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reason as a blunt instrument

14 June 2011 in Uncategorized | Tags: , , , , , , , | Leave a comment

Did the human capacity to reason evolve as a mechanism to acquire truth? Or was it only in the service of winning arguments?

This is the question at the center of an article by Hugo Mercier and Dan Sperber in The Journal of Behavioral and Brain Sciences. Described by the New York Times, the article observes that language and reason have little to do with “truth and accuracy.” Quoting Mercier:

Reasoning doesn’t have this function of helping us to get better beliefs and make better decisions. It was a purely social phenomenon. It evolved to help us convince others and to be careful when others try to convince us.

The position of Mercier and Sperber would appear to provide an evolutionary explanation for all manner of rhetorical devices and tendencies. Individuals, for example, have a tendency to ignore data that does not support their case. This phenomenon is called confirmation bias. In a sense, reason isn’t an instrument by which to acquire truth. Instead, it’s perhaps more ambiguous. Reason is a means by which to convince others, change their minds. Reason is coercive.

Mercier and Sperber’s argument has inflamed some elements of the academic community. Darcia Narvaez, an associate professor of psychology at the University of Notre Dame diminished the theory as a moment of academic fashion:

[it] fits into evolutionary psychology mainstream thinking at the moment, that everything we do is motivated by selfishness and manipulating others, which is, in my view, crazy.

Others have remarked that Mercier and Sperber’s argument is in fact an example of the wisdom of crowds or the aim of deliberative democracy, described by Rawls and Habermas. Jonathan Haidt, a professor at UVA quoted by the Times, suggested as much:

Their work is important and points to some ways that the limits of reason can be overcome by putting people together in the right way, in particular to challenge people’s confirmation biases.

Mercier and Sperber appear to be heading in this direction, as well. Their article points to the advantages of group dynamics in the development of strong arguments. The group, after all, is equipped to present and vet many perspectives in rapid succession. The group could conceivably pick apart instances of confirmation bias and illuminate flaws in reasoning. According to Mercier and Sperber,

At least in some cultural contexts, this results in a kind of arms race towards greater sophistication in the production and evaluation of arguments. When people are motivated to reason, they do a better job at accepting only sound arguments, which is quite generally to their advantage.

Yes. Reason may be coercive, but Mercier and Sperber seem to be saying that with enough reason, enough speech, the group should arrive at a better outcome. Indeed, it’s reminiscent of the logic underpinning the metaphor of the marketplace of ideas – that more speech and more argument might spawn better speech. Justice Holmes, who coined the phrase in 1919, would be proud.

The marketplace metaphor, however, is flawed. As we’ve seen at other times, through the views of Ronald Coase, Justice Stevens, and others, an efficient market in speech does not equate to some Spenserian concept of survival of the fittest.  Indeed, Mercier rather off-handedly observed, “It doesn’t seem to work in the U.S.” Which leaves us with a question, just what is this metaphor we call the marketplace of ideas? Is the mere presence of a group itself sufficient to present and vet a variety of arguments? How do economic resources distort the marketplace of ideas?

crossing trades

29 April 2011 in Uncategorized | Tags: , , | Leave a comment

another take

decimalization, make-or-take, and the markets today

19 April 2011 in Uncategorized | Tags: , , , , | 1 comment

Some 33% of US stock trading activity takes place outside of exchanges. Four years ago, only 20% of trading did. What does that mean? Now, only two-thirds of trading actually sets the price of a stock that zips along the ticker, down from 80% in 2007. Where has all the trading gone?

Call it high frequency trading or automated market making or any number of other monikers, but trading isn’t happening on the exchanges. Instead, they might be traded within a dark pool, through a crossing network, or absorbed within the platform of a broker-dealer. The prices in these venues, however, don’t make it to the tape, and we are left with a question: is that a good thing? Read the rest of this entry »

the diffusion of execution

30 March 2011 in Uncategorized | Tags: , , | 1 comment

The whiz-bang technology in markets today means that when things go wrong, they go wrong very fast

—Bart Chilton, CFTC Commissioner, on the flash crash and the perceived instability of trading outside of exchanges: via Reuters

crossing trades and odd lots

23 January 2011 in Uncategorized | Tags: , , , | 4 comments

BlackRock caused a stir in 2009 when it announced its intention to increase the practice of crossing trades. It signaled to the street that they were sufficiently large to find counterparties within and among their many portfolios and clients. They would no longer rely so greatly on the efforts of outside brokers. Brokerages recoiled in defense and BlackRock was forced to say that it would continue to be a big customer of the street. Nonetheless, their intention hung in the air.

It wasn’t that crossing trades would comprise a new development. Asset managers have crossed trades before and in great number for years. Why should an investment manager go to a brokerage to sell a security when another of the firm’s portfolios or clients would like to buy it? Cross the trade, and you don’t have to pay a brokerage fee. The practice lowers costs and lowers risks by limiting one’s reliance on the street for pricing, market intelligence, and execution. BlackRock’s scale, however, suggested that something might be different this time. But was it?

BlackRock’s proposal represents the slow realization of a long-standing trend in the securities market – the systematic and persistent diffusion of the market center. In practice, it has meant a progressive shift from transactions through a fully regulated cartel at the core to a spontaneous and dynamic arrangement of counterparties. In fact, BlackRock’s proposal today bears the same signature as the odd-lot controversy in 1975, when Merrill Lynch proposed executing odd-lot trades on behalf of their clients. But it differs in one important respect. Rather than a brokerage house, it’s the investment manager that is driving the change: a principal, rather than an agent.

Merrill Lynch approached the New York Stock Exchange in 1975 with a simple proposal. They wanted to execute odd-lot trades off the exchange. Odd-lot trades comprised orders of fewer than 100 shares. Brokers would typically pass these to floor specialists, who would bundle them in round lots and execute them on behalf of a Merrill Lynch client. Merrill proposed to match odd-lot trades with buyers from among their existing clients and execute them at a lower cost than otherwise. The specialists were terrified.

The Floor

Merrill’s proposal would shift transactions away from the specialized floor traders, such as Carlisle DeCoppet, for example, the reigning specialist in odd-lot trades. Odd-lot trading comprised less than 5% of trading on the exchange, but the members feared the change would undermine a carefully constructed cartel that, through policy and procedure, directed the vast majority of trades to the floor of the exchange for execution by member firms. Chris Welles, writing in New York Magazine, 20 October, 1975, laid out the stakes: “Carlisle DeCoppet’s monopoly would be destroyed and its profits all but wiped out if Merrill Lynch goes ahead with its plan, for Merrill’s 1.5 million customers account for 26 percent of Carlisle’s business.” Merrill Lynch would effectively create a mini-stock exchange, separate from the NYSE.

The NYSE had only just been compelled by the SEC to no longer fix brokerage rates in May. The exchange forfeited the 183 year practice on May 1st, 1975, a day that would come to be known as May Day. Members, having lost the organizing influence of the cartel’s discipline, quickly found themselves in a price war, undercutting each other dramatically. With it emerged the first generation of discount brokerages. Many rules, however, remained, but the exchange was losing power.

The debate had moved to Rule 394, which had been designed to limit off-floor execution of trades. Though it did permit them if the off-floor price was better than the floor price, the spirit of the rule was intended to keep as much execution on the floor as possible: “Even if Merrill Lynch isn’t formally breaking 394, they are opening up a wedge. They are violating the spirit of 394,” said Harry Jacobson, a specialist on the floor at the time and then head of the Association for the Preservation of the Auction Market, a 700-member strong association of specialists with an interest in floor trading. Donald Weeden likened it to the Blackout Rule for sports-fans, “league-sponsored rules erected to assure a full-house for club owners.” Welles had just published The Last Days of the Club, in which he outlined the decline of the then stalwart Wall Street firms and subsequent rise of their inheritors. The title alone told the story, but the market for exchange seats made it tangible. The price for an exchange seat dropped in one month from $125k to $65k on the news of Merrill’s plan.

Jacobson, the APAM, and the floor was already under pressure. The increased importance of block-trading and simultaneous emergence of new technology had changed the market. Institutional investors had reached a critical mass. With their increased asset base, they increasingly looked to the floor to handle block trades. These weren’t odd-lots or round lots. They were large lots. Individual investors had rarely required such large capacity, but with their assets pooled in large institutions, it became an expected and regular event for which the specialists on the floor were unprepared. If these trades took them by surprise, new technologies, their adoption by institutional investors, and their impact on the world around the floor would have seemed even more earth-shattering to the convivial contretemps so often associated with the floor – grab-assing, practical jokes, and hijinks. Automation had come and gone for the floor specialists, with one noting, despite the prospect of considerable savings for individual investors, “let’s not engineer ourselves out of business.”

Merrill Lynch would get its way. May Day had weakened the exchange. Merrill’s proposal did not violate 394. It saved their customers money, and it uncovered the swollen and unsympathetic features of the cartel that dominated equity trading through the NYSE. The securities market would begin the systematic and persistent diffusion of the market center in favor of the edge. In 1975, the market moved from the floor specialists at the center to the investor-facing brokers, such as Merrill Lynch, at the edge. The floor lost its monopoly and other firms, such as Merrill Lynch, other exchanges, or agents would emerge as competitors.

Almost thirty-five years later, Larry Fink would voice a similar proposal, but it would come from an asset manager, not a broker or an exchange: a principal, not an agent. In September 2009, Fink announced that BlackRock would organize a system to cross trades within its massive asset-base for the benefit of the firm and its clients. He introduced it in terms of “trading friction cost” and lamented, “we need to make sure we’re not being taken advantage of.” Just like Merrill in the odd-lot controversy, BlackRock would cross-trades to benefit their clients: “our clients are going to make more return.” Fink would go on to say, “There’s no question, you have seen huge profitability in some of these institutions. The widest bid-ask spreads are in fixed income — the more opaque the market, the more money the market makers are making.” BlackRock wasn’t just interested in equities, it was interested in fixed income and perhaps other markets as well.

BlackRock would raise the specter of crossing trades again in late 2010. The FT quoted BlackRock president, Rob Kapito, on 28 December 2010: “We are developing the technology in-house to offer better value by lowering trading costs.” BlackRock’s push was quickly compared to the ill-fated E-Crossnet collaboration between Merrill Lynch Investment Managers and Barclays Global Investors in 2000. The collaboration aimed to provide a buy-side only crossing network to circumvent traditional brokers. E-Crossnet was part of the same shift from the center of the marketplace that began in 1975, but it had more in common with existing ECNs of the time. It failed to gain traction and was sold to ITG who combined it with the POSIT dark pool – effectively as an external agent. BlackRock, however, would operate as a principal, crossing trades across its vast collection of portfolios. BlackRock would effectively create a mini stock-exchange, separate from the NYSE and separate from everyone else, entirely, and entirely different than E-Crossnet.

E-Crossnet relied on a network effect across buy-side clients. The resulting pool of liquidity would provide low-cost transactions among the participants, but someone still needed to run it. It needed an agent, so it went to ITG.  BlackRock’s network relies only on the ability of BlackRock Solutions to design and develop a crossing system that will sit within BlackRock’ trade processing and order management system. BlackRock will run it, and they have sufficient scale to make the returns on those investments economical. Nonetheless, it would not be surprising to see BlackRock license the system to third parties for others to implement in their order flow and trade processing systems, just as they do with the Aladdin system for risk management. It would not be E-Crossnet Revisited. It would be licensed.

The first call for liquidity in BlackRock’s system won’t be to a broker. It will be to BlackRock. And perhaps the first call for Fidelity or Capital Research or AllianceBernstein won’t be to a broker. It will be to themselves, through a clever piece of software written by BlackRock solutions and part of the overarching trend of the market to decompose its center, drive execution toward the edge: from the select membership of the NYSE cartel to a cluster of brokers and other markets, to dark pools and now to the underlying investors and owners of the securities, each linked by pools of liquidity.

Going Retail – Banking, Glass Boxes, and our changing relationship to money

12 May 2009 in regular | Tags: , , , , , , | 1 comment

Is this when banks become glass boxes and retail spaces?

The early eighties saw dramatic changes in the banking regulatory environment. These changes fundamentally re-oriented the rules and competition within the banking system. Two bills started the process, which would continue throughout the eighties and into the nineties. As one would expect, they emerged out of a deepening crisis.

DIDMCA in 1980 and Garn-St Germain in 1982 responded to the high-interest rate environment that had exposed and exacerbated competitive disadvantages at the community bank and S&L level that stemmed from the existing regulatory framework. The legislative answer, in the form of DIDMCA and Garn-St. Germain shifted bank’s focus to financial products and opened the competition across state lines. The result was a shift in mind-set. Banks became two things. First, they became retail institutions designed to sell increasingly complicated financial services. Second, they also took on the ability to hold and manage increasingly risky assets. Both got them into trouble, but the shift to a retail mind-set is what changed the architecture of the bank.

Banks had been institutions defined by their place and designed to hold your money in a limited and regulated set of products. Banking institutions had been more like farms than those we regard today. Their business was tied to the fact that they were a physical part of the region. The McFadden Act of 1927 and the Douglas Amendment to the Bank Holding Company Act of 1956 intentionally obstructed the development of national banks. Their financial services were regulated, and they competed for customers based on the fact that they were close. These banks, coddled by a stable regulatory structure, remained largely unchallenged by competing institutions and cultivated the architecture of safety.

The high interest-rate environment of the early eighties strained the regional banks and forced legislators to respond. Banking regulations had put community banks and S&Ls at a competitive disadvantage. Interest rates were regulated and had not kept pace with the high interest-rate environment ushered in by Volcker’s Federal Reserve. As a result, they were losing deposits, and the banking system was in turmoil.

The DIDMCA focused on establishing equality among financial services institutions, so it would level the competitive field. It removed interest rate caps on deposits for community banks by phasing out Regulation Q, so they could compete with money market funds and provide market rates. Thrifts were allowed to enter the consumer loan and credit card business. The bill provided a consistent framework for reserve requirements that would be managed by the Federal Reserve as an instrument of monetary policy. It also raised the FDIC insurance levels to $100k, which William Isaac later claimed, with Fernand St Germain, was a mistake. Banks started on a trajectory from being a place to keep your money to a place for accessing money-services on the open market.

The crisis did not abate. The economy was in a major recession. Paul Volcker had raised interest rates to unimaginable levels. The thrift industry was in crisis, and congress came to the rescue in two ways. First, it accelerated the deregulation of banks and S&Ls, so they could improve their business. Second, it interceded with insolvent banks through direct funding and opening the possibility of non-regional and interstate acquisitions of banks.

The deregulation of the banking industry introduced a tectonic shift in banking. Banks would grow into financial supermarkets of services. Services, such as interest rates, which had been regulated, became competitive and subject to active management. These new abilities would enable banks to become aggressive producers and managers of capital. This was evident in many respects. The bill accelerated the abolition of remaining Regulation Q differentials between banks and thrifts, which governed maximum allowable rates on deposit accounts. S&Ls and savings banks gained the power to invest up to 5% of their assets in commercial loans. Up to 30% of an S&L’s assets could be invested in consumer loans, and they also could invest in state and local government bonds. In a high interest rate environment, this accrued to their benefit by making their deposits more competitive, improving the returns on their deposits, and perhaps improving net interest margins. Garn-St Germain also de-regulated real-estate loans, removing statutory restriction on real estate loans for national banks, and preempted state regulation that would adversely affect the activities of a national bank.

Garn-St Germain convened a spectrum of solutions for failing institutions. The Federal Savings and Loan insurance Corporation (FSLIC) introduced the concept of net worth certificates. These would be purchased by the FSLIC, counted as regulatory capital, and provide for the ongoing operation of the bank as a solvent entity. The legislation authorized the FDIC to bless interstate banking acquisitions of closed savings or commercial banks with assets over $500m, and similar powers were granted to the FSLIC. Both the McFadden Act of 1927 and the Douglas Amendment to the Bank Holding Company Act of 1956 had been designed to obstruct the development of an interstate banking system by devolving regulatory responsibility to the states, leaving no consistent national regulatory fabric. The FDIC’s new powers were a direct challenge to 50+ years of banking practices that defined banks and financial services in terms of place, not product. The Competitive Equality Banking Act of 1987 would later make these changes permanent and pervasive. DIDMCA and Garn-St Germain shifted banks’ focus to products, and place, though still important, was no longer integral of the bank’s identity. Later regulation, such as CEBA, would compound and expand these changes.

The rising metaphor for banking became the retail store. The architecture of safety was for institutions that were rooted in the region and frozen in the regulatory structures that came out of the market crash and depression. The emphasis was safety, the product mix was simple and regulated, and banks looked more like traditional, quasi-state institutions. The changes in the early eighties forced banks to expand the financial services they provided and provide them just like retail stores. These were new, highly variable, and very competitive. It’s not for nothing that Garn-St. Germain included the initial Truth in Lending provisions. The new services at the local bank level required marketing support and additional education. A teller didn’t have to give their client a toaster to stand out. With Regulation Q retired, they could offer a more competitive interest rate. These dynamics are more typically associated with consumer goods, and the architecture changed to suit them, promote them, and grow the business. Retail banking begins, and with it, glass boxes and retail spaces find themselves occupied by the former tenants of the traditional and staid – banks.

Out of region and out of state competitors begin to spring up. They’ve acquired failed banks or otherwise joined the market. The new branches are designed to sell financial services and projected into new markets. They’re designed to be retail stores for financial services. Banks find that they can quickly open “new doors,” as they might say in the retail industry, and these doors are the source of new deposits and sale of loans, accounts, et al.

One question that emerges is, if the front end of banks begins to shift into retail and change its relationships with its customers, how does the back end change? How do banks change their relationship to the supply of money? The legacy of the local bank had been deposits funded by a local depositor base and lent to the local depositor base according to strict capital requirements. What happens as the community banks and S&Ls gain direct exposure to the capital markets? One answer is Liar’s Poker.

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