Who’s to Blame When It Rains? A Twitter-Inspired Fable about High-Frequency Trading
The following paraphrases a short Twitter discussion I had with @RemcoLenterman, @HaimBodek, and @AsselbergsSimon about high-frequency trading (HFT). It came about as a result of seeing the willy-nilly way the term was being used on the evening of ‘Black Monday’ 2015 to explain the market’s behaviour earlier that day.
Let’s say it starts raining. Clearly, umbrella sales will go up, and umbrella stores will profit. Clearly, one cannot blame umbrella stores for causing the rain.
If the umbrella store raises prices in response to higher demand, this makes sense because umbrella provision is not a public service that is to be provided at some constant price (say, like health care). However, if the umbrella store has an umbrella for sale at £10, and by the time you get to the checkout the price has gone up to £15 … this would be annoying (although perhaps less so these days in a world of Uber “surge pricing”).
If the umbrella store flips the ‘Store Closed’ sign just as you are about to enter the store that is annoying, too. However, the store has no public service obligation, and if it closes when it is raining it is not, strictly speaking, the store’s fault that you get wet.
Let’s say the umbrella store advertises it has 20 umbrellas spread over two city locations, but when someone buys two umbrellas at Moorgate, that store phones the St. Paul’s outlet, which quickly hides its umbrellas until it increases the cost on the price tags. This doesn’t seem very ‘honourable,’ but again ultimately it is the market reacting to demand. From the umbrella store’s point of view, the store doesn’t want to lose out to people walking along the street who can feel the first drops of rain and can quickly rush to buy all the umbrellas, thereby causing the store to lose out on profiting from the soon-to-materialise high demand.
Let’s say there is one particularly clever umbrella franchise that is able to predict rain very accurately and adjusts prices and umbrella supply to suit. It is never caught by surprise, and because of this it is confident enough to always offer the best umbrella prices on sunny days. Its success makes it impossible for anyone else to survive selling umbrellas in the city, and its rivals either close shop or invest in their own predictive abilities. Now, when the first drops of rain are felt by ‘scouts’ stationed at key places in the city, all the reformed umbrella stores start moving some umbrellas to storage to ensure they are not later caught short of supply, while the remaining umbrellas are quickly re-priced.
At some points in time it may even be possible that all the umbrella stores in the city are closed while they re-price their stock when it is raining. At this stage, many pedestrians may start to get nostalgic for the days when news agents and the chemist also sold umbrellas. The reformed umbrella stores would remind them that in those days the news agents’ and chemists’ umbrellas were expensive, of poor quality, and that they never had more than four or five umbrellas in stock at any time, and would quickly run out when it rained anyway.
If it starts raining, of course umbrellas are going to be in high demand, relatively low supply, and relatively high in price. This is how the market operates.
At CFA Institute, we do not think it is the umbrella stores’ fault it is raining, and it’s not a bad thing that they profit from rain. However, we:
- Want to avoid a disorderly crush of people waiting outside an umbrella store, trying to get in, when it starts raining.
- Are concerned when massive umbrella price swings occur, unjustified by the intensity of the rain, that start to impact other stores on the block as people have less money to spend at say the coffee shop since they ‘lost’ so much buying an umbrella.
- Worry that a general distrust of umbrella stores will lead to a dysfunctional umbrella market even on sunny days.
The minutiae of how an umbrella store sets its prices and determines the quantity of umbrellas for sale is of little interest to anyone. But it is in everyone’s interests that, on a broad level, when it is raining, umbrellas are available.
It is difficult to determine whether this is the case when on the one hand you have drenched pedestrians complaining loudly that they are wet, and in reply, the umbrella stores saying that it is not their fault that it rained.
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Image Credit: iStockphoto.com: claudio.arnese