Analogies – and Blaming It on the Rain

Let’s go a little “light” this morning.

Often times, analogies are used to take complicated topics and make them easier to understand. This is not inherently a bad thing, but there are times when the topic has too much nuance and complexity to adequately be explained by a simple analogy. After all, the word analogy comes from the Latin “anal” – meaning “from the butt”, and “o-gies” – meaning “Oh Jeez”. Some of Wall Street’s best rackets have been engineered and carried out under a cloak of complexity; it is easier to carry out misdeeds in murky complexity than in clear simplicity. Michael Lewis touched on this point in Flash Boys.

We at Themis fondly remember when Quantlab’s Cameron Smith tried to defend high speed trading using the analogy of a sailor saving a little boy from drowning, only to be asked by the boy’s mother, “yeah but where is his cap?”.

Yesterday we read an article (on the CFA Institute’s website by Sviatoslav Rosov) that touches on the role of high frequency trading in the ETF Flash Crash of August 24th. The article discusses high speed trading and “Flash Monday” with a new high frequency trading analogy that uses umbrellas. With the devils that live inside of details appropriately banished from the article, it becomes very difficult to understand Who’s to Blame When It Rains?

Here is the analogy:

It rains. Demand for umbrellas increase when it rains. Umbrella stores increase prices when it rains. It’s not the fault of umbrella stores that it is raining, or that prices have gone up.

And if some very clever umbrella store figures out a way to quantitatively perfectly predict the weather, and umbrella demand, by using scouts to watch the sky at hundreds of points throughout the city, and is able to perfectly adjust his pricing and supply of umbrellas, well that is not his fault either.

And if the old pharmacies and newsstands that used to sell umbrellas (they have been squeezed out by the clever umbrella store) no longer sell umbrellas… and we pedestrians get nostalgic for their always having $10 umbrellas ready for us to buy during the rain, we need to be reminded that the umbrellas were of poor quality, and they could have been sold for way less than $10 on average.

Ultimately, today we have Clever Umbrella Stores that sell us umbrellas cheap on sunny days, and “surge price” on rainy days.

Many of you probably feel that we don’t need to be buying umbrellas on sunny days. It’s probably less impactful to you that you can buy an umbrella for $8 on a sunny day on average, instead of paying $10 for one on average from the old newsstands and pharmacies that used to sell them.

Many of you probably would rather have the security that you can buy an umbrella for “the overpriced” sum of $10 on a rainy day, rather than finding precious few umbrellas available, and where the available ones cost $250.

Equity market structure today is very complex. The Clever Umbrella Stores have squeezed out the newsstands and pharmacies, in part because The City has given them many little-understood perks that translate to “edge” for them. And those perks are not always disclosed. The devils in those details are hard to uncover.

Of course we do not blame the Cheetah for hunting the Antelope successfully. Of course we do not blame any store for peddling umbrellas in the manner of its choosing – provided it is legal. But it is certainly proper to consider the implications of poor policy decisions by the City, The Regulators, and Industry Leadership, and make changes so that first and foremost, pedestrians can buy the umbrellas when they need them, and not at a cost of $250.

Wait – I just thought of another analogy – the one where the Bank of England’s Andy Haldane notes that high speed trading seems to provide liquidity in a monsoon, and consume it in a drought.