Friday, June 4, 2010

I Beat You By 200 Milliseconds, So Sue Me!

The future of finance is wrapped up in information technology. First because the technology deals with information and secondly because the technology is rapidly improving, even as I write this sentence.

In lectures I have given around the country on how information technology is going to impact the future I tell my audiences to keep their eyes on two groups of people and what they are doing with computers. First, check out what large governments, like the United States are doing about computers, because in order to keep their position in the world they must continue to be better than anyone else at killing people.

The first modern computer, the Eniac, was funded by the government in order to be able to better track the flight of artillery shells so that the army could be more accurate in hitting their targets. The Quantum Computer is going to be built because the government must be able to keep secrets and Quantum Computers are so fast that current coding systems are inadequate relative to the speed at which these new computers will be able to calculate. Also, these computers will be so fast that the ability to attack targets far away and the ability to simulate battles before they happen will be an overwhelming tool for the military. Obviously, America cannot afford to be second in the race to build the Quantum Computer.

Second, I suggested, watch what the kids are doing. If you want to know what is going to be “ubiquitous” in a few years, check out what that eight year old in your family is doing with electronic gadgets. And, by-the-way, in terms of stimulating battles and what kids are doing, read “Ender’s Game” by Orson Scott Card. In this book, a set of children are being trained to repeal an invasion of earth. The invasion is simulated by computer games with “faster than light” communications. After much practice, another game takes place. However, as we learn, it is an actual invasion and the only thing protecting the earth is these kids!

Great book…you should read it if you haven’t already read it. Actually, put “Ender’s Game” on your bookshelf right there along with “The Quants”! (See my review: http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.) The important thing, however, is that this book is hugely popular, it is what young people are familiar with, and it presents a picture of what they believe the technology of the future will be like. And, the book was written in 1985!

What does this have to do with finance?

The Wall Street Journal this morning contains the article “Fast Traders’ New Edge.” (See http://online.wsj.com/article/SB10001424052748703340904575285002267286386.html#mod=todays_us_money_and_investing.) “Some fast-moving computer driven investment firms are getting an edge by trading on market data before it gets to other investors…The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers.” Although these moves may only produce pennies, if one multiplies the pennies by thousands of trades, “big profits” can be made.

“The ability to estimate price moves ahead of the national best bid and offer price can give traders an advantage of about 100 to 200 milliseconds over investors who use standard market tools.”

This practice is called “latency arbitrage” and, of course, those investors that are not into it at the present time are searching for ways to protect themselves. Of course, the first thing you do is see whether or not you can compete electronically. Obviously, if you can’t compete electronically then you ask for regulation.

But, this is the world of the future. This is “Ender’s Game” only it is beyond the simulation exercises, it is the real thing. It is also a part of that netherworld that includes high frequency trading and dark pools.

My point is that advancements in computer technology are not going to slow down. If anything, these advancements will speed up. And, with the possibility that Quantum Computers will become a reality within the next decade or so the ‘speed up’ will tend to be exponential and not linear. Furthermore, the generations that will follow us expect this ‘speed up’ to happen and will look on these capabilities as just another part of their ‘normal’ lives.

If we do not comprehend this future, if our elected officials and regulators do not comprehend this future, then we will not be prepared for the economic and financial systems that are on the horizon. Hence, we will all make mistakes.

The “Quants” made mistakes this last time around. But, they are alive and well, and, I believe that it is a very safe bet to say that they have learned from their mistakes and have already modified their systems to take advantage of the most recent information available to them. Many “Quants” are trained in Information Theory, the study of the messages that are contained in strings of data, even though these strings may seem to be random in nature. Their systems are now more robust than they ever were in the past.

This is how humans become better decision makers. They adapt their models and systems so that they can make better predictions of the future in order to make better decisions or solve more difficult problems. This process is part of being a human and humans will not cease to put it into practice.

The discussion so far has been at the “top of the pyramid,” so to speak. But what about the “bottom of the pyramid”? How is technology playing out there?

This morning there appeared in the Financial Times a description of how banks in the South African Township of Tembisa are using mobile phones to develop their customer base. (See “Banks find potential in mobile phone growth,” http://www.ft.com/cms/s/0/0f6fad92-6f28-11df-9f43-00144feabdc0.html.) Banks have changed over the past decade because “as the spending power of low-income groups increases, more and more banks are competing for the business of the 15m adult South Africans who had previously been excluded from the financial system.” And they are using information technology to do it!

And, the players are not small. “In South Africa, Capitec and African Bank pioneered the drive…” and Vodafone, the British telecoms company, “launched one of the most celebrated mobile banking initiatives.” “Instead of opening an expensive branch network, many of these new operations work with agents such as shops or bars.” Mainstream banks are following suit.

This is not the only technological initiative taking place at the “local level” in the world. Electronic finance is here to stay and it is spreading further and further into previously under-served communities every day. Remember, finance is really nothing more than information and the exchange of information.

So the Obama administration, Congress, and the regulators in Washington (and politicians and regulators in the rest of the world) are attempting to prevent the last financial collapse from happening again.

Should I smile…or giggle…or break out in laughter?