April 16, 2013

When you create a something so complex that it is hard to understand, it becomes easy to steal things that do not belong to you.

In my prior piece, Can We Do Better? Bad Parenting I said, "I think a fundamental problem of our industry is that the concept of property has become so abstracted and ambiguous that it can become unclear who owns what. Some people think that if title isn't pinned down then it is OK to pocket something that does not belong to them."

This needs clarification. What do I mean by abstracted and ambiguous property?

When I leave for home at 4:30, I look out the window at the offices of sell-side firms that will be lit up into the wee hours by people hunkered down creating products with so many pieces that nobody is able to price or keep track of them properly. I know because I have worked at some of those firms.

Example 1: In days of yore, you could often get a better execution for a market order than you would expect from the publicly displayed quote. The right to "price improvement" belongs to the person generating the order; but frequently the broker would fill you at the quote and keep the price improvement, or sell his order flow to someone who would.

Example 2: When you display a limit order to "Buy" you are writing a put option to all who see it. Conversely, a "Sell" order creates a call option. The writer does not receive a premium. Instead the value accrues to the person who uses these orders to stop their losses.

Example 3: Banks securitize mortgages and sell them into the markets rather than carry them on their balance sheets and thus creating an imbedded option to walk away from responsibility. They sell everything else and keep that option for themselves. The option to walk away has tremendous value; just ask anyone who is fighting over alimony and child support how much they would pay to just walk away.

In extreme cases, such as Example 3, some people can get stuck holding the bag who hadn't signed up for such duty. Can you guess who they are? Hint: The answer begins with "Tax" and ends with "ayers.”

Brooke Allen is a 30-year industry veteran who most recently founded a quantitative trading desk now celebrating its 17th year in continuous operation. For years he wrote a monthly piece ...