Thursday, January 29, 2009

Time to be a market taker, not a market maker

As I said in Harvard ten years ago, we need an early warning system so that international financial flows are properly monitored. UK PM, Gordon Brown

I've had the good fortune during my career in finance to be both a market maker, one who sets prices, and a market taker, one who trades on prices made by others. Depending on market conditions there are virtues of either approach. When markets are efficient, using Fama's definition, market making tends to be profitable as price setters capture the bid-offer spread. When markets are inefficient, and thus likely to be discontinuously volatile, market taking seems wiser as you don't get forced out of (or into) positions.

Modern Central Banks, by definition, are the ultimate market makers in the shortest term interest rate markets of their respective currencies- e.g. The Fed sets the Fed Funds rate and maintains it against all market takers.

More and more over the past few decades, Central Banks and other public sector directed funds have expanded their market making activities into foreign currencies, equities and commodities, especially, Gold. If, for instance, mortgage bonds fall in price, Central Banks, in one manner or another act to set a floor under the market. Setting a bid in a market is a market making action.

Setting a ceiling in a market, like Gold, as Britain, in effect, did in 1999, when Gordon Brown was Chancellor of the Exchequer was also a market making action, one which proved to be most unwise.

That same Mr. Brown, now promoted to Prime Minister (Peter Principle perhaps) would like some credit for seeing the current crisis coming. Mr. Brown, as the opening quote relates, may have seen the crisis coming, but he didn't understand it.

Let me explain with the help of a Brit wiser than Mr. Brown, one Bertrand Russell.

In The Analysis of Mind Russell argues: a person understands a word when a) suitable circumstances make him use it, b) the hearing of it causes suitable behavior in him......Understanding words does not consist in knowing their dictionary definitions, or in being able to specify the objects to which they are appropriate.... understanding language is more like understanding cricket: it is a matter of habits.

He gives an example: Suppose you are walking in London with an absent-minded friend, and while crossing a street you say, "Look out, there's a motor (i.e. car) coming." He will glance round and jump aside....He "understands" the words, because he does the right thing.

In Gordon Brown's case, it would be as if someone told him, while he was in the road, that a car was coming at him and he said, "We need an early warning system to help pedestrians know if cars are coming at them," but didn't get out of the way.


It seems clear now that selling England's Gold Reserves was not the "suitable behavior" of Russell's definition if one understood a crisis was coming. According to the Sunday Times, Mr. Brown's actions were not considered "suitable" at the time: At a secret meeting with senior gold traders, Bank of England officials were warned that the proposed auctions would achieve the worst price for taxpayers. The officials are understood to have agreed with the analysis but said they were powerless to influence the Treasury.

In my first post on equilibrium I related an observation which might explain Mr. Brown's curious view: I sometimes wonder if the distinction [between correction, i.e. the government produced variety or, as they seem to think of it, exogenous action and self-correction, i.e. the private sector induced variety, or as it is known, endogenous] is, in part, a result of a desire to see government as Aristotle's (or Aquinas' if you prefer) "unmoved mover," adjusting a game board on which the rest of the world plays.

As the disgraced and recently deposed former government of Iceland can attest, the state is not exogenous to the rest of the country.

In hindsight, the financial managers in Iceland likely see the wisdom of pricking a bubble before it implodes, instead of fomenting it and taking credit therefore. Even if the managers are impotent in pricking a bubble, policies, both in word and deed which aim to prick a bubble will save at least their credibility when it does implode, as all such bubbles must.

But, I digress, a bit.

I began by arguing the current virtues of being a market taker. One key aspect of such a strategy is the perspective of market taking- endogeneity.

Market takers don't fight the market, they try to profit from it, or at least avoid losing in it. Market takers are aware that unrealized profits are less valuable than realized profits, by which I mean, profits which might accrue due to a position in an ongoing trend are not profits unless that position can be liquidated, either by reversing the trade or making use of the material. To wit, a market taker who bought gas early in 2008 at $100 could have profited either by selling the position at a higher price or by using the gas himself when prices at the pump were higher.

Market makers, when markets are inefficient, by contrast, often find themselves with large and growing positions which they cannot liquidate- liquidation is a market taking action. Because the market maker's price is wrong, sometimes radically, market takers are always acting on one side of the price and thus never take the market makers out of their position. The Bank of England's failed defense of GBP in 1992 is a classic example of market making run amok- market makers who get the price wrong will inevitably be forced to become market takers, at the worst prices.

Here at home, I find some of the talk of the Fed becoming a market maker in long dated Treasuries a disaster in the making from the same mold that led to the BoE's error.

Far better, it seems to me, for US Financial managers to be market takers. If the world wishes to buy long dated Treasury paper at such low rates, the US should sell it and extend the duration of the public debt.

Alas, market makers, whose self-image tends to that so aptly described by Tom Wolfe in Bonfire of the Vanities- Masters of the Universe- rarely see the wisdom of becoming market takers without "touching the stove" and being forced to liquidate during a crisis. Sherman McCoy for Treasury Secretary?

Me, I'm just happy to be a little market taker.


Dan Passarelli said...

I LOVE the idea behind your blog here. As a former market maker, I now believe the edge is pretty much gone from the floor. I started to work with "retail traders" to help them exploit opportunities off-floor.

I look forward to your next posting.