Tuesday, March 8, 2016

Wall Street, Main Street

This expression is  thrown around a lot by politicians: "We care for Main Street, not Wall Street, it has run amok, messed things all up". But *what* is Wall Street exactly?  Does any form of speculation, any form of financial firm, or instrument fall under this umbrella?

A clarification is in order: Finance is not just "stocks", and it's not just about banks. There are hedge funds which in their entire history, never needed tax payer money to be bailed out. There are many other financial instruments without which Main Street could not survive.

Let's take future contracts. They tie a buyer and a seller around a commodity transaction; corn, metals, oil, what-not whereby the seller *must* deliver a specific item in a specific quantity at an agreed price at a specific time. This is important (and different from stocks) - the price is agreed upon beforehand. This way the seller "locks" a price, and sleeps easier at night. The seller could be a farmer, producing corn. There is a standardized corn contract; he sells it, and goes about his business without being bothered whether the price of corn will be $10 or $1000 in 6 months.

Now, during these 6 months, due to many other factors, price of corn can go up and down, therefore this corn contract can ve valued differently (the seller still does not care, but whoever buys and resells the contract, do). Here speculators can make money buy buying low selling high, or short selling high and buying low. But these people are not "bunch of Wall Street speculators", they provide much needed liquidity to "Main Street", in various exchanges around the world first of which is in Chicago. They provide that busy environment in which the seller, producer of corn can simply "sell" their contract to without caring who buys it. It's like doing a stage dive during a rock concert: before a stage dive would you like to have 5 people in front of you - three skinny girls, one kid, and a fat guy on the side who is sort of looking away not paying attention, or, 200 people with their hands up screaming "Jump! Jump!  Jump!". I bet the latter. In this instance the crowd is the speculators.

There is leverage, but it is tied to the margin requirements, around 5-10%, and trading is cheap. But still relatively safe from total blow-ups, because brokers make sure customers stay within their margin (checked every business day). The delivery is real - if you have a contract for the delivery of cattle and do not get out of the contract before expiry, cattle will be delivered to you. You open your door and there they are - Muuuuu. I exaggarate a little, delivery is made to a known warehouse; but it is as physical and real as it can be. A clearinghouse service makes sure the quality, the delivery requirements of the contract is adhered to.

The futures market is several times larger than the equity (stock) market. Ditto for the bond market. The currency market is bigger still, bigger then the futures. What blew up during subprime crisis was unrelated to exchanges (directly); the suck unraveled around over-the-counter transactions for mortage bonds where banks / investment banks were the main culprit.

There are some services the investment banks are good at of course; for example underwriting bonds. The beer maker InBev dropped a big fat bond recently, worth $46 billion, which was underwritten by the familiar cast of characters. This is a lot of legal work, and someone has to do it (unless this is also somehow standardized and pulled into exchanges, dunno; I heard regulators after subprime crisis were pushing financial firms towards the use of clearinghouses (?) -a side service of futures exchanges-, not sure where that process is, or even if it is still being pursued).

Coming back to the hedge funds: they come in different shapes of forms, but they are mostly technical in nature, extremely algorithmic in some cases. There are the "macro" guys like Soros and his protege, they look at interest rates, countries, currencies, central banks, there are the "pair traders" who "hedge" one stock with another (this is where the name hedge fund comes from but this is not the only approach anymore), there are information theory / statistics gurus like Jim Simons - this guy is revered like some kind of mystic, he made boat loads of money even during the last crisis. And there are the stock pickers of course, and value investors like Buffett. They deal long-term and are mentally contrarians in nature.

So, I am loving the show Billions -Damian Lewis and Paul Giamatti in the same show? What can go wrong?-, but some of the items in the backdrop are not reflective of recent events. Yeah writers take an artistic license sometimes - we need a "rich guy", "a financier", and a government guy, both characters fight, fine. But Lewis' character is running a hedge fund using insider information, this is a rare event, there have been only very few instances where hedge funds have been involved in such matters, mainly such approaches are out of their "area of expertise". The sausage makers at the investment banks would be much better at that because the walls between their myriad departments get leaky.