
Death by Derivatives - pepys
https://www.damninteresting.com/death-by-derivatives/
======
dsacco
That was a nice read. I like these pieces about the historical context of
financial instruments.

 _> Michael Lewis details one such practice in his book Flash Boys, where
market makers use superior networking technology to change the market price of
a security after a customer sees it and places an order, forcing them to trade
at an inferior price._

This is a potentially misleading description of HFT algorithms. HFTs cannot
see a customer’s order before it executes on an exchange. They cannot “jump in
front of” an atomic order. HFTs only have insight like this at the inter-
exchange level, i.e. in latency arbitrage. But by default a customer’s order
won’t be routed to multiple exchanges unless there is insufficient liquidity
to complete the order on the first exchange (which, if that’s routine, means
you’re likely an institutional customer). Alternatively, if they submit
several orders, HFTs will (logically) adjust their prices in response to the
new order book activity, which would result in price slippage for the
customer.

~~~
cryptonector
HFTs == market makers. You need market makers in order to have a functioning,
liquid market. Absence of market makers -> higher volatility.

Market makers can lose a lot of money under certain market conditions. Their
profit margins are rather small. Market makers are practically heros.

~~~
vinceguidry
It's a bit naive to equate the two. Plenty of strategies can be found that
leverages high transaction speed and volume that aren't market making.

What defines market making is the fact that you buy and sell the same
commodity at the same time, taking advantage of the spread to make money.

Two other rapid transaction arbitrage strategies involve market manipulation,
in which trades are placed that are designed to fool other trading algorithms
into believing that the price is going to move a certain way, and statistical
arbitrage, which searches for temporary price differentials across exchanges.

Neither of these two strategies create liquidity on the market, that is,
offers more opportunities for anyone who wants to buy or sell to do so.
Instead they seek to create, and/or exploit opportunities.

~~~
dsacco
_> What defines market making is the fact that you buy and sell the same
commodity at the same time, taking advantage of the spread to make money._

You need not be a formal market maker to increase liquidity. Technically
speaking even retail customers will receive small transaction fees for
increasing liquidity in certain circumstances where it's particularly lacking.
More generally speaking, any strategy that rapidly connects two parties is
market making, even if the two parties are not immediately next two each other
in the strategy's trading queue.

 _> Two other rapid transaction arbitrage strategies involve market
manipulation, in which trades are placed that are designed to fool other
trading algorithms into believing that the price is going to move a certain
way_

Market manipulation is not a good term to use for this, and it's a fairly
serious accusation to levy against a trader. Market manipulation is an illegal
activity that typically involves cornering or collusion. More abstractly, this
is a net improvement in price discovery, because one party notices that
another party can be fooled (which means their algorithm has a glaring pricing
inefficiency). In repeatedly taking money from the other party, the other
party becomes incentivized to stop executing that strategy. Once there is no
counterparty to take that trade anymore, the inefficiency has been traded
away, and the market is now (likely imperceptibly) more efficient.

 _> Neither of these two strategies create liquidity on the market, that is,
offers more opportunities for anyone who wants to buy or sell to do so.
Instead they seek to create, and/or exploit opportunities._

This creates liquidity. Any situation that increases trading activity
increases liquidity by definition. You do not need purely symmetric market
making to improve overall liquidity - if many low latency trades are being
executed, and they are finding counterparties, the liquidity of that market is
increasing as a result of the volume. HFTs do not buy and hold, which means
they are rapidly connecting buyers and sellers, even if it individual
securities are bought and sold asynchronously.

~~~
cryptonector
This is a very good answer.

I suspect too that HFTs do not buy and hold simply because the cost of holding
must be very high for an HFT, e.g., transaction fees may be higher when you
mean to hold, and anyways, whatever you're holding is burning a hole in your
pocket, much like cash does for an investor -- it represents a missed
opportunity.

I also don't see how offers/bids that no one wants to take exploit anything.
If they are unreasonable then they are noise that a) can be filtered, b) costs
the HFT something. If they are reasonable then they may end up in an actual
trade (improving liquidity). Either way they help price discovery!

------
skrebbel
> Indeed, the string of early derivative traders taking their own lives grew
> long enough that one writer gave it a name: the “crimson thread of suicide.”

I fear the day that Bitcoin & friends come crashing down.

~~~
jstanley
During the 2014 crash there were details of suicide hotlines pinned to the top
of r/bitcoin

------
jstewartmobile
If you haven't yet, read his story on Colonel Sanders. You can thank me later.

[https://www.damninteresting.com/colonels-of-
truth/](https://www.damninteresting.com/colonels-of-truth/)

~~~
goldenkey
That was an awesome read. Never knew the Colonel was a real person. A little
sad how they managed to screw him over with no stock considering he founded
the company. Good news though as of late, is that KFC is going back to its
roots: [http://www.bizjournals.com/newyork/news/2016/04/04/kfc-
redo-...](http://www.bizjournals.com/newyork/news/2016/04/04/kfc-redo-stores-
return-to-colonel-chicken-method.html)

Might have to try it again :-)

------
kleiba
Damn, I clicked on the link thinking it would be an article on murderous
calculus...

~~~
sp332
Well here's the first related joke that came to mind:
[https://www.reddit.com/r/Jokes/comments/2o1rsw/a_calculus_jo...](https://www.reddit.com/r/Jokes/comments/2o1rsw/a_calculus_joke/)

------
wyager
> The scale of today’s derivatives market is almost too vast to comprehend.
> It’s measured in trillions of dollars.

The commonly stated notional value of the derivatives market is sort of a
nonsense number. It’s based on (very roughly speaking) the number of
derivatives contracts times the value of their underlyings. This means that if
you had, let’s say, a billion binary contracts that paid out one cent if Apple
was above $180 in one month, this would have a notional value of like $175B,
even though the maximum amount of money that changes hands is $10M and the
market value of the contracts is even less than that.

I looked actual estimated market value of all derivatives contracts a while
back and it was something like 1.5% of the stated notional value. It’s still
really big, but iirc substantially smaller than “normal” investments like
stocks and commodities. Not saying the article’s wrong, it is indeed trillions
of dollars even after accounting for this. Just an interesting thing that
isn’t usually mentioned.

------
Synaesthesia
> _The scale of today’s derivatives market is almost too vast to comprehend.
> It’s measured in trillions of dollars. Traders, aided by the most
> sophisticated software money can buy, place bets — billions per second — on
> the future prices of every manner of stuff._

My grandpa can’t comprehend how bitcoin has “created value out of nothing” but
really the finiancial world has been doing it for ages.

~~~
JackFr
> the finiancial world has been doing it for ages

Well, not really.

Financial instruments like stocks and bonds are real legal claims on the real
assets of an entity. They are not creating value out of nothing, they are
transferring ownership rights.

Derivatives are a zero-sum game. There is no value out of nothing, the money
you make is your counterparty's loss.

Seignorage is what the government does when it creates dollars (or when
bitcoin is created). That truly is creating money for nothing.

~~~
usefulcat
> Seignorage is what the government does when it creates dollars (or when
> bitcoin is created). That truly is creating money for nothing.

Institutions such as banks and credit unions are also able to create money
'from nothing', via lending.

When they make a loan, it's not as though they deduct the amount loaned (or
any part of it) from someone else's account, and typically they're allowed to
make loans totaling many times (9x? 11x? I forget) the amount of deposits they
possess.

~~~
eli
How could they make loans multiple times the deposits they have unless they
too are borrowing money from somewhere?

~~~
carapace
They just do.

> Because banks hold reserves in amounts that are less than the amounts of
> their deposit liabilities, and because the deposit liabilities are
> considered money in their own right, fractional-reserve banking permits the
> money supply to grow beyond the amount of the underlying base money
> originally created by the central bank.

[https://en.wikipedia.org/wiki/Fractional-
reserve_banking](https://en.wikipedia.org/wiki/Fractional-reserve_banking)

It is literally just paperwork.

Fractional-reserve banking is the greatest scam ever, or a pillar of our
economic system, depending on whom you ask.

~~~
eli
I think one of us is confused. Your link says they can loan out money that
people have on deposit even though they technically owe it to depositors. They
only need to reserve a fraction of what people have deposited (so better hope
they don't all withdraw at once). It doesn't say they can loan out MORE than
had been deposited.

~~~
carapace
You asked "how" not "whether". I'm not an economist, I'm some dude who read a
book once, so I don't really know what's going on. That said, _if_ the banks
"loan out more than had been deposited" they do it by ledger legerdemain.

~~~
eli
They... don't.

------
amelius
A more ironic title would be "Death by Securities".

------
matt4077
It's funny how people consider government intervention and centrally managed
economies to be terribly inefficient, yet nonody counts the collective revenue
of financial institutions as (at best) a necessary inefficiency of a market-
based system. Same for advertisement, deadweight loss, artificial scarcity
etc.

It's pretty obvious that free markets (with a few guardrails) work better than
anything else we've tried so far. Yet there's so much overhead spent on
managing the system, one wonders how anything ever gets done...

~~~
runeks
Financial institutions are not a product of the free market — they are heavily
regulated by government.

On top of that, the currency that has been given legal tender status by
government, and the currency used as the basis for calculating capital gains
tax, just happens to be issued by the central bank that’s willing to monetize
the government’s debt. What a peculiar coincidence.

~~~
Retric
Financial institutions predate government regulations. Their general role is
cash flow management (ex: Loans) or risk mitigation (ex: Insurance).

~~~
runeks
You’re right. I should have written “contemporary financial institutions”.

