Part 4 – Nerds Gone Wild – Wired Markets in Distress

Financial Nerds Gone Wild – Global Markets in Distress

The original plan for this book stopped after the three parts that you’ve just read. These parts are about how markets became machines, and about using more machines to pick stocks and trade them electronically, bringing in an assortment of nifty ideas from finance and computer science along the way.

By the fall of 2008, it was clear that stopping there would have made for a book that seemed quaint. How could any financial author ignore what has happened since then? The problem was that I had spent my entire financial career in the stock markets, and the stock market was a victim, not a cause, of the Great Mess of ’08.* The causes came not from the stock side of Wall Street, but from a mix of abuses, greed, and sheer stupidity from the people who created, repackaged, and sold overly complex derivatives that started with mortgage loans that should never have been made, and were assembled into an over-leveraged financial house of cards that is still collapsing today.

These final chapters are about that collapse. Chapter 12 – Shooting the Moon: Stupid Financial Technology Tricks, is about how wildly complex derivatives traded in opaque markets, and the misuse of mathematical models to value them, contributed to the mess.

This is informative on how responsible use of market technology might have avoided the crisis and can help avoid an even more dreadful sequel in the future. Technology errors of omission and commission have contributed to our present woes. Stock markets are almost perfectly transparent, with full information available to all, and the best electronic clearing and settlement in history. These technologies were omitted in building the skyscraper of cards (“house of cards” seems too mild) out of collateralized debt obligations (CDOs), credit default swaps (CDSs), synthetic collateralized debt obligations (SCDOs), and the rest.

The Hall of Shame for those guilty of incompetent engineering features collapsing bridges, flaming dirigibles, exploding spacecraft, and melting reactors. We can add a new wing for overly complex derivatives, modeled in exquisite detail by myopic nerds with Ph.D.’s who got lost in the ever more complex simulations but ignored the basic principles, and their lavishly paid bosses who ignored the warnings from the best of them so they could be even more lavishly paid.

Chapter 13 – Structural Ideas for the Economic Rescue, expresses the view that as structural flaws in the current recovery plan become increasingly apparent, it seems clear that there is a need for a coherent systems approach to these problems. At first, I felt a great deal of trepidation about delving into this. As a longtime stock guy, I felt I didn’t know what I was talking about in this area. It has become increasingly clear that the people who are in charge don’t know what they are talking about, either. They try to solve problems charging up one hill with $700 billion of our money, drop a couple of hundred billion, then charge back down leaving the same problems in place.

Many aspects of the plans put forth are overly complex, and seem to ignore central aspects of the problem to protect and further enrich the people and institutions that created the mess. This chapter describes two original ideas suggested by my colleagues that address key issues in the economic recovery in a simple, straightforward way. Both have a near circuit designer’s approach, removing “gain” in a system that makes it unstable, and bypassing systemic flaws that impede the desired goals. These ideas are:

• Fractional home ownership. My Berkeley office-mate John O’Brien is one of the founders of the field of financial engineering. His idea, which expands on a suggestion from Fed Chairman Ben Bernanke, has the potential to address the crisis where it started, in the housing market.
• New American bank initiative. This is an idea for getting ourselves out of the hole we are in. With my coauthor for this chapter, Sal Khan, I describe a structural solution, free of the inherent flaws and conflicts that have resulted in a tragic waste of time and money in recent months.

Chapter 14 – Nerds Gone Green, discusses how many nerds are finding themselves cast out of Wall Street. Some will find their way back, but many will not. What’s a former Wall Street nerd to do? The answer may lie in market technology that is valuable outside of financial markets. Just as the Internet started out as a way for the Department of Defense to link military computers, there are future uses for market technology that may rival or surpass those involving traditional financial instruments.

Efficient, environmentally sound use of energy is one of the most important. We hear from voices as diverse as Thomas Friedman, T. Boone Pickens, and Ted Turner that energy technology is the next big thing. It is not just about making energy; it is about matching the consumers and the producers of this resource. For oil, the markets are there. For electricity, they are not, at least not in a useful way (unless you were Enron in 1999). Matching consumers, at the individual and business level, and producers, including small alternative suppliers of solar panels, is an allocation and communication problem.

Wired markets have developed to a remarkable level in finance, giving individual buyers and sellers the capabilities to interact with each other and with market makers using direct electronic access that was once found only in large institutions. There is a parallel path in energy markets. Simple real-time spot pricing is not a full solution.

Consumers need to know that cutting back today to help producers produce less pollution or greenhouse gases will not cost them more tomorrow. They effectively need software to manage trade futures, and it needs to be simple and reliable—a considerable technology challenge. Nerds with pink slips may find they go well with green.

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* Jon Stewart has a much better non–politically correct name for what has transpired lately. It begins with “Cluster.” But everyone tells me I can’t put it in the book or use it at conferences. I think you need to watch the Daily Show to pick up on its continuing economic coverage. Stephen Colbert, whose show follows Stewart’s, says the financial markets are like a roller-coaster ride where you vomit money. This brand of fake news has its share of dumb gags, to be sure, but there is more “truthiness” to be found there than in much of what passes for serious broadcast journalism.

Recent guests include Barack Obama, Bill Clinton, John McCain, and Tony Blair. There are frequent appearances by Al Gore, that pesky rascal responsible for all the weird weather lately, who is a huge Daily Show fan. In The Assault on Reason (Penguin Press, 2007) Gore praises Stewart to the sky, and quotes Dan Rather in pointing out that a great deal of mainstream television news is “dumbed down and tarted up … to glue eyeballs to the screen … and sell advertising.” (p. 17)

Wall Street Analytics

• About (David Leinweber is a Haas Fellow in Finance at the Haas School of Business at UC Berkeley, and founding Director of the Center for Innovative Financial Technology at Berkeley. He is the founder of two pioneering financial technology firms and successfully managed multibillion-dollar institutional portfolios for many years. Dr. Leinweber has consulted, published, and lectured widely [...])
• Contents of “Nerds on Wall Street” (Foreword by Ted Aronson Part 1 - Wired Markets Chapter 1: An Illustrated History of Wired Markets Chapter 2: Greatest Hits of Computation in Finance Chapter 3: Algorithm Wars Part 2 - Alpha as Life Chapter 4: Where Does Alpha Come From? Chapter 5: A Gentle Introduction to Computerized Investing Chapter 6: Stupid Data Miner Tricks Part 3 - Artificial Intelligence and Intelligence Amplification Chapter [...])
• More Praise for “Nerds on Wall Street” ("New technologies are exploited first by "alpha geeks," folks with the skills to push the envelope. This is as true on Wall Street as it was on the web. Leinweber was one of those alpha geeks, but is also the first to chronicle the innovation process from early adopter to mainstream acceptance." Tim O’Reilly Founder & CEO, [...])
• Chapter 01 – An Illustrated History of Wired Markets (An Illustrated History of Wired Capital Markets "Progress might have been all right once, but it has gone on too long." -- Ogden Nash This chapter is based on a number of ever-evolving dinner and lunch talks I have given over many years, all called “Nerds on Wall Street" irrespective of their actual subject. Many financial conference [...])
• Chapter 05 – A Gentle Introduction to Computerized Investing (Computerized Investing, Index Funds, Quantitative Investing, and Active Management “Life would be so much easier if we only had the source code.” — Hacker proverb The beginning of index investing in the 1970s was the result of a convergence of events, one of those ripe apple moments. Institutional investors began to use firms like A.G. Becker to actually [...])
• Forward by Ted Aronson (Nerds on Wall Street Forward by Ted Aronson Quantitative finance is not a topic usually associated with laughter. That is about to change with the publication of Nerds on Wall Street. I was first exposed to Dave Leinweber’s wit when he delivered a speech entitled “Nerds on Wall Street.” I believe the event happened 20 or 25 [...])
• Chapter 07 – A Little Artificial Intelligence Goes a Long Way on Wall Street (A Little AI Goes a Long Way on Wall Street: Artificial Intelligence and Securities Trading “If you give someone a program, you will frustrate them for a day; if you teach them how to program, you will frustrate them for a lifetime.” This is a history and technical overview of one of the earliest artificial intelligence (AI) [...])
• Praise for “Nerds On Wall Street” ("Leinweber isn't half as crazy as people said! He foresaw the profound change that wired technology would bring to markets (robots trading millions of shares in six milliseconds). Now he nails the Stupid Financial Engineering Tricks that dumped the markets, and offers his patented, sound insights on how the nerds will help bring us back." [...])
• Chapter 03 – Algorithm Wars (Algorithmic Trading Strategies and Automated Stock Trading “How about a nice game of chess?” — WOPR computer in "War Games" There used to be two market structures for U.S. equity traders to contend with: the NYSE (for listed stocks) and NASDAQ. Recent counts put the number at roughly 40. Many are sources of dark liquidity, which sounds [...])
• Part 3 – Artificial Intelligence and Intelligence Amplification (Artificial Intelligence and Intelligence Amplification in Financial Markets Securities Markets are Machinery Now. This raises the question of how to best participate in the world’s new wired markets. People who use information technology most effectively will be rewarded. Artificial intelligence (AI) as an academic discipline began at the famous 1955 Dartmouth conference organized by John McCarthy from Stanford [...])

• Alpha as Life (Passive Investing - Active Investing - Alpha Returns Index funds are passive investments; their goal is to deliver a return that matches a benchmark index. The Old Testament of indexing is Burton Malkiel’s classic A Random Walk Down Wall Street, first published in 1973 by W.W. Norton and now in its ninth edition. For typical individual [...])
• Wired Markets ( Financial Markets - Electronic Markets Not too long ago, going to a stock market meant you would meet lots of new people who were energetically shouting, running around, and making a mess with great quantities of paper. No more. Visiting a financial market now is more like visiting a telephone exchange. It can be a wild ride versus parking your cash in a few money market funds. Computers and network gear [...])
• Nerds Gone Wild – Wired Markets in Distress (Financial Nerds Gone Wild - Global Markets in Distress The original plan for this book stopped after the three parts that you’ve just read. These parts are about how markets became machines, and about using more machines to pick stocks and trade them electronically, bringing in an assortment of nifty ideas from finance and computer science [...])
• A Little Artificial Intelligence Goes a Long Way on Wall Street (A Little AI Goes a Long Way on Wall Street: Artificial Intelligence and Securities Trading “If you give someone a program, you will frustrate them for a day; if you teach them how to program, you will frustrate them for a lifetime.” This is a history and technical overview of one of the earliest artificial intelligence re (AI), and is a far cry from simple financial planning software [...])
• Collective Intelligence, Social Media, and Web Market Monitors (Web Market Monitors and the Impact of Social Media on Financial Markets "The words of the prophets are written on the subway walls." — Simon & Garfunkel, The Sound of Silence Opinions vary widely on the value of collective wisdom, with ample supporting evidence both for and against. The Internet has many positive examples: The collective ratings [...])
• Artificial Intelligence and Intelligence Amplification (Artificial Intelligence and Intelligence Amplification in Financial Markets Securities Markets are Machinery Now. This raises the question of how to best participate in the world’s new wired markets, and this is anything but simple. People who use information technology most effectively will be rewarded. Artificial intelligence (AI) as an academic discipline began at the famous 1955 Dartmouth conference organized by John McCarthy from Stanford [...])
• AI, IA, and the New Research (Hunting Investment Alpha and Trading Alpha from Online News, Social Media, and Rumors Alpha hunters are always looking for new territory. When a strategy becomes known and used by too many players, the collective market impact of getting in and getting out will squeeze out all the profit juice, and only the lowest-cost transactors (large sell-side [...])
• Stupid Data Miner Tricks (To Err Is Human. To Really Screw Up, You Need a Computer. — Popular Campus T-shirt, circa 1980 Stupid Data Miner Tricks in Quantitative Finance This chapter started out over 10 years ago as a set of joke slides showing silly, spurious correlations. Originally, my quantitative equity research group planned on deliberately abusing the genetic algorithm (see Chapter [...])
• Greatest Hits of Computation in Finance (Computational Finance, Stock Market Analysis, and Investment Trading "A computer does not substitute for judgment any more than a pencil substitutes for literacy. But writing without a pencil is no particular advantage." - Robert McNamara The Journal of Portfolio Management (JPM*) is one of the more upscale investment management and financial article publications around. For $500 a year, you get [...])
• An Illustrated History of Wired Markets (An Illustrated History of Wired Capital Markets "Progress might have been all right once, but it has gone on too long." -- Ogden Nash This chapter is based on a number of ever-evolving dinner and lunch talks I have given over many years, all called “Nerds on Wall Street" irrespective of their actual subject. Many financial conference [...])
• A Gentle Introduction to Computerized Investing (Computerized Investing, Index Funds, Quantitative Investing, and Active Management “Life would be so much easier if we only had the source code.” — Hacker proverb The beginning of index investing in the 1970s was the result of a convergence of events, one of those ripe apple moments. Institutional investors began to use firms like A.G. Becker to actually [...])
• Three Hundred Years of Stock Market Manipulations (300 Years of Stock Market Manipulations - From the Coffeehouse to the World Wide Web's Stock Manipulations In previous chapters, we saw that many of the changes in securities markets brought about by information technology in general and the Internet in particular are positive, democratizing access to markets and information. We also saw that technology is [...])