Last week, the well-respected Bloomberg website ran a story about the most
successful investment bank in the world today -- Goldman Sachs (GS). In the
first quarter of this year GS made a profit on every trading day. Yet,
during the same period, 9 of its 11 published forecasts to its own
investor-clients turned out to be wrong. (Those two figures might be
slightly wrong here -- it could have been 7 out of 9. I'm relying on
memory. I should have kept a copy but I didn't realize at the time that my
subconscious mind would be working on this astonishing fact.) Needless to
say GS clients are pretty upset by this revelation.
Now, in the conventional way of the frequent buying and selling shares or
currencies, any investment manager will tell you that the odds against
being able to do this profitably over as long a period as a quarter year in
non-boom times are very great. To do this on every working day of that
period, the odds approach infinity.
The only possible way that this can be done is by being able to survey
every potential price movement that is available at any instant of time
during the 24 hours and to pile-in on the slightest evidence of an upturn
or a downturn. If the investment is large enough -- relative to the size of
the object item (the shareholding of a business or a tranche of currency)
-- then the effect can only be to enhance the initial movement.
Once the price of the object item has moved up or down sufficiently to
exceed the difference between the bid price and the offer price
(commissions charged by intermediaries in the transaction) then the
original transaction can be reversed and a profit made. If enough
transactions are being made simultaneously, even if only a miniscule profit
is made on each in-and-out, then a consistent, failure-proof cumulative
profit can be made.
This strategy could even be enhanced if, for example, a client of GS asks
them to make a purchase or a sale. On balance, this decision is likely to
be slightly more informed by expert knowledge (perhaps by an insider?) than
otherwise. Once again, if such a transaction is judged sufficiently large
to potentially nudge the market, even if ever so slightly, then GS can pile
in with additional money of its own. However, unlike its client, GS would
immediately follow with a reverse transaction of its own money as soon as a
profit was realized.
I also remember reading somewhere that such is the intensity of
transactions on the shares or money markets these days that object items
can be bought and sold in 11 seconds!
Overall, how large this consistent (daily) profit can be made by an
investment bank (or hedge fund) depends on how many opportunities can be
surveyed and acted on simultaneously and how much capital it has at its
disposal or can reliably borrow at short notice. Unlike, say, 10 or 20
years years ago, when sufficiently powerful supercomputers were still few
and far between, this strategy would have been impossible.
Today, however, an investment bank or hedge fund the size of GS can afford
such a supercomputer. All that remains then is to devise algorithms that
will survey hundreds (or thousands) of object items with the slightest sign
of life and then buy or sell them automatically -- and reverse them almost
immediately afterwards once a profit has been made.
This, however, has two problems -- both of a catastrophic nature. The first
is that although the strategy appears to be fool-proof, the algorithms may
not be. It was the simpler and cruder sort of automatic stop-loss
algorithms (program trading) that initiated the stock market crash on Black
Monday, 19 October 1987. Starting in Hong Kong, where shares crashed 45%,
it continued all round the world. The crash was only prevented from going
further downwards when program trading was stopped and normal movements of
share prices resumed. Even so, many economists were afraid that a recession
of 1930 proportions would follow. In the event, normal trading resumed but
it took two years before all the paperwork was sorted out and the previous
level of share prices was regained.
This time, however, with larger money markets involved (including sizeable
tranches of government bonds which had previously been the province of
individual investors or investment managers), and highly competitive
strategies between large financial bodies, there is no guarantee that
weaknesses in program algorithms might not recur and something even more
catastrophic than the 1987 event might happen. These days, how many years
would it take to sort out the paperwork? (The paperwork of the 2008/9
credit crunch is still not sorted.)
The second problem is that by this fail-safe method of aggrandizement, GS,
or perhaps two or three of such sizeable financial bodies, could
theoretically end up owning the whole world! Or, more accurately, the whole
of the Western world. Of course, in practice, bankrupted governments,
businesses and electorates everywhere would have revolted long before this
situation could be reached.
Indeed, it's already the case that there is a powerful general mood at all
levels outside the financial sector of the Western world that many of the
financial operations carried out by GS and large hedge funds must be
stopped. During this very week-end, the future of the Med country members
of the European Monetary Fund might be at stake. (The Sunday Times tells me
this morning that Spain is now as jittery as Greece.)
But what can be done? Apart from tinkering about with regulations
concerning investment banks and hedge funds -- which both the Senate and
the House of the US Congress are now considering -- which can only lead to
more evasion by cleverer people in due course, almost nothing really
constructive can be done. It still remains that our present financial
system has already resulted in all Western governments being deeply in debt
-- some irremediably bankrupt already -- with the prospect of deep
deflationary recession or hyperinflation in the years to come. Orthodox
economists can't decide.
The phrase of the moment is "a new model is required". Could it be that the
new model ought to be the old model -- the one that obtained before 1931
and 1971? In 1931 the UK pound (then the predominant trading currency in
the world) was disestablished from real underlying value (which happened to
be gold -- although that particular commodity is not an absolute
requirement); and in 1971 the US dollar was similarly disestablished.
Since then, the paper documents of currency have been printed at will by
governments (subject to what their electorates allowed them to get away
with by way of inflation), usually by playing around with central bank
interest rates. Without solid foundations, currency prices have wobbled
about -- sometimes wildly -- against one another. It's no wonder that,
since then, following the fashion set by governments, a whole raft of other
financial documents quite beyond useful insurance policies against risk
should have been invented. These can now ricochet around the world with the
speed of an electron so that nobody can possibly know what the true overall
situation really is. We now have CDOs, CDSs, CDXs, CDO1s, etc and no doubt
other derivatives are already forming in the minds of inventive people in
the investment banks and hedge funds.
I won't end with another repetition of the solution that I've make all too
frequently in the last year or two, save to say that it has long been
advanced by what is called the Austrian School of economists. What they
write is usually so convoluted that it's almost unreadable, but they
certainly have the only solution that's possible -- the restoration of the
old economic model which served the world very well for most of the time
since the first coin was minted at around 900BC in order to improve on
bartering.
Keith
Keith Hudson, Saltford, England
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