The Game

“I don’t think that anyone would ever admit that the markets are hackable.  But why would they not be?” – Stephen Borsher

I was talking to my friend that runs a hedge fund the other day, and he made an interesting analogy.  He likened Wall Street to a game of Halo, the popular science fiction video game where Master Chief battles an alliance of aliens to save humanity.  In the game of Wall Street, high frequency traders program complex algorithms that battle each other in search of “alpha” (return in excess of the risk borne).  Contrary to old finance textbooks, these traders do not care about the fundamentals of the company they trade in, but rather quantitative, statistical analysis.  Many people on ‘Main Street’ may not be familiar with these methods, and almost all that aren’t statisticians do not understand them, but over half of all trades in the U.S. each day are executed on behalf of high frequency traders.  It’s a virtual war where trillions of dollars and billions of transactions are executed on a daily basis.

Thousands of these programmers write code that is connected to a massive network of computers that power our financial markets.  One could compare these financial arbitragers to SEO marketers on Google’s marketplace.  However, our financial markets lack the technological oversight that Google’s does.  Andrew Lo, director of MIT’s Laboratory for Financial Engineering and chief scientific officer of quantitative-analysis hedge fund AlphaSimplex Group, told Bloomberg “Technological advances have outstripped our ability to regulate them [financial markets]. It’s like the Wild Wild West.”

Some of you may remember the ‘flash crash’ on May 6, 2010 when the Dow dropped nearly 10% erasing approximately $900 billion in value from U.S. equities.  According to a report by the SEC investigating the crash, they were able to single out one mutual fund’s computer driven trade as the catalyst that sent the market into a tailspin.  It’s hard to imagine that one trade can send the entire market into such turmoil.  Even more, the report didn’t offer many answers for why it happened or how to stop it in the future.  Reading the blow by blow of the flash crash paints a picture of chaos where no one knew how to find or fix the problem.  Shares of Accenture plunged from $40 per share to one cent.  Shares of Procter & Gamble traded at $40 on one exchange and $44 on another.  Shares of Apple dropped $23 in two minutes.  The regulators’ response was to pull the breaker and turn it off, and they reportedly had trouble even doing that.

If you think about, the system of money it is nothing more than a game itself.  Money has little more value than a virtual crop in a game of Farmville.  We have a fiat monetary system.  This is another way of saying that money has no intrinsic value, other than the paper it is printed on, and increasingly money is completely digital.  Money is backed only by the promise of the government, which we hope is enough to inspire faith in its value by citizens.  In other words, money only has value because you believe it has value and therefore I believe it has value in return.  It was, in part, this realization that inspired Peter Thiel to start Paypal in the belief that the Internet could be a new medium for money.

The government of most economic fidelity has historically been the U.S.  However, the U.S. finds itself in a state of increasing debt and decreasing credit quality.  Although the U.S. may be the biggest economy in the world, it is by no means the most creditworthy (see General Motors).  In fact, as a country, we continue to spiral into more and more debt.  Recently, most of it has been transferred from the private sector to the public sector via government spending and subsidies.  As with housing, this is not a sustainable solution.  We hope that China will continue to finance us, but it would be foolish to depend on hope alone.  It is true that we are China’s biggest customer, but we are also its biggest debtor.  Mainland China, Hong Kong and Taiwan have stockpiled over a trillion dollars in U.S. treasuries and will only look to diversify their economic future away from the U.S.

Most of us are used to analyzing companies’ performance in the form of revenue and expenses, or profit.  Last year at the Web 2.0 conference, Mary Meeker put the U.S.  finances in the form of an income statement, which produces some rather straightforward insights.  We have been losing money since 2002, and a lot of it.  Our finances look more like that of an early stage technology company that is investing heavily in hopes of a big payoff down the road.  However, we are not a young startup when it comes to development and cannot defy the economic laws of gravity.  China, India, Brazil and other developing economies may experience sustainable GDP growth rates in excess of 5%, but we will not.

It is true, we have benefited tremendously from our position as the biggest and most powerful economy in the world.  However, we cannot count on these countries to finance our debt indefinitely on that basis alone.  We have already begun to see cracks in the façade.  The price of real assets such as real estate, oil, commodities, etc., especially those real assets denominated in dollars, have skyrocketed.  For example, the price of crude oil is up 268% over the past ten years while the S&P 500 is down 25% over the same time period.

There are interesting parallels between the financial system and technology.  Technology is being incorporated into our daily lives at an increasing pace making us ever more dependent upon it.  Think about the amount of time we spend in front of a computer each day, the tremendous value we derive from the internet, the amount of personal information we upload to Facebook, or the possibilities that are created by having a smartphone with the computing power of all of Google’s servers in our pocket at all times.  We are entering a new paradigm with cloud computing.  Computing infrastructure is being rebuilt from the ground up.  If the promise of cloud computing comes true, more and more applications such as smart grid technologies will be powered by this massive, consolidated network of computers in the ‘cloud’.

The trends of technology and globalization will make the games we play ever more interesting and pronounced.  The winners of these games will learn how to ‘hack’ them.