as opposed to traders) and (b) the crazy large winnings to the victors in this game.


  5. Kaleberg
    December 23, 2013 at 11:32 pm

    Back in the late 1980s, Mars, the big candy company was a big user of satellite imagery and aerial photography, because they wanted to know how the chocolate crop was doing. Like most candy companies, they bought chocolate on the open market, but they also bought chocolate futures for delivery, and locking in a good price was really important.

    They were not the only company doing this. For example, airlines were always following the petroleum market as well as weather forecasts. They’d lock in prices as best they could with futures contracts, but they’d still have a date with the refinery. When their oil was delivered, they still had to choose whether to go for jet fuel or heating oil, and screwing up could cost them dearly.

    If your company relies on a commodity, it makes a lot of sense to get all the information available. If that meant paying for satellite images, sending up aircraft with cameras, listening to market scuttlebutt in West Africa or Argentina, or buying pricey newletters published by various consultants and analysts, then you did it.

    It wasn’t just companies reliant on commodities either. There were a lot of people who were simply traders. They’d follow the markets and place their bets. Sometimes, they were right and their counterparty was wrong. Sometimes it was the other way around. Their goal was to be just a bit right enough more often to make a profit.

    I’m not surprised the hedge funds are getting into this. They had a magic reputation some time back, but anyone following the hedge fund business knows that hedge funds produce mediocre performance at best and are often spectacularly wrong. My impression is that wealthy people create hedge funds to give their sons-in-law a job that can support their daughters in style. (I don’t know of any created for daughters-in-law. They tend to get charitable foundations like Sofia Coppola in Godfather III.) Given how desperate hedge funds are for producing high return in a dead economy, they are probably ripe for plucking by the serious traders.


  1. December 29, 2013 at 4:52 pm
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