The Hour Between Dog and Wolf: Risk-taking, Gut Feelings and the Biology of Boom and Bust. John Coates
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of rationality and morality a dark urge for power and dominance. Modern neuroscience, however, has lifted the lid off this hitherto mystifying brain and found something far more valuable than the entities proposed by nineteenth-century German philosophy – a meticulously engineered control mechanism. More valuable because it has been precisely calibrated over millennia to keep us alive in a brutal and fast-moving world. And we can thank our lucky stars for it, otherwise we would long ago have been battered to extinction. Lifting the lid of our brain does not reveal the nether world of Kant’s unsayable, nor the volcanic will of Nietzsche’s superman, nor yet the hellish subterranean den of Freud’s subconscious. It reveals something that is a lot closer to the inner workings of a BMW.
FAST TIMES ON THE TRADING FLOOR
Let us now return to the financial world, and consider the importance of fast reactions to the success and survival of risk-takers. Traders like Martin frequently face high-speed challenges which demand an equally fast response. The challenges may not demand quite the same speed of reactions as fielding at silly point, but traders nonetheless regularly face time constraints, and when they do their decision-making and trade execution must bypass conscious rationality and draw instead on automatic reactions. This is especially true when markets begin to move fast, as they might in a frantic bull market. Then Martin is obliged to sell bonds to clients or risk alienating the sales force, and must scramble to buy them on the broker screens or from other clients before losing money. At times like this trading is much like a game of snap, and the fastest person wins.
This simple point carries unexpected implications for economics. It is not often appreciated that financial decision-making is a lot more than a purely cognitive activity. It is also a physical activity, and demands certain physical traits. Traders with a high IQ and insight into the value of stocks and bonds may be worth listening to, but if they do not have an appetite for risk then they will not act on their views and will suffer the fate of Cassandra, who could predict the future but could not affect its course. And even if they have a good call on the market and a healthy appetite for risk, yet are shackled with slow reactions, they will remain one step behind the market, and will not survive on the trading desk – or anywhere else in the financial world, for that matter.
Treasury traders, like flow traders more generally (a flow trader is one who trades with clients, handles the flows coming off the sales desks), therefore require a battery of traits: they need a high enough IQ and sufficient education to understand basic economics; a hearty appetite for risk; and a driving ambition. But they also need the physical build. They must be able to engage in extended periods, hours at a time, of what is called visuo-motor scanning, i.e. scrutinising the screens for price anomalies between say the ten-year and the seven-year Treasury bond, or between the bond and currency markets. Such scanning requires concentration and stamina, and not everyone can do it, just as not everyone can run a four-minute mile. And once a price discrepancy has been identified, or a high bid spotted during a sell-off, a trader must move quickly to trade on these prices before anyone else. Not surprisingly, most flow-trading desks, be they ones trading Treasury or corporate or mortgage-backed bonds, usually employ one or two former athletes, a World Cup skier, say, or a college tennis star.
The physical nature of trading is even more apparent on other types of floors. On the floor of a stock exchange or the bond and commodity pits at the Chicago Board of Trade, a trader’s job can resemble a day spent in a wrestling ring. Hundreds of traders stand together, jostling each other and vying for attention when trying to trade with each other, something they do with an arcane system of hand signals. When markets are moving fast and a trader needs the attention of someone on the other side of the pit, then height, strength and speed are of paramount importance in executing a trade, as is the willingness to elbow a competitor in the face. Needless to say, there are not a lot of women in the financial mosh pits.
Another style of trading that makes punishing physical demands is what is called high-frequency trading. This activity involves buying or selling securities, say a bond or stock or futures contract, sometimes in sizes amounting to billions, but holding the positions for only a few minutes, sometimes mere seconds. High-frequency traders do not try to predict where the market is going in the next day or two, let alone the next year, as do asset managers who invest for the long term; they try to predict the small moves in the market, a few cents up or down. As a general rule, the shorter the holding period for a style of trading, the greater the need for its traders to have fast reactions.
Having said all this, there are good reasons for expecting the physical aspect of trading to decline in importance in the financial world. More and more activities are now carried out electronically. The first and most dramatic sign of such a change was the closing down of physical stock exchanges, such as the London Stock Exchange. In their place mainframe computers took over the task of matching buyers and sellers of securities. Today only a few physical exchanges, with tumultuous floors and face-to-face execution of trades, remain, the New York Stock Exchange and the Chicago Board of Trade being the most famous.
The same evolution has begun in bond and currency trading at banks. Many banks began to post the prices of the most liquid securities, beginning with Treasuries and mortgage-backed bonds, on computer screens, and then allowed their clients access to the screens. That way they could execute trades themselves, without the need of going through a salesperson like Esmee. Normally traders like Martin post prices on these screens for a limited size, say $25 to $50 million, and these will be executed electronically by clients; but for bigger trades, like DuPont’s, clients still prefer to call their salesperson. Nonetheless, many people within the banks think the flow traders are dinosaurs, and will eventually go extinct.
Perhaps the greatest threat facing the human trader, though, comes from computerised trading algorithms known as black boxes. Life for many traders has always been nasty, brutish and short, given the vicious competition between them. Survival has depended on their relative endowment of intelligence, information, capital and speed. But the advent and insidious spread of the black boxes has begun squeezing humans out of their ecological niche in the financial world. These computers, backed by teams of mathematicians, engineers and physicists (‘quants’, they are called) and billions in capital, operate on a time scale that even an elite athlete could not comprehend. A black box can take in a wide array of price data, analyse it for anomalies or statistical patterns, and select and execute a trade, all in under 10 milliseconds. Some boxes have shaved this time down to two or three milliseconds, and the next generation will operate on the order of microseconds, millionths of a second. The speeds now dealt with in the markets are so fast that the physical location of a computer affects its success in executing a trade. A hedge fund in London, for example, trading the Chicago Board of Trade, lags at least 40 milliseconds behind the market, because that is the time it takes for a signal, travelling at close to the speed of light, to travel back and forth between the two cities while a price is communicated and a trade executed, and the delays added by routers along the way mean the actual time is considerably longer. Most companies running boxes therefore co-locate their servers to the exchange they trade, to minimise the travel time for an electronic signal.
Many of these boxes are what are called ‘execution-only’ boxes. This type of box does not look for trades, it merely mechanises their execution. At this task, boxes excel. They can take a large block of equities, for example, and sell it in pieces here and there, minimising the effect on prices. They test the waters, looking for deep pools of liquidity, a practice known as pinging, just like a sonar searching the depths. When they find large bids hidden just below the surface of existing prices they execute a block of the trade. In this way they can move enormous blocks of stock without rippling the market. At this trading exercise, boxes are more efficient than humans, faster and nimbler. They do what Martin did when he pieced out of the DuPont trade, only they do it better. Many managers have started to ask why traders spend so much time and effort executing client trades when a box could do it just as well, and never argue over its bonus.
Other boxes do more than execution: they think for themselves. Employing cutting-edge mathematical tools such as genetic algorithms, boxes can now learn. Funds running them regularly employ the best programmers, code-breakers, even linguists, so the boxes can parse news stories, download economic releases, interpret them and trade on them, all before a human can finish reading even a single line of text. Their success has led to an