Sunday, March 28, 2010

The speed of money

Apparently there is an entire small industry devoted to reducing the latency of financial transactions (typically measured in milliseconds).

And that's only a tiny part of the larger industry that makes the infrastructure for electronic transactions of all sorts. Here's a random company in that field. On that site, go find "Switching engine demo" (can't link directly, it's all Flash). Watch out for the sharks!

My ignorance of the financial world is nearly total, but it seems to me that stuff like this must be either a symptom or a cause of the recent collapse. The existence of hundreds of thousands of hair-trigger electronic automated trading rules all linked to each other through near-instantaneous networks seems problematic. What kind of dynamic system does this create? Doesn't it sound like you could get small-scale bubbles happening on a second-to-second basis?

It also sounds like another indication that the financial industry is a net economic drain. Think of all the people working on shaving milliseconds off of financial transactions. What possible benefit are they bringing to society? Presumably the only reason to care about millisecond-scale latency of transactions is because it brings some kind of advantage, in other words, you are racing to make your trade before the next guy can. The relation of this to any actual economic value escapes me.

I am enough of a believer in capitalism to acknowledge that the capitalist function of allocating capital productively is worthwhile. In fact I found my way to this topic via a casual conversation with a VC -- and whatever you think about Silicon Valley VCs, at least they are actual investors, not pure speculators; unlike the sorts of people who slice up shitty mortgages and resell them and unlike people who are slaving away to shave milliseconds off of transaction times. But 95% of the energy of the financial world seems devoted to things that have no visible relation to actual, real-world economic value.

Is there a way to bring the financial world closer to reality? One possible answer is a tax on financial transactions, which would put some dampers on whatever crazy feedback loops might exist in this system. Hm, Keynes had this thought in 1936:
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

And here's a recent op-ed piece saying much the same thing.


hoyhoy said...

Max Keiser, zerohedge, Jon Stewart and others have noted that HFT is an institutionalized form of fraud. It's ultimately a clever device for emptying whatever perceived wealth that's left in pension accounts. -

Absolutely nothing has been done to stop it by the SEC. HFT along with Repo105s and CDS scams are still completely legal and not a single jihadi banker has been prosecuted for engaging in these practices.

Do you remember those stories about the Romans adding impurities to gold coins as their empire became bankrupt? HFT is rather similar to that.

Anonymous said...

Your "speed of money," referring to the minute increases in the Fisherian velocity of money (V)caused by improvements in electronic funds transfers, is not "either a symptom or a cause of the recent collapse." Shaving time off settlements for economic transactions has little effect on the overall velocity of money. The fastest settlement is, after all, the most old-fashioned of all - paying cash. At the same time that electronic funds transfers take place more quickly, more and more businesses stretch terms of payment on credit - individuals pay retail credits more slowly - and so it is hard to know whether minute savings of time in settlement have done very much at all to speed the velocity of money in what is overwhelmingly a credit, and not a cash economy.

The correct variable is staring you in the face: the quantity of money (M).

Unlike previous economic downturns which originated in the securities markets, this one originated in the real estate market. The stage for it had long been set by various direct and indirect government subsidies, but the real build-up began after 9/11/2001, when the Federal Reserve Board lowered the discount rate (the rate at which FRB member banks can borrow from the Fed) from 3% (as of Aug. 21, 2001) in steps down to 1.25% by Dec. 11, 2001, and then to a low of 0.75% on Nov. 6, 2002.

This was done by Greenspan et al. out of fear of a recession in the aftermath of the attacks. Since all other interest rates are dependent on the discount rate, lowering the discount rate makes it cheaper for borrowers of all sorts to borrow money, which they then spend, pumping market demand and keeping employment levels robust - or so the theory goes. In the absence of a gold standard, the ability of the Federal Reserve Board to create money by lowering the discount rate and reducing bank capital requirements, or to tighten the money supply by raising the discount rate and increasing bank capital requirements, is theoretically limitless and purely arbitrary.

Seeing signs of recovery in economic conditions beginning in 2003, the Fed then began raising the discount rate, in steps from its 2002 low to a high of 6.25% on June 29, 2006. This wrung an enormous amount of liquidity out of the markets - just as similar withdrawals of liquidity precipitated previous crashes, including the great 1929 crash. You can find a history of the target fed funds and discount rate at:

I could give you an explanation of why this crash began in the residential real estate market, and not in the securities markets as earlier crashes and panic did (there are easily identifiable regulatory and tax provisions that encouraged a real estate bubble) but their details would not fit under the 4,096 character maximum comment length permitted by Blogger. A remarkably prescient article outlining the bubble's causes may be found in "Mortgage Banking" magazine, for October 2007, entitled "Anatomy of a Meltdown" by Robert Stowe England. Note this was a year before the failure of Lehman! Unfortunately the journal's archives are available only upon payment. If you are interested, go to:
Select "Archives" and search for the article named. The charge is $3.95.