I’ve always said that people come online mostly to do variations of two things – talk and play.  Today, Matthew Ingram had a great post on GigaOm titled “Why Everything Is Becoming a Game.”

The gist of the post was that a generation of gamers are getting older and that being able to adapt games wisely is becoming a winning strategy.  Matthew writes:

What is the impact of all that gaming on our society? One academic, Lee Sheldon of Indiana University, says the generation that has grown up with ubiquitous online gaming is bringing that culture with it into the educational system — and ultimately, into the workforce. “As the gamer generation moves into the mainstream workforce, they are willing and eager to apply the culture and learning techniques they bring with them from games,” Sheldon, an assistant professor at the university’s department of telecommunications, told ITNews. He said older managers will have to “figure out how to educate themselves to the gamer culture, and how to speak to it most effectively.”

He goes on to give examples of companies who have used games effectively such as Slashdot and Wikipedia.  He believes games are successful because they take advantage of peoples “innate desire to compete with one another”.  I agree.

One such “game” I have been playing lately is a music discovery site, thesixtyone.  thesixtyone is a beautifully designed site whose goal is to help users identify great music and bring it to the attention of other users.  The game underlying the site is very market-based.  You get a fixed amount of hearts that you can give to songs.  A heart is like currency that you invest in songs. If you heart a song that other people heart, you earn reputation points. Essentially the investment throws off some return.  The more reputation points you earn the more control you have within the economy.  This control includes bid to revive songs, which puts a song on the “home” page (which in market terms gives your song a massive amount of attention and “liquidity”).   If you run out of hearts you can earn them by listening to really “illiquid”  new or unheard of songs, or going on various quests that nudge you to explore music.  It’s really a fascinating site.

What I find most interesting about such a site is the game underlying the site forces you to do work.  Any audiophile knows that listening to music can be quite rewarding. As most rewarding things, however, it involves a decent amount of work.  Pop music is very easy to consume but often times not as complex and rewarding in the long term.  Most people don’t want to do the work to discover and find great music but someone has to do it.  What the thesixtyone does, is turn that work into a game.  Through many of its quests to earn the currency within its economy, it makes you go through the process of discovering and listening to music – and makes it fun and addictive at the same time.  It is essentially a market that is designed to allocate the best songs to the most amount of ears.  Awesome!

As I said earlier, people come onto the web to mostly to talk and to play – not work.  For the next phase of web to really take off a lot of work must be done.  A lot of people hate on foursquare but they quite brilliantly use a simple game to get users to do something they ordinarily wouldn’t – share their location.  This is work to most people but foursquare has turned it into a game.

We don’t have the algorithms yet to automate things like curation as many algorithms can be gamed too easily.  I really think games (and markets) are going to be critical in order to organize and optimize all the information on the web.  There is a global web workforce eager to add a curated filter to the web, but I’m afraid the only way to get them do to the heavy-lifting is to get them playing.

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Yesterday, The Epicurean Dealmaker penned an excellent piece laying out his “poacher turned gameskeeper” theory on financial regulatory reform.   The heart of the “poacher turned gameskeeper” theory is belief that in order to regulate investment banks, you need investment bankers (and you need to pay them banker wages).

He writes,

Now Dick Fuld, at least in his prime, was a forceful and scary man. It takes a certain kind of personality to tell such a man to go fuck himself to his face. Fortunately, we just happen to have a substantial supply of brass-balled, take-no-prisoners, kill-’em-all-and-let-God-sort-’em-out people ready to hand. By happy coincidence, these individuals also happen to be intimately familiar with the ins and outs of the global financial system, the nature and construction of the myriad securities and engineered products polluting financial markets, and the numberless tricks and stratagems large financial institutions use to end-run rules and regulations designed to keep them in check.

These people are called investment bankers.

That’s right, boys and girls: It’s time for the chickens to band together and hire themselves some foxes to guard the chicken coop.

At the end of his post he alludes to the many naysayers who say “it could never happen” and concedes that perhaps they are correct.  To this I would say the U.S. Government has already done this in some respect in protecting its information system, so why not it’s financial system.

Last year, it was announced that the U.S. government was looking to hackers to help protect its cyber networks.

From USA Today,

Buffeted by millions of digital scans and attacks each day, federal authorities are looking for hackers — not to prosecute them, but to pay them to secure the nation’s networks.

General Dynamics Information Technology put out an ad last month on behalf of the Homeland Security Department seeking someone who could “think like the bad guy.” Applicants, it said, must understand hackers’ tools and tactics and be able to analyze Internet traffic and identify vulnerabilities in the federal systems.

The rationale behind hiring hackers and paying them to change the color of their hat from black to white is the same rationale that TED uses to hire investment bankers to regulate and protect the system.

Can the financial system be “hacked”.  Leigh Caldwell thinks so. In his piece, “Why Can Finance be Hacked?” he writes, “the finance market has nearly all the characteristics of an insecure, unstable, hackable multi-user computer”

And, thus aren’t bankers similar to hackers? The regulators lay out a set of rules of the system and the bankers seek to “hack” the system to their advantage.  Who better design and regulate the system then the hackers themselves?   You pay them enough to change teams and we might end up with a financial system that is more secure.  We are already doing this with the system that protects our national data, why would it be so radical to do it system that protects our national wealth.

Besides, aren’t both really just bits and bytes of information?

The Social Lottery

A tweet the other day rehashed an idea I had regarding engagement in social networks, specifically Twitter.  The tweet was from a Twitter-newcomer, Conan O’Brien.

Sarah Killen just won the Social Lottery.  At the time of that tweet she had something like 100 followers, now she has over 14,000.

Twitter suffers from an engagment problem.  How best do you engage new users?  Twitter says “Join the Conversation”, but its very difficult for new users to do so. Often times a new user is talking to nobody.

A Social Lottery could help solve that problem.  If Twitter used their bullhorn to regularly recognize some average user who is using their service right and just being awesome, think about how many more people would actively engage in their service.  Think about it.   Each week, tension would be high to see who wins the social lottery. Mashable, Techcrunch and all the other tech blogs would pick up the story and overnight some random user would have his or her Warholian moment.

As the Volcker Plan limps through Washington and many are screaming bloody Armageddon, an idea has been floating through my head.  This is an idea that is sure to really rile up those on Wall Street, many readers of this blog, and followers on Twitter.  It is an idea that at the onset seems ridiculous but after pondering for some time has some merit.  This idea is nationalizing market-making in vanilla financial instruments.

Liquidity is to the flow of capital as as roads are to the flow of traffic.   Most would argue that both the flow of capital and the flow of traffic are both vital to economic well-being.  Yet unlike in transportation, in markets we largely leave our market infrastructure up to the private sector.  While provision of transportation infrastructure would not pass the public policy test of a pure public good, many would agree that is important and government has a inherent interest in making sure that traffic flows.   Why not leave this role up to the government in the capital markets?

Below are some reasons why this idea keeps banging through my head:

Additional Tools for Policy Makers

Over the past 20 years we have experience multiple liquidity crises where the Fed has had to step in and provide liquidity to financial institutions so that they could turn around and use that money to get the markets moving again – aka make markets.  The government is already somewhat on the hook as a “liquidity provider of last resort” to the markets, so why not do it all the time.

Think about the additional tools it would give policy makers.  Markets getting bubbly? Increase your spreads.  Capital not moving?  Decreae your spreads.  Too much debt being issued? Shift market making capital to equities.  Want to create the incentive for Alternative Energy companies? Make liquid markets in their debt and equity.  The private sector would never do this.  They make markets in wherever it is most profitable at the time.  Sometimes to aid other businesses that they are in and can get out of the game in a moments notice.

Steve Waldman at Interfluidity writes that Information is Stimulus:

A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But “hangovers” do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that’s no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.

Nationalizing market making gives policy makers a really interesting way to receive information from and inject information into the markets.   I take Waldman’s premise further and say that Capital flows towards information.  Under a lens of uncertainty, capital doesn’t flow, but if capital knows that there is a liquidity provider out there with an interest in allowing it to flow, it can flow more smoothly.  Nowhere can this seen better than the capital flow to arbitrage strategies, the “sure” thing.

Ability to Put Financial Innovation to Good Use

The last decade of financial innovation in the form of financial engineering should be used to improve market microstructure not allow a few rich people to profit.  Staying with the transportation metaphor, engineering breakthroughs such as bridges and roads weren’t built for a few rich people to benefit, but for society as a whole to improve.  These financial innovations should be applied in the same way.   We should take these brilliant minds, have them build robust, fair market making algorithms, and embed them in our market microstructure so that they benefit society as a whole.

Bid-Ask Spread is Already a Liquidity Tax

The market maker spread is essentially a tax on liquidity.  The market-maker provides liquidity and for doing so collects the spread.   On top of this brokers get their share in the market. In addition, many are throwing around the idea of a Tobin Tax on top of this.  Why not just simplify things and allow the government to simply collect the bid ask spread – a liquidity tax and in return be a stable liquidity provider.

While there are obviously concerns I have with such an idea, such as regulatory capture and inefficiency of the government to operate, the more I think about it, the more it makes sense.  I also know that this is something that would never go through in lifetime.  In any case, this has been something that I have been ruminating on for some time, not going any further in my own head, and wanted to share it with the blogosphere to see what they think.

Now, please, tear it shreds!

Today I read a piece about how the US Postal Service is looking to cut costs as they stare at a potential cumulative $250 Billion shortfall in 2020.

From Reuters:

The U.S. Postal Service, faced with less mail and bigger shortfalls, plans to cut Saturday delivery and overtime, raise prices and trim its workforce by about 30,000, its chief financial officer, Joseph Corbett, said on Tuesday.

Because of e-mail and private delivery companies, traditional mail volume is expected to be down from last year by about 10 billion pieces in 2010 with first class mail expected to drop 37 percent by 2020, leaving the service with a cumulative shortfall that could hit $238 billion by 2020.

Faced with that shortfall, Corbett said the service was planning a moderate increase in stamp prices and pressing for a law to be changed that would allow it to drop Saturday delivery.

In today’s mailbox, out of 10 -12 pieces I received, only one was actually somewhat important.  I would figure most Americans have a similar experience.  While this article says that the problem is due to mail volume is dropping, I think the problem is completely the opposite.  There is WAY too much mail.

The US Postal Service is setting a price for mail at which the supply dramatically outweighs the demand.  This has led to the proliferation of Sharper Image catalogs and Super-Saver coupon packs.  It allows many companies to lay off some of their spamming marketing costs onto the post office.   The original intention of the post office wasn’t to give horny old men cheap thrills twice a month when the Victoria’s Secret catalog arrived, but to deliver important, relevant messages.  Even if I’m wrong, the internet is killing that intention too!

Since the postal service could essentially become a government subsidized spam factory, is this even a business we want to be in?   There must be a better and cheaper way to work alongside the private market to ensure that vitally important messages are promptly delivered to the citizens at a reasonable cost.

This week, the Obama Administration turned their attention away from healthcare and towards the banks, announcing the Volcker Plan.   While the official plan hasn’t yet been released, the blog and tweetosphere have been buzzing over the last few days.  The reactions have ranged from angry to confused.

I figured I would share a few of my thoughts:

  • It will be very difficult to define what prop trading is. Two great pieces that illustrate this point are Kid Dynamite and Bronte Capital.  That does not mean that it can’t be intelligently done, but it will be difficult (and unlikely).  This issue is not simple and those saying it is on either side are wrong.
  • This is political but the ends can still justify the means.  While this is obviously a political reaction. it doesn’t mean that it should be completely ignored and written off.  Let’s be honest here, EVERYTHING that comes out of Washington is political.  Many people who were criticizing Obama for not putting forth financial reform are now criticizing Obama because he did.  Yes, what he is proposing is not the solution, but criticize the idea not the man.  If there is one thing that both sides of the aisle can agree on is that there needs to be some financial reform of some sort.  The masses will be happy with something, so it should be in the interest of all incumbents to come together and pass something good.  I don’t agree with Obama on many issues, but still would like to see him pass some meaningful financial reform.  We must be constructive in how we approach this, not destructive.  Use this as a launching pad.
  • Just because prop trading didn’t cause the financial crisis doesn’t mean it can’t. A popular argument against the proposed reform is that it doesn’t address the causes of this crisis.  This is absolutely true.  This crisis wasn’t caused by prop trading (although it was a Bear Stearns internal hedge fund which helped to get the ball rolling).   This doesn’t mean that the next one can’t be.  Most would agree that reform shouldn’t seek to be solely punitive in nature nor should we engage in regulating in the rear-view mirror.   It doesn’t address specific causes of the last crisis, but does address a more general, timeless, and universal one – mixing opaque risks with customer deposits.
  • Just because something makes up a small percentage of a banks business or all bank business doesn’t mean it can’t present harmful risk into the system. In today’s WSJ Intelligent Investor Jason Zweig writes:

    But the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking, according to financial historian Eugene White of Rutgers University. Of the more than 7,500 banks in the U.S. in 1929, only 3% had significant securities operations. Nor did hawking investments make banks riskier for shareholders. From 1930 through 1933, nearly 2,000—or more than 26%—of federally chartered banks closed. But only about 7% of the banks that had a securities business
    went bust.

    Yes this is true, but the problem which caused the bank run in the 30’s was that some banks were holding the bag on worthless stocks.  This fear grew to speculation that ALL banks had this exposure.  If you remember this is similar to what happened with subprime.  Everybody was asking is this bank or that bank subprime.  Subprime loans were a small percentage of the total assets on the balance sheets but caused a disproportionate amount fear. Fear is a powerful emotion and if you look at the opacity surrounding some principal investments banks invest in, it isn’t hard to see this happening again.  It’s best to keep risks surrounding customer’s deposits as simple and transparent as possible. While this proposal isn’t as far-reaching as Glass-Steagall was, I don’t think the original law was completely unfounded.

  • This isn’t going to kill market-making as many people are claiming.  One of the biggest options market maker is Citadel.  Citadel is a hedge fund, not a bank.   There is no law in finance that says the same place I deposit my money has to be making markets in securities.   Market makers provide a valuable service to the market place – liquidity – and they get paid a spread to do so.  It also helps dealers underwrite and provide capital.  It is a business that is obviously viable on its own and existed before Graham-Leach-Bliley.  If prop trading is something that helps facilitate market making perhaps the whole enchilada should be separated.
  • Most large financial supermarkets failed, why argue against reality?  Citi and Bank of America (and Wachovia) should be a referendum on Graham-Leach-Bliley.  In the 1990’s, the bill was introduced in order to put the Citigroup merger through.  Citigroup has failed and is still on government life support.  There is nothing that has happened that convinces me that this is the model that works, so why fight to save it?  To those that scream “FREE MARKETS!”, the market has spoken and it said it doesn’t like these large financial institutions. Without government intervention they would already be dead by now.

Those are some of the ideas that have been bouncing around my head the last few days.   As I was writing this, The Epicurean Dealmaker shared an interesting FTAlphaville article that says how the proposal also helps crack down on some conflicts of interest on Wall Street and indirectly on pay, that is worth reflecting on as well.

I welcome comments, criticisms, and ideas.  I think those looking for reform have been given a gift here, as reform is now back on the agenda.  Instead of attacking the idea we in the blogosphare should be thinking more deeply, constructively criticizing, on it and improving it, because hopefully they are listening.

Set FAZzers to “Done”

While not a student of the markets as much lately, I am a student of StockTwits.  I pore over the stream all day every day and today noticed something.  Conversation in the Inverse ETF’s such as $FAZ and $SRS has virtually stopped.   Below is a tag cloud of the most popular tickers on StockTwits today (click to enlarge):

$FAZ and $SRS, two of the more popular Inverse ETF’s are nowhere to be found.  Compare this to a visualization of the top tickers on StockTwits for 2009 (where they were some of the most popular:

Since there is a major relationship between tweets and share volume, one would expect the volume in these ETF’s to have dropped as well.   This is indeed the case:

While some of this low volume is due to the holidays, volume is clearly slowing down compared to what it was this summer when people were “FAZ-zing their faces off”, as The Fly would say.

During the entire summer the bears were feeding the bulls through vehicles like $FAZ and $SRS.   This is the first real evidence I’ve seen that the bearish euphoria is waning.   Is this bullish or bearish?  I’m not quite sure.

The idea for this post hit me the other day while hearing some news about Iran invading Iraq’s oilfields which consequently made oil rise.  Having recently allocated some of my father’s retirement money into energy stocks, I got excited by this news – which is all other respects is not “good” news.

This made me think.  If for a split second someone like me who is loosely tied to this investment in energy could psychologically put aside ethics and common sense and root solely on greed, what about those with a larger investment in such resources and companies or, even worse, the means to manipulate the value of their own investment?

Greed is a powerful emotion and what many attribute to conspiracy is simply the fallibility of man.  Money makes people do stupid, sometimes evil things.

Luckily, the United States is a capitalist democracy.  Sure there is a powerful elite, a “capital class”  but it is kept in check by the majority of people, the “labor class”, as well as market forces themselves.  This system works well unless the interests of labor somehow become aligned with the interests of capital, or what I like to call the “capitalization of labor”.  The greed of labor usually checks the greed of capital, but when labor’s interests are aligned with capital, capital can hijack the market and become too powerful.

While most who know me know that I am a huge supporter of the individual investor and for technology that empowers him, one must question whether democracy in investments eats away at the capitalist democracy that we have built.  Does the large percentage of the Average American’s net worth tied up in relatively meaningless amount of voting shares of American corporations devalue his right to vote?

Think about it.  If people didn’t have 401K’s and the ability to check them daily, would the plummeting stock market back in October 2008 really have swayed them to take such quick and drastic action in the bailouts?  Probably not.  The unemployment rate was only 8% or so at that time, but the percentage of people holding equities was MUCH higher.

Would people be so apathetic about the corporatism run amok in our government if they weren’t long those same securities in their retirement accounts?  Probably not.

Freedom of the masses to invest does not necessarily bring with it political freedom – in fact it may bring the opposite.  We are so quick to look at the economic benefits (and indeed there are many) we overlook some of the possible negative political costs of such an innovation.

The solution to this is not simple, and won’t come from the government but  from the general public realizing that the most valuable voting shares they own are not in their 401K.

One currency pair that many traders watch is the $EURJPY.  It’s historically been correlated with equity markets and is a good proxy on risk taking in the marketplace.

Back in March, two weeks before equity markets rallied, the $EURJPY started moving up, perhaps signaling the rally.  Since then the two have moved pretty much in lockstep – until recently.

Below is a chart (click to enlarge) showing how recently the two have diverged.  The $EURJPY is selling off whereas the market has been trading in a range off the year’s highs

Surely, the $EURJPY can play catchup, and since the dollar has become the carry trade currency of choice old relationships may not hold.  Regardless, this is a relationship to watch.

Most think that the last decade was characterized by excessive risk-taking in the economy.  While I do admit that as an economy we took on tons of debt, I think our problem was that we tried to avoid all risk whatsoever.  The increasing desire to be completely hedged of all risk has resulted in a economy that essentially believes in nothing – and that’s a bad thing.

Exhibit A Output Price Hedging

Today Barricks Gold announced that it has reduced its hedges and now is fully levered to the price of gold.  Well that’s nice considering it’s a fucking GOLD miner.  If you decide to get in the Gold mining business, one would think that you have some belief that Gold is something that people would want and you would want exposure to such a thing – or else why mine for the shit to begin with?

“Oh we don’t want our business to experience the volatility in Gold prices”, they will say.  Fuck that you pussy, you’re a Gold company not a hedge fund (and we will get to them later)

Exhibit B – Credit “Enhancement”

One of the first shoes to drop was the the bond insurers such as Ambac and MBIA and climaxed with the CDS mess known as AIG.   Why did this all happen?  Because investors were too pussy to take credit risk without someone holding their hand and telling them it is safe.  A good capitalist economy has investors that believe in the investment or project he is funding.  An economy scared of its own shadow uses credit “enhancement”, instead of taking good old-fashioned risk.  Ironically enough, we ended up holding a bag of blown hedges.

Exhibit C – Market Neutral Investing

Market Neutral Investing is to risk taking as John Mayer is to Rock Music.

While I hate all the “bubble-calling” going on I’m going to say that the next bubble to pop is something I call the market-neutral asset class.  This isn’t a real asset class, but basically a bunch of hedge fund strategies that seek to avoid market risk.  It’s my belief that many of the obscure, derivative products designed over the last few years have been invented to meet the demand for this asset class, as traditional, underlying assets couldn’t support the volume needed for its existence.  Need to conduct convertible arbitrage? Not enough convertible debt out there? Fuck it – here’s a CDS.

All this market-neutral investing, by definition is a belief in nothing.  We have thrown tons of money after these supposedly risk-free arbitrage strategies rather into entrepreneurs who actually want to put money at risk in the market.  And while I guess there are some positive externalities, such as liquidity (and its effect on ability to raise capital), there are positive externalities to sports gambling as well.  Put all our capital to work in strategies that hedge spreads at various sportsbooks across the countries and you’ll see tons of bookmakers and some new sports leagues sprout up and small economies develop around them, but it is certainly not the best use of our capital.

A hedged economy is an economy that believes in nothing.  Although we have failed, what has crushed us has been our desire to invest capital in a fantasy land where risk does not exist instead of investing it using good old fashioned risk taking.

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