The Adaptive Genius of Rigged Markets

April 20, 2014


Same as it ever was, same as it ever was, same as it ever was, same as it ever was
– Talking Heads, “Once in a Lifetime”

You may be a business man or some high degree thief
They may call you Doctor or they may call you Chief
But you’re gonna have to serve somebody, yes
You’re gonna have to serve somebody 

– Bob Dylan, “Gotta Serve Somebody”

Horace Clark, Vanderbilt’s son-in-law, was always a favorite with the stately old gentleman. Having decided to wed the young lady, he called upon his future father-in-law, and, without preliminary, began – “Commodore, I wish your daughter in marriage.”
“You mean, you want my money,” growled Vanderbilt from his chair.
“You and your daughter be damned,” flamed out the young lawyer, as he clenched his hat in his hand and turned to leave the room.
“Hold on, young man,” said Vanderbilt, straightening himself on his feet. “Hold on. I rather like you. I only said you should not have my money. You can have my daughter.”

– James Medbery, “Men and Mysteries of Wall Street” (1870)

David Byrne, of Talking Heads fame, is something of a personal hero of mine for the way he handles the business of his music. Byrne is famously protective of the copyrights associated with his work, in the sense of controlling the uses of the music for long-term goals rather than a short-term pay-off, and it’s a non-myopic approach to intellectual property I’ve tried to adopt with my own work. I also appreciate Byrne’s ability to put on a show. His music stands on its own, for sure, but Byrne was into multimedia before it was a word, and part of his genius has been an ability to reinvent consistently the experience of his music. I know it sounds crazy to anyone under the age of 30 that a Big White Suit could be both revolutionary and really cool as performance art, but there you go. More to the point, Byrne knew when to move on from the Big White Suit. He knew how to adapt to a world that was still hungry to hear what he had to say, but not if it were presented in the same way ad nauseam.

If you don’t adapt, you die. Or worse … for an artist, anyway … you become uncool and passé. Your performance art becomes performance shtick. And yes, I’m looking at you, Elvis Costello. There’s anadaptive genius to the David Byrne’s and the David Bowie’s of the world, quite separate from theirmusical genius, and that’s what I want to examine in this note.

Adaptive genius is not limited to the popularly beloved and the socially respected. It’s not only, in zoo-keeping terms, the “charismatic vertebrates” like elephants and giraffes who demonstrate this quality, but also decidedly non-charismatic invertebrates like the hookworm. I’ve written before about why I believe that parasites are beautiful creatures from an evolutionary perspective, which is another way of saying that they possess adaptive genius. It’s the same sort of beauty I see in parasitic market participants who generate real alpha by feeding off a consistent informational edge they identify from either non-economic or differently-economic market participants. As I wrote in “Parasite Rex”, a giant pension fund isn’t engaged in commodity markets because it has an opinion on the contango curve of oil futures; it’s trying to find a diversifying asset class for a massive portfolio that needs inflation protection. If you’re an experienced trader in that market and you see signs of the giant pension fund lumbering through the brush … well, you’re in the wrong business if you can’t skin a few dimes here. This is what good traders DO, and the really good ones have devised effective processes so that it’s not just a one-off trade but an expression of a robust strategy.

Parasites, whether they exist in nature or in markets, are almost always models of efficiency and adaptive genius. I may dislike them. I may well be the host from which they suck out resources. I may want to squash them without mercy. But I can’t help but respect their evolutionary prowess and ability to carve out an informational advantage. And if I get the chance, I’d like to invest money with them. They’re not the only source of alpha in this world (you can also create an informational advantage by perceiving the world differently and more correctly than most), but they are, I believe the most consistent and powerful source of alpha out there.

Or at least they provide the most consistent and powerful source of alpha within the limitation of being a market participant, of being a buyer or a seller of a security in order to express an opinion on whether that security will go up or down in price in the future. Of course, if you could hijack the entire infrastructure of the market, if you could somehow develop an omniscient view of market communications and intentions under the guise of market-making or liquidity provision … then you’d be talking about some serious alpha.

Oh wait … that’s exactly what happened with Getco and Virtu and their High Frequency Trader (HFT) brethren.

I don’t want to belabor the details of how this market infrastructure hijacking works. You’re better off reading Michael Lewis’s book or, better yet, check out Sal Arnuk and Joe Saluzzi’s Themis Trading website and readtheir book, “Broken Markets”. But I will share my experience of how this hijacking plays out in the professional investment world. My bona fides: co-managed a large long/short equity fund where we experienced all this on a daily basis, wrote extensively about HFT and market structure in client letters, and was part of a loose group of like-minded buy-side managers exploring these issues for the past 5 years. I was an HFT critic way before it was cool to be an HFT critic, and here’s our core complaint: in an HFT-dominated market infrastructure, you can always get your order filled but you will never get a better price than your limit.

What does this mean? Imagine that you’re an equity PM and you want to buy $5 million worth of XYZ stock today. You have a positive fundamental view on the company, the stock’s been weak of late, and for whatever reason you’ve decided that today is a good time to pull the trigger and add to your existing position here. Average daily volume in the stock is, say, $500 million, so your order is going to be about 1% of that – not inconsequential for how the stock trades, but highly unlikely to have a big market impact. All the same, though, you tell your trading desk that you want to put a limit on the order, say 1% above wherever the price settles after the market opens. So now it’s 10:05 am, XYZ stock is trading at $50.00, and your trader hits the button

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