Should capital markets slow down?

I've been following the recent Knight Capital algorithm debacle for some time, and am a bit puzzled: what's the advantage of allowing all these algorithms to run amok in the capital markets? In particular, those algorithms that make hundreds of trades per second.

Brokerages and exchanges will want these algorithms in the market, since algos will allow them to earn commissions. With a global trend of declining commissions, most brokerages and exchanges need to increase the volumes to make up for the declining commission rates. Prop firms (including hedge funds and proprietary desks of investment banks) will want these "algos", since the algos supposedly give an "edge" (i.e. competitive advantage over the rest of the market). As my previous trading boss used to say, "no edge, no profit". 

However, if you look at the capital markets on the whole, it's hard to see how the advantages outweigh the risks involved. A rogue algorithm running amok in the market can react much more quickly than any human, causing markets to crash without any underlying economic basis: besides this Knight Capital incident, the Flash Crash of 2010 also comes to mind. This can spread fear through a market faster than you can swear "F----"... and fear (as an emotion) is a dangerous emotion to have spreading throughout a market. Worse, once a "situation" occurs, it's next to impossible to stop it without disrupting the entire market's function. High frequency trading basically raises the possibility of more negative black swans, without any real economic benefit.

It's also arguable if allowing milli- and micro-second trades helps in the price discovery process: is it really meaningful price discovery between a willing buyer and seller who can cognize the price and economic benefit/cost, or is it just "noise" between one algo and another? Can it really be meaningful price discovery if a human watching the exchange (even an experienced floor trader) won't be able to cognize the price, as it just happens far too quickly?

Perhaps as a policy, exchanges globally should consider limiting the speed of transactions, s.t. an algorithm cannot be faster than, say, the typical human reaction time on an electronic trading desk. Otherwise, we run a real risk that the Machines will overtake the markets, and leave us wondering what happened in the aftermath. 

It's been a while...

I haven't blogged on this since I started working in my current organisation. This had to do with lack of time, but also lack of familiarity with the environment: what can I write about? What can't I write about (especially since I'm under the Official Secrets Act)? Rather than risk it all with commentary, I thought it safer to wait a while, understand the "new" landscape, before taking any risks. (The Polish saying "only a fool tests unknown waters with both feet" comes to mind...)

Hence, after a three year absence, I've decided to dip a tiny portion of my little toe into these once-familiar waters. Why? The answer is similar to George Mallory's reply, when he was asked why he climbed mountains: because it's there. If you were to try a six-year-old's interrogation technique (of repeatedly asking "why" to every reply), Mr. Mallory would probably have replied "because I like climbing" and ultimately "because it's fun".

And so, in my case, I'm writing again in this blog, because (a) this blog is here, and some previous blog entries were pretty good, in my not-so-humble opinion, (b) because I like writing, and (c) because I find writing fun.

It's also the case that a blog serves as a great way to capture ideas and thoughts. Reading some of my older blog entries, it's unthinkable for me to be replicate them, largely because the moment is lost. Reading a blog entry, for me, is a bit like re-acquainting myself with my past-self. It's like meeting an old friend (i.e. my self from the past), or more accurately, like a ghost or a memory.

To be sure, there are a few things that this blog won't capture:

1. Nothing mundane ("I ate breakfast today. I had an egg omelette that was fan-TASTIC and black coffee blah blah blah".... FTS). You don't need to know when I take a crap, as it's my own business (literally). 
2. Nothing official or official-related. Everything here is my own personal view and take, and shouldn't be viewed as representative of my affiliates, employers, etc. 

This blog is really an intellectual playground for myself, since I tend to think aloud (but not so quickly that I can verbally improvise). So, really, this blog is a mirror for myself, for me to talk to myself like a narcissistic schizophrenic with split personality disorder. 

But you're welcome to listen in the dialogue. And to comment, too. 

:) 

Amsterdamned

I've been in Holland for about a day, and I've been here before, and have come to really enjoy Holland. The people are invariably friendly and things function really well.

I'm particularly impressed by how the Dutch somehow balance the dynamic creativity of capitalism with certain social institutions and safety nets of the stereotypical "socialist" European society: when you go through Amsterdam, it has the feel of a very lived-in and dynamic place, with lots of entrepreneurs setting up businesses. It's a very capitalistic society (they had the earliest stock exchange in the world, and also pioneered the concepts of the corporation).

But then it is also interesting that this same society seems relatively egalitarian: there are practically no homeless drunk people in the streets (if you exclude the drunk/stoned Brits drooling on the sidewalks), and their entire social system (from what I can gather) seems to place an equal weight not just on pure profit, but also on fairness (a concept that most capitalistic societies seem to treat as a luxury good), with a focus on making sure all sides are heard and all parties are taken care of. For example, employers have to pay 8 percent of your salary in "vacation money", meant to pay for tickets, hotel bookings, etc., for you to go on vacation. This is on top of the paid vacation time that you are already entitled to as your normal compensation packet, and (get this) even if you are unemployed! The reasoning (based on the NY Times, the Oracle of Manhattan) is that "if you can’t go on vacation, you’ll get depressed and despondent and you’ll never get a job".

With a society like this, it's little wonder that there is quite a strong social glue holding the whole society together. I went to the Dutch Resistance Museum today, which was awesome (though the same can NOT be said of the owner of the cafe next door: please avoid the cafe unless you want to get harangued about "manners") and extremely eye opening about how diverse, yet united Dutch society is. The Dutch seem to have taken great pains to ensure that all groups are included in the societal dialogue, with no single group being superior; as a consequence, even though the Germans in WWII treated them as "pan-germanic brothers", the general sentiment across the society was one of resistance. A particularly funny episode I read there: this Dutch woman was arrested for anti-German sentiment. In prison, she was given the socks of SS soldiers to mend. She proceeded to "mend" by sewing up the sock holes entirely (so they were unwearable) "by accident"!

This led me to think about Singapore, and how tenuous the link is between most Singaporeans and Singapore. Can I honestly look at a fellow Singaporean who has migrated to Australia, and tell him that "your country has done so much for you"? Can we honestly say that our dialogue includes all strains of thought, that our system is fair, that we tried our best to help the disenfranchised and the unfortunate? I'm not sure.

There are times when I consider certain things (like the lack of consumer rights in Singapore) and wonder, if my friends and family left, "would I still go back to Singapore?" Having come to Amsterdam, that question continues to ring loudly in my mind as I think about this.

Review on article in the Economist about bank stocks and employees

Sorry to my non-existent readership for not updating this in a while, as I have been busy being funemployed.

My favourite magazine in the world, The Economist, just published a brillant article over the weekend about bank employee compensation and their returns to shareholders (over the same holding period). The most striking thing about this article was the diagram that they used to illustrate the investment-turkey-payoff vs. the employee compensation for Lehman Brothers (see below, from the Economist website). From this, it is fairly obvious that (a) it sucks to be a shareholder of an investment bank that is going bankrupt, and (b) it's great being an investment bank employee, as you get all upside and absolutely no downside whatsoever.

The second thing that was striking about this article was the last paragraph, which is much the same said by Nassim Taleb, phrased in a different way:

Banks pay low dividends, and when they get into trouble the capital that shareholders have retained in the firm typically gets wiped out. Employees have taken money out of their firms each year. It may be time for the owners of banks to mutiny over the bounty.

Read the article, and then think for yourself whether speculation in bank stocks really is worth the risks involved: you might be better off trying to get into a bank as an employee than playing with their stocks.

As I'd previously highlighted in this blog, we Singaporeans hardly have a choice in the matter, given Temasek's huge investments in banks as a proportion of its portfolio. But I do hope that the powers-that-be are looking closely into their portfolio, and demanding more "bounty".

And in response to Temasek's repeated exhortation that they are investing in stocks "for the long run", it is worth considering what ex-Morgan Stanley Asia chief economist Andy Xie (who apparently got into trouble for his candid remarks about Singapore, ball-carrying Westerners and PM Lee) has to say about stocks in the long-run:

It's a widely accepted notion that long term stock investors make money. Actually, this is not true. Most companies don't last for more than 20 years...In the long run, all companies go bankrupt.

(from the English 财经 magazine, link here)

From my other blog: http://daftfadertrader.blogspot.com

I've been reading Jim C Collins' book Good to Great (Why some companies make the leap and others don't), which is a very well-reasoned book backed by lots of data.

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Introduction to the Stockdale Paradox

The Stockdale Paradox was coined by Jim Collins, and was named after Vice Admiral James Stockdale, USN, who was the highest ranking US prisoner-of-war in the Vietnam War, and who was held for eight years (from 1965 to 1973) and tortured over twenty times. Most impressively he actually took command within the Hanoi Hilton (together with Brigadier Risner), and never allowed himself to be used by the Vietnamese for propaganda, even slitting his face on purpose.

During an interview with Admiral Stockdale, Jim Collins asked "Who didn't make it out?"

Admiral Stockdale's reply was enlightening:

"Oh that's easy; the optimists. They were the ones who said, 'We're going to be out by Christmas.' And Christmas would come, and Christmas would go.

Then they'd say, ' We're going to be out by Easter!' And Easter would come, and Easter would go.

And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart."

He then ended with this:

This is a very important lesson.You must never confuse faith that you will prevail in the end - which you can never afford to lose - with the discipline to confront the most brutal facts of your current reality, whatever they might be.

The Stockdale Paradox is something that I have thought about many times before. What Admiral Stockdale called the optimists, I call them the unhealthy optimists, guilty of unhealthy optimism. How does unhealthy optimism manifest itself? It very often manifests itself in explicit and outcomes-focused positive self-talk, like "best training", "cutting edge", "best performing", "peerless" and other superlatives. You can see this in certain people (especially, in my experience, inferior managers) who talk about "positive thinking" and "positive self-talk"; arguably what these people are doing instead is positive denial. They refuse to confront reality, instead cling on desperately to their illusion of positivity.

A friend of mine not so recently remarked to me that she had tried positive thinking for a while, but gave up because it made her feel worse. I suspect that her positive thinking is what I call positive denial, and her reaction is exactly what happens when unhealthy optimism meets with brutal reality.

When you believe in your own bullshit, you end up in really deep shit, especially when you are finally confronted with the reality of the situation. This applies to organizations that believe their own propaganda, and to individuals who believe their own self-talk, and to both organizations and individuals who do not face up to reality.

The reverse of unhealthy optimism is healthy optimism. Healthy optimism is implicit: if you're good, you don't need to say it out. In fact, it is often impossible to spell it out without sounding like a broken record. Far more often, you would prefer to not say it out and just focus on what you need to do. This is something that can be trained: arguably the healthy optimism mindset is the basis of all sports training and self-improvement, allowing the mind to actually focus on feedback instead of feeding on emotional fears and internal dialogue.

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Crystalizing moment

Personally for me, the crystallizing moment between unhealthy and healthy optimism actually occurred during Basic Military training, during the final 24-km route march. After the fifth time of telling yourself "I can do it!", this self-talk begins to sound like what it really is: an empty promise to yourself. Internally it becomes very clear that there is a very sharp contrast between what your head is saying and what you are actually feeling: your rational voice is saying "I can do it!" but in actual fact you are despairing at the sheer pain.

Instead, what actually worked for me (especially since I developed a huge blister by the 4th kilometer) was to internalize the belief that I can do it, literally by saying to myself, "yes, you can do it, so shut up and do it" and then I just focused on the reality of the situation: that I will only finish this one step at a time. So I literally focused on one step.

Then the next. And so on, for the remaining 20-km with the blister.

It was the confrontation of the reality that allowed me to cope, because ultimately reality is what you experience. Interestingly enough, the memory of this has also given me the confidence to overcome other things that I have experienced before in my life. Healthy optimism begets more healthy optimism.

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Stockdale paradox in relation to trading

Specifically, in trading, the Stockdale paradox is the ideal trader's mindset: ideally a trader will never lose faith in his/her ability to learn the markets and to trade profitably, while confronting the realities that manifest in his losing trades.

Unhealthy optimism manifests itself (I think) in some of the following ways:

1. A trader looks only at the opportunities, and overlooks the risk: a case of positive self-talk ("There is plenty of opportunity in the markets!") without focusing on the reality ("You could lose your pants in the markets too!")
2. A trader adds to losing trades: again, a case of positive self-talk ("The market will turn! This is good value! I am right!") vs. market reality ("There go your pants again, thank you, O liquidity provider!")
3. A trader looks perpetually for the perfect indicator, the perfect broker, the perfect market, and the perfect trading teacher who will teach one to be a perfect trader: this is less obvious a manifestation. Underlying this search for perfection is an optimism that such perfection actually exists, and that this panacea will be readily available to the trader looking for such a thing. Like the wishful thinking in the examples above, this is usually an evasion of self-control and self-responsibility. Usually this trader's self-confidence in the perfect indicator/broker/market/trading teacher lasts until the first big loss, after which the trader's mindset turns around from "this indicator/broker/market/teacher is perfect" to "damn this scheisse!!" Again, when wishful thinking meets brutal reality, brutal reality usually wins.
4. A trader who trades without a plan, only with self-confidence: wishful thinking.

Undoubtedly everyone has gone through some of these flaws at some point or another. What differentiates the (eventual) winners from the losers is their ability to face up to reality, and to take steps to deal with reality. Often these steps are small baby-steps, but these are still very important. Many times, you will dance the Annoying Tango of Frustration ("one step forward, three steps backwards").

But ultimately, my belief is that the person who most readily faces up to reality, and who most actively seeks rational solutions to his/her reality will be the most likely to succeed in the longer term.

Rules-based naïveté

Singaporeans are stupid. - Li Ao

新加坡人笨。 － 李敖

When Chinese television personality Li Ao made the above comment in 2006, it sparked off a furor in Singapore, with a wave of indignant anger mostly from the Chinese-educated Singaporeans (most English-educated Singaporeans don't even know who Li Ao is).

In general, I frown upon such generalizations and stereotyping, as labels tend to stick and often set up the basis of bigotry. Most of what he said on television about Singaporeans is hugely debatable and plain wrong (including his assertion that "Singaporeans have poor genes" and "no culture", as our "ancestors came to Singapore from China with only their underwear, let alone any culture whatsoever"). I think what Li Ao said is hilariously funny (especially if you don't take him too seriously), and I think what he says needs to be taken with enough salt to cause kidney failure in an elephant.

But what Li Ao says is not without a seed of truth, especially if you translate the Chinese word 笨 into clumsy or naïveté, rather than stupidity.

While I would not be so extreme as to say that Singaporeans are stupid, I would say from my limited personal experience that Singaporeans can be very naive; they tend to be pre-occupied with rules and regulations, and often have their thinking limited by those rules and regulations (see my previous blog post on my condominium's security guards).

When I see Singaporeans in a rules-free environment, I am often reminded of this Zen story about a horse that worked its whole life turning a grinding stone in a mill; when it was retired and allowed to graze on a large field, it went to the only tree in the field, and continued walking circles around the tree (like it did when it turned the grinding stone).

Like the horse, a lot of Singaporeans who grew up with a lot of explicit and implicit rules tend to be lost when they are thrown into an organic environment where the only limits are the ones you set for yourself. Like the horse, they then draw their own rules, and limit their own thinking to the imaginary box that they grew up with. So even if they are in a large open field, they will find their own tree and orbit around it.

I myself am not immune to this, as I remember what it was like in the Matrix, and the shock I had upon stepping out into the New World. I still vividly remember my surprise at how freely and easily my American classmates challenged professors in class (once, about the need for homework!) I also remember how pleasantly surprised I was when a venture capitalist who was guest-speaking at my course said that venture capitalists prefer entrepreneurs who had failed before, which surprised me as failure in Singapore is a social stigma to be buried and never talked about.

I suspect that is why there are so many implicit social rules for Singaporeans, like "marry and have three kids", "get a stable job", etc., often without any real questioning of assumptions. Most people in Singapore complain about the pressure of social norms; they really only have themselves to blame if they unthinkingly accept those norms and apply them to their own lives.

This naïveté is also perhaps why I have heard more than one Singaporean prescribe a standard set formula to developing nations: "Why is everything so disorganized? They should pass some laws and fine people to get them to behave. They should put bad people in jail, death to drug smugglers. They should have laws and rules forbidding pollution, corruption, etc. They should attract foreign investment."

But in my experience, mainland Chinese and Indian (especially those from the big urban centers of both nations) will understand that, it's often not that simple, especially in big countries with large populations (i.e. very complex systems) and myriad conflicts of interests by myriad parties. Some Singaporeans can be very simplistic, because we have grown up in an engineered-environment where we often do not see the larger consequences and ramifications of decisions because we are not big nor complex enough for these decisions to go wrong. (My working hypothesis is that people from big and populous nations have seen enough central plans go awry, because they come from nations which are big and complex, and where simplified engineered solutions often go completely wrong.)

Despite this, things are definitely changing in Singapore, as more Singaporeans study and travel overseas and as the next generation comes to being. You can see that in the younger generation, with people questioning how things are done in the Straits Times forums and in the local blogs. We can only change our viewpoint one assumption at a time.

The question I have for you, dear non-existent reader, is this: what assumptions around you and inside you have you questioned today?

Should Singapore focus more investment in "soft" science research?

Lately I've been toying with the possible idea of doing a graduate degree in behavioural economics, and started doing some online research on any programmes.

Not surprisingly, most of the graduate programmes available are in the US, with an additional programme in Nottingham, UK. But what surprised me was that there were next to no behavioural economics/finance research programmes here in Asia that was picked up by Google.

So this got me thinking, and I thought about what a great idea it will be for Singapore as a test-bed for behavioural economics: most of the research currently being done seems to focus primarily on test samples from the West, but nobody seems to yet have done a categorical study into the possible variations of key behavioural concepts (anchoring, frames, etc.) across different cultures. Given that Singapore is centrally located, and is a confluence point for both East-West, perhaps this is the best place for such inter-cultural behavioural studies to be done.

Also, instead of the Singapore government spending huge amounts of money on technological research programmes and fixed technological infrastructure that might or might not work (does anybody still remember the calls of Philip Yeo for Singaporeans to study engineering and biotech?), perhaps Singapore should increasingly focus on developing our "soft" research. "Soft" research areas in the social sciences are relatively cheaper: compare the amount of specialized equipment needed in a chemistry lab (mass spectrometers, lasers, NMRs, etc.) vs. a behavioural psychology lab (attractive female research assistants, hidden cameras, cookies, etc.).

As a consequence a large portion of investment in hard-science research facilities go into fixed costs (equipment), while investment in soft-research tends to go to variable costs (man-hours): the operational leverage of hard-science research is a lot higher.

Which logically means that perhaps the risks/rewards are higher if we put our research money into "soft" research than "hard" research. If Singapore puts more money and emphasis into "softer" research like psychology, economics, behavioural economics, sustainable development, etc., we might be able to boost our economy by creating niche industries and innovations that spinoff from such research.

We actually already have exported some behavioural economic innovations, albeit innovations that have come from our government. For example, congestion road pricing was first implemented in Singapore. Now, drivers in London curse and swear at their own road-pricing system, which was adopted by their Singa-phile ex-mayor Ken Livingstone. As another example, the Singapore Government's Central Provident Fund has been quoted in Akerlof and Shiller's latest book "Animal Spirits" to be a potential way to increase savings rates in the US.

Suppose that we invest in a research center focused on behavioural economics, and our research generates interesting findings of the different behaviours between, say, Chinese and American consumers. It's not unthinkable that our researchers will be able to setup consulting firms to advise foreign companies on the best ways to attract Chinese/Indonesian/Indian consumers.

Or if we setup a research institute on sustainable development, then Singapore could not unthinkably become a Southeast Asian hub for sustainable development research across different countries and regions.

This strategy of trying to improve one's academic standing by focusing on the "soft" sciences was adopted by New York University in 2003: New York University tried to revamp its reputation as a top liberal arts research institute by aggressively expanding its economics department , which seems to have been quite successful.

Having setup a Biopolis, perhaps it is time for us to look at a Behaviouropolis?