In The Trading Game, The House Wins

I don’t like to play games I can’t win – including games where the only way I can win is due to a statistical miracle. This is why I don’t buy lottery tickets, and it is also why I don’t trade stocks.

I do, however, invest in stocks. Investing means buying something and holding it for the long term with the expectation that, over time, some combination of good management and societal progress will make it worth more than you originally paid. Trading is something entirely different. It means buying something now on the expectation that you can sell it for more than you paid a few days, a few minutes or, these days, often just a few seconds later.

Trading is not a game individuals can win. It’s not even a game most businesses can win, including investment businesses such as mutual funds or pension plans.

The only way to consistently win in trades against fellow traders is to have faster execution or better information than your rivals. Today’s trading involves both. Companies pay a premium for high-speed access to financial exchanges, as discussed in a study released late last year, or for early access to non-government but market-moving information, as detailed by a recent article in The Wall Street Journal. (The latter article is located behind a pay wall.)

There is one other way to win: Find yourself in a position to manipulate data and take advantage of your customers. Big banks have already acknowledged doing this in connection with the London Interbank Offered Rate (more often called Libor). Now Bloomberg reports that certain banks – it does not name any, but there are four big players in the market, along with many smaller participants – are doing the same with foreign exchange.

The allegations may be hard to convert into prosecutions, as the Bloomberg article explains, because trading one currency for another at the current price for delivery within two days (called “spot foreign exchange”) is not considered a transaction involving a financial instrument, and so falls largely outside of regulators’ reach.

That does not mean, however, regulators are prepared to just stand by. After the Libor scandal, British regulators especially are eager to restore banks’ reputation. Sharon Bowles, the chairwoman of the European Parliament’s economic and monetary affairs committee, said in an interview, “They need to get to the bottom of it [the manipulation of currency rates]. It’s quite upsetting we have got another bad-new story.”

How, exactly, might banks manipulate foreign currency prices?

When you land at a foreign airport, you know you will pay your bank a markup when you withdraw cash from the nearest ATM. You will pay a similar markup to the bank that issues your credit card when you settle your bill at an overseas restaurant or hotel. Sometimes this markup is clearly disclosed as a foreign transaction fee; sometimes it is hidden in the rate that your bank charges for converting your dollars to something else. Often it is a combination of both. But at least we can all view this transaction as a “purchase” of foreign currency, rather than a currency trade. We understand that we pay our banks to provide these services.

Now suppose, instead of a tourist, you are an airline. You are about to pay 200 million euros to Airbus for your latest order of new jets. You ask your bank to exchange the requisite number of dollars (around $265 million, at recent rates) to supply the euros for your payment. You negotiate with your bank to provide those euros at that day’s 4 p.m. closing benchmark price in London, plus a tiny markup for the bank. You think you have cut a good deal.

But unbeknownst to you, the bank goes out that afternoon at 3:30 p.m. and buys your euros. Then it uses your order, in collusion with other, similarly motivated banks, to “bang the close” and drive up the 4 p.m. benchmark high above the euros’ 3:30 price. In the end, the bank doesn’t only profit from the tiny markup you knowingly negotiated; it also profits from having used your trade to drive up the reference price. The other banks’ customers are similarly abused.

This is the world of markets – not just today’s markets, but all markets since the dawn of commerce. Regular players, big players and middlemen with informational advantages always dominate trading to the disadvantage of everyone else. Regulators may curb this truth in certain ways at certain times, but the heavyweights are much like Vegas casinos. You may win a game by sheer chance, but over time, the house always wins.

This doesn’t mean we should never use markets. Sometimes we need what is sold in them. But it means we should keep our visits as infrequent as possible, and we should try to take advantage of those markets that offer us the fairest terms – meaning the most genuine transparency – and the most cost-efficient vehicles in which to conduct our business.

And we should never confuse trading with investing. Investors have a rational expectation of long-term profit. Frequent traders who lack significant advantages in speed and information can make no such claim.

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About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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