Life and Debt (2001, Stephanie Black) is a documentary film that discusses the machinations of international finance in the country of Jamaica. Although it is not riveting in its execution, it does beautifully combine narrative and documentary to effectively communicate some things about how global finance has functioned in so-called third world countries. Through a short first person text by Jamaica Kincade entitled ‘A Small Place’ in which a Jamaican narrator addresses words to a tourist visiting her island, the director speaks to the audience, situating the viewer in the story, in their potential role as ‘tourist’. On the one hand, there are the glistening azure beaches; on the other, hidden in the foliage, there is massive poverty, currency devaluation, and deep social unrest.

Although the film comes from a ‘globalization’ perspective – which often, in this kind of media, tends to be an ideological critique and a diatribe against obvious injustices – this film is somewhat more subtle. It does an excellent job of capturing how trade policies create situations on the ground that affect agricultural practices, employment conditions and state finance. Rather than simply inflaming the viewer at how many panties a Hanes Jamaica pieceworker in the ‘free zone’ is expected sew per shift, the director is also careful to point to bigger issues, to the deep ironies of a tax free manufacturing area whose infrastructure is paid for by the Jamaican government indebtedness, for the benefit of American industry.

Nevertheless as the film progressed I was left with many pressing questions that nobody who studies globalization seems to be able to answer. The heart of the film was to document the slow erosion of Jamaican agriculture by the importation of cheaper food products from the U.S. An influx of powdered milk drowns out fresh dairy; frozen brown chicken meat (what’s left after the white has been taken to make chicken nuggets) floods the market at 20 cents a pound; imported carrots replace locally grown carrots. Ok, so this is happening, I see it on the screen… But my question is how?

It seems to me that trade policy alone is not a sufficient answer to the pricing puzzle. Beyond policies that lift trade barriers and do away with preferential tariffs there is still the burning question of price calculation: How is it possible for the price of an imported carrot, coming on a refrigerated, oil powered containership, to cost less for a Jamaican citizen on the marketplace than a carrot pulled out of local soil and transported by truck? (It takes only 12 hours to drive around the entire island.)

Most stories about prices in the globalization studies will show how so called free market prices are either not free because of hidden subsidies, or will defer to the ‘fact’ that superior farming practices create supply that drives prices down. But what nobody seems to show is the actual valuation process, the (calculatively legitimate) cost accounting mechanisms that constituts one carrot as being less expensive than another carrot. Is it sufficient to say that political interests fix prices so that they benefit some parties over others, or is there something to be said about how the technical processes of pricing confer differential value on goods?

My question is: Is there a problem here for the social studies of finance?

‘Life and Debt’ is available on streaming video from Netflix.

The news of Eliot Spitzer’s fall from grace as the governor of New York following the exposure of his patronage of a high end prostitution outfit called the Emperor’s Club, is being largely reported on as a ‘sex scandal’. Interestingly enough if you can get beyond the issue of moral disgrace, the judicial core of the charges hinge upon the details of his financial transactions. In addition to possible charges for having violated the Mann Act, which banns the interstate transport of females for ‘immoral purposes’, federal investigators are pursuing Spitzer for having potentially engaged in ‘structured cash transactions’. As reported on in the New York TimesUnder the Bank Secrecy Act, all financial institutions are required to file currency transaction reports with the federal government for any deposit or withdrawal of more than 10,000.” (This is the reason why the blue and white U.S. customs cards ask people to report whether they are carrying in excess of $10,000 in financial instruments into the country.) Structuring’ (IRS Manual, Section is the act of breaking up cash transfers over several transactions to avoid being detected and is considered a felony. In short then, it is the govenor’s methods of payment more so than his sexual practices that are of central legal concern. Apparently, however (according to the same NYTimes article quoted above) “If the governor was simply trying to conceal his activities from, say, his wife, it would be considered different from trying to deceive federal authorities.”

For a brief but informative NYTimes radio account of structuring click here, and then on clip featuring Gerald L. Shargel, a criminal defense attorney commenting on the legal issues of the case. For the story of the woman whose services unleashed the storm, see here.

Roach on recession.

March 6, 2008


Op-ed, New York Times

Stephen Roach, chairman of Morgan Stanley Asia, thinks there’s ‘Double Bubble Trouble’ in the air.  In an op-ed today he argues that the situation in the U.S. looks a lot like Japan in the 1990’s.  Commenting on Washington’s recent manoeuvres to mitigate the onset of a recession – aggressively lowering interest rates, negotiating relief for homeowners, OFHEO’s uncapping Freddie and Fannie – he observes that:  “If the American economy were entering a standard cyclical downturn, there would be good reason to believe that a timely countercyclical stimulus like that devised by Washington would be effective. But this is not a standard cyclical downturn. It is a post-bubble recession.”  His frank assessment?  For asset-dependent, bubble-prone economies, a cyclical recovery — even when assisted by aggressive monetary and fiscal accommodation — isn’t a given.”  Gulp!

Peter Erdelyi, wrote a very nice and accurate summary of the public symposium about the edited volume Market Devices. Peter: many thanks for this!

The latest ‘Chinese toothpaste’ panic and the way ‘China’ is constructed in the American public discourse reminded me of another episodes of economically driven or perhaps, economically reflected jingoism, that of the 1980s American car industry (see, for example, here and here). There are many similarities between what we are experiencing now with regard to ‘Chinese Import’ in general and between the ‘Japan is going to overtake Detroit’ of the 1980s. A quick look at both cases shows that transformation process took place whereby products, production methods, wholesale and retail practice were reduced into a national character. Hence, those were not Toyota or Nissan who were threatening the dominance of GM or Ford in the American auto market. Instead, those Japanese’ were gaining dominance over ‘an American industry’. Of course, the social and, indeed, societal processes that unfolded were much too complex for a blog post. Nevertheless, the fact that we see again, 20 years after that wave of jingoism, the emergence of another one should raise some question marks about the omnipotent power that we tend to assign to global economic factors. After all, if globalization in general and ‘the global economy’ in particular have gained dominance, why does the question of where exactly the cars or the toothpaste come from make headlines?

The NY Times is asking whether NY is still the ‘capital of capital’ mentioning that, among other things, the largest mutual funds are not based in the city, the biggest securities trading floor is no longer that of the NYSE (see here about the demise of open outcry trading and here more discussion about it):

[I]n today’s burgeoning and increasingly integrated global financial markets — a vast, neural spaghetti of wires, Web sites and trading platforms — the N.Y.S.E. is clearly no longer the epicenter. Nor is New York. The largest mutual-fund complexes are in Valley Forge, Pa., Los Angeles and Boston, while trading and money management are spreading globally. Since the end of the cold war, vast pools of capital have been forming overseas, in the Swiss bank accounts of Russian oligarchs, in the Shanghai vaults of Chinese manufacturing magnates and in the coffers of funds controlled by governments in Singapore, Russia, Dubai, Qatar and Saudi Arabia that may amount to some $2.5 trillion, according to Stephen Jen, a Morgan Stanley economist.

However, as financial markets become more distributed, we should re-evaluate the connections between geographical location and capital.

One potential direction that is hinted in the NY Times story is the preferred location for IPOs (initial public offering). The article refers to the fact that nine out the ten largest out-of-country IPOs (IPOs done outside the country where the company is incorporated) in the last year were held outside the US. IPOs, of course, are the fundamental building blocks of financial markets as through them new stocks enter the market. Knowing that NY is the traditional location for IPOs, we can pretty much equate US with NY. The meaning of this figure is that NY does not attract to the same degree it used to the types of people and institutions that perform IPOs. Instead, the story tells us, new urban ‘financial-attraction’ centres are rising (at least as far as IPOs go). Hong Kong seems to be one of New York’s major rivals, as are some European cities.    

So, what are the conditions that attract IPOs to a particular urban centre? The immediate conceptual candidates are human capital (experienced underwriters, for example), institutions, liquid capital and, inevitably, a social network that binds these ingredients together effectively. All of this may sound fairly basic to a sociologist, but in spite of the fact that there is considerable research about urban financial centres, to best of my knowledge the crucial element of IPOs has not been studied empirically from a sociological perspective. Having said that, a paper by Richard Florida analyses the demographic conditions that induce creativity among urban populations and thus may help to conceptualise the question of where IPOs are likely to take place. It can be that one of the reasons for this relative lack of academic attention is the fact that to understand what makes IPOs happen, one needs to witness the inner mechanisms of the process and these are not easily accessible, as this classic ethnography-like Fortune magazine story about Microsoft’s IPO shows.

Daniel, the NY link of this little London-NY collaboration, sent me this link to a NY Times article about the immanent closure of some of the physical trading floors of the New York Stock Exchange. Some of the readers of this blog came to a tour of the New York Mercantile exchange where a similar message, about the rapid move from face-to-face to screen-based trading, was conveyed (see here).

This article, however, implies to yet another dimension of the move to screen-based that’s less obvious:

After becoming a publicly traded company itself last year by merging with Archipelago Holdings, the exchange’s operator merged in April with Euronext, which owned stock and futures exchanges in London, Paris, Brussels, Amsterdam and Lisbon.

This gradual amalgamation of financial markets at the institutional level into a single techno-social network means, for many institutions, that traders would have to go home (either retire or trade from outside the floor). But, this also means that markets now would use unified clearing and settlement systems (Euroclear), or in other words, that the exchanges’ risk management is gradually becoming centralised. In fact, by the end of 2007, Euroclear, who provide clearing and settlement services for Euronext will “move into the implementation phase of our platform consolidation programme, with the launch in production of the Single Settlement Engine (SSE).” It is feasible that such consolidation will deliver better efficiency, but it also raises questions about the ability to manage financial risks in a cross-owned network of exchanges that constitutes a large share of the global trading volume. For example, the operation of a unified risk management system may create inadvertent drops in prices in entire sections of the market by generating sale orders. I am sure that Euronext are much more sophisticated than this, but, at least at the conceptual level we can ask the question about the new forms of risks that are introduced to the financial markets through the creation of such exchange conglomerates.

An inspiring event just took place at Columbia. On September 7-8, David Stark and I organized a workshop on Knightian uncertainty. It brought together distinguished economists, including Nobel laureate Douglas North, as well as sociologists and management scholars, to talk about Knightian uncertainty.

Why uncertainty? It is not an exaggeration to argue that most post-war advances in social sciences have focussed on risk. From Black Scholes to Porter’s Five forces, Nash equilibrium to the efficient market hypotheses, the social sciences have modeled with great success situations in which the future can be predicted. But in a world of innovation, hedge funds, financial bubbles, climate change and terrorism, Knightian uncertainty — not risk — sits at the center of every decision-makers’ agenda. The workshop prompted reflection on these issues. What does uncertainty imply for policy-makers? for managers? For arbitrageurs? For strategists?

Here’s a few of the issues that we touched on.

First, the sheer importance of uncertainty. This was cogently articulated by Douglas North. Moving past the intellectual concern with institutions that won him general acclaim, North has turned to the problem of radical uncertainty, mental models and economic growth. North takes a really long perspective –five or ten centuries– and observes that some countries have risen from poverty to wealth, whereas others remain in misery. Why such wide differences? None of the orthodox economic explanations, he argues, account for it. To North, the explanation lies in the differences in mental models that guide the creation of institutions which, in turn, promote economic growth (or the lack of it). On the same session, Joe Porac expressed his disagreement with one of main premises of the workshop — that uncertainty is behind much of the activity that we see in the economy. Porac pointed to possible psychological mechanisms that may be having a similar effect.

Uncertainty is also central to the corporate world. For example, how should managers confront uncertainty? One of the most counterintuitive aspects of Knightian uncertainty is that the recipes that work best in a predictable world of risk can create major disasters under a scenario of uncertainty. This difficulty was emphasized by Nassim Taleb with the concept of rare events or “Black Swans.” Taleb distinguished between two realms of action: the real of non-rare events or “mediocristan,” and “extremistan.” The former describes phenomena that adhere to a normal Gaussian distribution (size of mountains, weight of people), while the latter are described non-normal distributions (wealth of Bill Gates, stock price movement in 1987). In extremistan, actors have to prepare for the potential occurrence of or rare but disruptive events. They face extraordinary success… and failure. Extremistan is where the key problems, the bankruptcies, the defaults, the shocks arise. It is particularly dangerous for decision-makers take mediocristan for extremistan, and assume they know more than they really do.

How, then, should companies operate in an extremistan-like world of uncertainty? As noted, it requires a very different organization. Firms that operate in this environment, according Anna Grandori, should espouse an “epistemic rationality”. Traditional concerns with optimality and saving resources should be replaced by efforts to discover the environment. The notion of heuristic, Grandori argued, also needs to be redefined: under uncertainty, the challenge no longer lies in recognizing familiar patterns but in discovering new models, novel relationships, etc. Search should no longer stops when performance is good enough, but when the firms’ insights make accurate predictions. The entire organization, in short, needs to be engaged in active research of one kind or another.

A different answer was provided by David Stark’s concept of heterarchy. Uncertainty poses managerial problems that go far beyond profitability. In extreme cases such as transition economies, the definition of success is itself in flux. Profits may not be the key measure of success; employment, sales, production — even location — may be the central reason why a company gains resources. How do you organize for such flux? Stark called for a different internal logic of organization — one that allows companies to adhere to competing conceptions of worth. To accomplish this, companies need to avoid hierarchy and bureaucracy. Instead, firms should pursue a dense network of horizontal interactions and distributed power relations.

The managerial problem, and more specifically the problem of strategy implementation, centered the presentation by Sarah Kaplan. Strategy involves the future. But consider the conundrum faced by an optical fiber company immeditely after the burst of the Internet bubble. A company that had been virtually living in the future for several years was suddenly confronted with a collapse in their market, as well as in their own confidence to predict the future. Kaplan identified the mechanisms whereby the company managed to restore sense and bridge their past, present and future.

Uncertain markets

How do capital markets confront uncertainty? The question goes at the heart of the conversations in the workshop, as well as at the core of Wall Street’s present headaches. Indeed, the cleavage between risk and uncertainty is at is widest in finance. From the CAPM model to the Black-Scholes equation, orthodox finance has provided Wall Street practitioners with the tools to engage in a new financial strategy, quantitative finance. But in contexts of uncertainty, those models seem to stop working and sometimes even turn against their users. In this sense, Emanuel Derman described quantitative finance in a lucid and succinct manner. Mathematical formulae, he argued, provide a mind-broadening ability to associate the value of a stock to the value of some other, seemingly different one. Unlike physics, which works with axioms, modern finance operates by analogy. But these analogies may break down in contexts of uncertainty. Examples of these include the 1987 crisis, the 1998 crisis and… the current subprime debacle (which was in the mind of all participants). What do to then?

In some ways, my own presentation addressed this very problem, and pointed to financial tools as a solution. I examined how merger arbitrageurs used a specific visualization device, known as the “spread plot,” to confront their own interpretations with those of their competitors. The spread plot provides arbitrageurs with information about what their rivals think. By alternating between their own estimates of merger probability and the probability implied by the spread, arbitrageurs stay alert to their own misinterpretations and are prompted into search. As arbitrageurs adopt financial positions, their beliefs feed back into the spread. Over time, the social use of the spread plot among the arbitrage community leads to gradual convergence in probability estimates. The arbitrageur’s solution to uncertainty, I suggest, is a financial tool: the spread plot.

Harrison Hong widened the discussion of financial uncertainty with a generalized model of disagreement in markets. His discussion centered on discrepancies between the beliefs of market actors and the ways in which these influence traded volume and price volatility. Behavioral models, Hong argued, provide some explanation for either of these, but no single model can explain extraordinary movements in both volume and prices. And yet, this is the central trait that distinguishes situation of uncertainty such as the dot-com bubble. In many ways, the concern echoes the problem raised by Beunza. Namely, that because arbitrageurs draw on all the social clues at their disposal, perception and action, prices and trading, fluctuate together. Hong presented several models in which differences in interpretation, constraints on shorting and differences in media coverage combine to yield the co-movement in prices and volume that is observed. In short, then, disagreement and differences in interpretation is crucial. Without them, one cannot account for bubbles or other periods of uncertainty.

The role of disagreement on Wall Street was further studied by Raghu Garud. A key group in this setting is Wall Street’s securities analysts. They play central role in articulating, using and debating different perspectives about company value. Garud described the role of analysts in advancing different opinions about during the emergence of the Internet. Analysis even interpreted the same piece of news in radically different manners. Eventually, however, their differences in interpretation collapsed when the milestones and rhythms promised by the dot-com optimists were not confirmed by events. But the process took three years.

Uncertainty and strategic interaction

What does “strategy” mean when the opponent is unknown? Traditionally, strategic interaction has been studied in game theory. But according to Adam Brandenburger, game theory can sometimes be unhelpful; specifically, orthodox game theory typically assumes that both players in the game know how the other person thinks, her interests and her payoffs (the so-called assumption of “common knowledge”). Bringing uncertainty into our understanding of games radically shifts the problem from an abstract exercise of calculative anticipation into something much different. In the so-called school of “epistemic game theory,” strategic interaction is seen instead as the way in which the players discover each other. What does the other person think? What does he or she stand to gain and lose?

In understanding “the other,” it is helpful to keep in mind the logic of justification that defines him or her. According to Laurent Thevenot, it is not the same to operate in a domestic regime (one rooted in tradition) than in a market setting (determined by competition) or a civic setting (shaped by the general interest). These different regimes not only bring with them different geographical locations, goals and metrics for success, but even differences in values. Such multiplicity of worth has been studied in detail by the French school of “economics of convention.” Conventions, according to them, are the solution to the problem of coordination in games.

But how does a convention arise? Such was the question addressed by Olivier Favereau. The heterodox economist explored the process whereby a collective of people who do not share a language are able to espouse a convention, underscoring the role of intersubjectivity in bringing about common knowledge.

All in all, an extraordinary event. The description above only begins to scratch the surface…. very soon, I’ll also be reporting on some very provocative commentaries by Bruce Kogut, Harrison White, Yuval Millo, and Fiona Murray.

Stay tuned.

The hybrid market

August 19, 2007

The ASA conference finished this week. I listened to some very good papers and attended some very interesting sessions, as you can see in a recent post in Org Theory . I will cover these in more detail when I get copies of papers from presenters. This time I would like to talk about a tour we took of the New York Mercantile Exchange . Daniel Beunza, my partner in blogging here in Soc Finance, arranged the tour and it is a good opportunity to thank him publicly for an innovative step that resulted in an exciting and memorable experience. Our guide on the tour gave a nice overview of the exchange’s history, trading practices and even gave us a little tutorial in tossing trading cards to the exchange’s clerk.

This was all light-hearted and entertaining, but there was a more sombre undertone to the visit. As went through the exchange’s little museum floor, the guide continuously mentioned the fact that the trading floor used to be much busier and that that nowadays much, if not most of trading is done ‘from home’. When we got upstairs to look at the trading floor proper, it was obvious that the guide was lamenting the immanent disappearance of open outcry trading in the exchange, a process that has already started, and soon to be replaced completely by screen trading.

This all sounded very compelling, but did we really see pure outcry trading from the visitors’ gallery? A slightly more observant look showed that all traders were using tablet computers. It turns out that trading was not done only face-to-face. In addition to trading in the pit, trades also filled orders that came through their computers. These trades, it has to be mentioned, were completed anonymously. That is, traders could fill orders from the public as well as initiate trades anonymously. That is, without the knowledge of the people standing inches from them in the pit. The existence of these two separate trading routes can be used to create interesting informational manipulations. For example, a trader can split her book of order in such a way that only a fraction of the real activity is revealed publicly, and the rest is conducted in stealth, through the handheld terminal. In fact, it would not be surprising if two traders who rub shoulders in the pit would be trading anonymously with each other.

The hybrid nature of the market does not end there. From the visitors’ gallery I could see on some of the handhelds’ screens the familiar windows of portfolio management software. Again, like the automatic order routing, this is hardly surprising: if you have to carry a computer on the trading floor, you might as well run some useful programs on it. But, where does this leave the distinction between open outcry and screen-based trading? That is, the traders see the market both with their own two eyes, watching out for the tale-telling body language, the noise level and, laterally, word of mouth. In addition, they also see the market with the help of ‘x-ray goggles’ in the form of computer-based risk management.

As Fabian Muniesa would have put it, the market was already partly folded into a machine. For the traders, this form of hybrid market seems to have the best of both worlds. They receive the unmediated and irreducible information that only a live trading pit can produce: the facial expressions of one’s trading counterparty, the reactions of the pit to news, fear and greed in their naked, and most revealing forms. In addition, the handhelds provide them with different types of information: what other markets are doing, how the last trades affected the trader’s portfolio and what is the current risk picture. Combined, these two streams of information are unparallel in their richness and scope. There is little doubt that trading this way is potentially very rewarding for the traders.

Well, then, if it’s so good, why would anyone want to give it up? The answer here, like in so many other cases, boils down to one word: privatisation. The traders don’t want to go home. Although many of them do leave the floor, trade from home and do very well, many others realise that they cannot trade facing only the screen. In the tour, our guide says that she sees some of the ex-traders in Home Depot. They don’t want to go home, but the exchange is not theirs anymore and they don’t have a say about it. The NY merc, like many other exchanges was sold and the owners moved to screen-based trading. The technological dimension of the story is well known:
price determination is done much more efficiently through computer algorithm than doing so through face-to-face trading. Higher volumes of orders are processed this way and since trading volume is the lifeblood of any exchange, the decision to move to automatic order routing and quote generation is easy.

However, the tour gave us a hint about the political dimension that it embedded in that ‘purely-technological’ transfer to screen-based trading. Our guide mentioned that thinning business on the floor mean that frequently traders walk home with a profit of a few hundred dollars, not like a few years ago when ‘a trader would make $50,000 a day and then would take the rest of the week or even the rest of the month off’. So, it is not only that electronic price determination is faster; it is also important for the exchange that computers do not take days off and take off some potential liquidity with them. It is a common saying that traders are the working class of the financial world. Indeed, many of the traders in the commodities exchanges come from working class background. The move to screen-based trading seems to complete the analogy: you are part of the working class if one day they replace you with a machine.