Thursday, July 21, 2011

Long Term Capital Management

A capitalist we know specializes in long term capital investments and explains that by long term he means greater than 1 msec. What is the market function of such an investor? Or for that matter, of the sort of “short term” investors whose investments depend on powerful computers linked to the trading system by paths only a couple or so micro seconds long?

Some have suggested that such traders are purely parasitic, and represent a sort of insider trading. There are about 31 billion milli-seconds in a year, so even a pretty large investment (say a billion Euros) for 1 msec. doesn’t provide much net capital, only about 0.03 Euros per year.

One function such trades do perform is providing markets with liquidity – they make it easier to move money in or out of given investment. Is that important? For certain it is.
Investment can be looked upon as a kind of information warfare. The buyer of a security is in effect guessing that he understands the future value of a security better than the seller does, or at least, that that future value is worth more to him than it is to the seller. Illiquid markets make it possible for those with the ability to trade to extract large rents by buying cheap and selling dear.

A classic case is the credit default swaps and other instruments of mass financial destruction that created the financial meltdown of 2008. Those instruments were not only obscure, but also difficult to make and very difficult to trade. It was very difficult to get into that market unless you were a multi-billion dollar hedge fund or big bank. The winners in “The Big Short” were those intrepid few who managed to surmount the huge informational and institutional obstacles to getting into the market. The calamity occurred because these became grossly mis-valued. It’s plausible but hardly certain that the whole Ponzi scheme would have been nipped in the bud if liquid and transparent markets in the instruments had existed.