Rogers, the Telecom Cannibal

One of the most difficult choices that an established and very profitable company must make when faced with a small and nimble competitor, one that has everything to gain and nothing to lose, is lowering their prices or investing in new technology to address the new competition. They quite sensibly will put off these decisions for as long as possible. The delay will be criticized, and even ridiculed by the competition, yet it is still the right choice. Rarely is the decision so urgent that a company will forgo current profits to chase what may turn out to be a mirage. That is, they will strive to avoid cannibalizing profitable businesses -- by lowering prices, offering new services or investing in new technology -- until it becomes unavoidable.

The reasons why delay if often the best business decision are several:

• The new competitors, especially in the telecom business, must invest heavily to deploy a new network. The massive debt load when combined with lower prices (to differentiate from the incumbents) and what may turn out to be a slow acquisition of customers can derail or destroy the competition, even when the incumbents make no changes to their prices or products. Time is often on the side of the incumbents.
• It is not unusual that new technology, while dazzling to customers and the media, is not adopted rapidly by customers. Consider VoIP as a good example of this phenomenon. Rapid investment in the new technology that competitors are also deploying can often be done at a slower pace when combined with good marketing. In effect, telling the market that the technology is being deployed (which is true) while doing so quite gradually.
• Lowering prices does not guarantee customer retention. First, even if prices are held steady, many customers will no switch since they will be more conservative in their choice, opting to go with, for example, good wireless coverage and service dependability. Second, customers preparing to switch will often do so even if the incumbent lowers their prices since there are other factors in their decision, such as escaping poor customer service.
• Investors may rebel or will at least defect (sell their shares) as the incumbent damages short-term profitability by lowering prices and increasing capital expenditures, even though they may understand the reasons for the company's decision. It is no certainty that the competitors will be irreparably harmed by the company's actions, or how long it will take. Yet for the present they must tolerate a lower company valuation, due to lower profits, and therefore lower share prices; the company's share price in part reflects investor expectation that company profitability be sustained or increased.

With this background, let's look at yesterday's quarterly results from Rogers. As recently as this summer I wrote that Rogers was still looking good since there was unlikely to be any near-term impacts on their financial state due to new competitors such as Wind and Mobilicity. It would take time for them to build out their networks to become a credible alternative and take a significant bite out of Rogers' subscriber base. This appears to be the case, despite some analyst warnings to the contrary.

The new landscape includes a handful of upstart wireless firms, such as Wind Mobile and Mobilicity, that are building traction with consumers through discounted pricing, simplified agreements and aggressive marketing campaigns.

And this one:

...Dvai Ghose, a telecom analyst with Canaccord Genuity, in a research note earlier this month. “In our view, the market is ignoring reprice pressure in Canadian wireless, both from new entrants and incumbents.”

Nevertheless, Rogers did respond with their flank brand, chatr, to mimic Wind's pricing to compete with them without threatening their core wireless business. That has, in part, had an impact on their quarterly results.

The modest year-over-year increase in net subscriber additions for the quarter primarily reflects increased prepaid subscriber additions offset by an increase in the level of postpaid churn associated with heightened competitive intensity. The increase in prepaid subscriber additions was the result of Wireless' launch of its urban zone-based unlimited voice and text 'chatr' product and also its continued offering from earlier in the summer of prepaid wireless service plans for Apple's recently introduced touch screen tablet computer, the iPad. In addition, Wireless introduced prepaid Rocket stick wireless data plans that offer the same speed and reliability as existing postpaid plans but designed for customers seeking the convenience of prepaid online credit card activation.

Although Rogers has taken steps to restrict new chatr plans to the areas when competition is now ongoing, they are to some extent -- thought it is not really possible to say how much -- cannibalizing their own business when their existing customers switch to chatr. It is also interesting that their subscriber growth is slowing despite the additional services they are offering for new devices such as the iPad and internet access for PCs and netbooks.

The number of new Smartphone subscribers was the second highest ever in a quarter. This resulted in subscribers with smartphones, who typically generate ARPU nearly twice that of voice only subscribers, representing 37% of the overall postpaid subscriber base as at September 30, 2010, up from 28% as at September 30, 2009.

This is another impact on their results which is not only a sign of future growth and not at all related to competition. When you buy a smartphone from Rogers -- iPhone, Android or BlackBerry -- they must purchase the phone from the supplier at full price while selling it to you at a heavy discount. They make it up over the contract term(including data plan), but account for the expense in the current quarter. Yet these subsidies, and current quarter losses, indicate future revenue and profit.

Some analysts feel that smart phone upgrades, as opposed to pure subscriber growth, is a more important indicator of success in the industry as wireless data revenue – which was up 28 per cent in the quarter – becomes more important than revenues from voice services.

That is, a ramp in these subsidies is a good indicator of future profits and corporate health. We should also note that they are not only on the receiving side of competitive pressures, they are taking telephony market share from Bell Canada and other incumbent telcos.

Cable telephony lines in service grew 9% from September 30, 2009 to September 30, 2010. At September 30, 2010, cable telephony lines represented 27% of the homes passed by our cable networks and 43% of television subscribers.

Although Rogers B-class shares lost 7.7% on Tuesday in response to their quarterly results, I do wonder if this is either an overreaction or a overly-negative interpretation of their earnings decline. I don't like Rogers as a customer, and I am not currently either a customer of theirs or a shareholder, but I would not write them off just yet. I would also suggest that they may be too aggressive in cannibalizing their wireless business, even though they've segregated budget pricing to the chatr brand. Perhaps they really are running scared, though that does not seem likely to me. More likely is that they hope to hurt the competition now while they're still at the critical market-entry phase and very sensitive to meeting subscriber and revenue objectives.

As consumers, not shareholders, we do have some choices even if their coverage and options are still limited. That can't be bad. There is even good news for Rogers shareholders since, if my guess is right, this drop in share price could turn into a buying opportunity for those willing to hold for another quarter or two.

Chasing Currencies: Smart vs. Dumb Money

Currency watching seems to have become a big deal recently with the emergence of QE2 in the US and the increasing glitter of gold. More injection of money into the market by the US Federal Reserve effectively devalues the US dollar and, if truly a hedge instrument, the price of gold rises -- at least when measured in USD. Devaluation is however a relative sort of thing, so you do have to specify just what it is that the USD is being compared.

In addition to gold, US investors watch the currencies of other major economies, in particular the Euro, the British pound and the yen. The Canadian loonie is only of secondary interest to them. Despite the huge trade between our countries, our economy is relatively small and, like Australia, our currency is often seen as little better than a proxy for mineral commodities (which is largely true).

Aside from the high-stakes currency games in play across the globe, there are many people in Canada -- those that do not actively participate in the markets -- that see the CAD:USD exchange rate as a type of sports match; they cheer the home team (the loonie) when it is near par with the USD and are distressed when it declines. This is silly since par has no economic meaning, or at least no more than any other exchange rate. It can even infect those who ought to know better. I once had a CEO who one morning was all giddy about the strength of the currency. I quietly reminded him that our major market was the US and the currency appreciation was making our products more expensive for our customers and therefore less competitive. Worse, our parts costs were fixed in local currency even though many were imported from the US so we couldn't benefit on product costs on the other side of the ledger.

While we keep our laser focus on the linear threshold that represents the par value of the CAD:USD chart (adjacent), and the US compares their dollar to other currencies, there are still others who compare the USD to gold and even to stocks. That last one really puzzled me, as you can see in this October 15 article in the Wall Street Journal. Here we have someone not only comparing the USD to domestic stock indices but then saying that there is an investing opportunity when they diverge, as if there is some fundamental measure of fair value that proclaims they ought to be closer together. In other words, if the USD is declining when the market is rising there will soon come a revaluation of the market lower, in concert with the USD, as a type of reversion to the mean.

Even if we assume for the moment that there is a mean (fair value) to which the market will revert, there is no reason to assume that the market will move. We can get reversion by the USD rising, the USD and market both rising and both falling, or meeting somewhere in the middle. Yet we are to believe that the "smart money" -- by this the author means financial professionals, not you and me -- will bet on the market falling if the USD rises. That doesn't sound so smart to me. One fundamental reason is that as the USD declines, the competitive position of exporting US companies is improved which will be reflecting in their share price and therefore the market. There is perhaps a better argument to be made for the divergence to be a positive feedback loop that will (to a degree) drive the USD and market further apart. So who's dumb and who's smart?

This also impacts the loonie and Canada since there is tension between an increasing need for Canadian resources due to renewed economic expansion in the US and their higher cost of importing our resources. It's this sort of conundrums that keep the talking heads yapping in the media. It also reinforces the point that investing can be a perilous venture for the likes of us when major economies play power games with each other.

Robocalls From O'Brien and Other Politicians

Robocalls cover several categories of automated, mass calling systems. Perhaps the most benign of the bunch (if there is such a thing) is the type that appears to have used by the O'Brien campaign. This is were a list of numbers in the targetted demographic or geographic area are machine dialed, and when the call is answered a prerecorded message is played. Very convenient and (importantly) inexpensive for the campaigner but terribly annoying in most cases for the rest of us.

There are other, more-insidious varieties of robocalls, and it is perhaps no surprise that they have, in general, been banned in countries like Canada and the US, and a growing list of others. Unfortunately, calls from campaigning politicians are excluded from the Do-Not-Call registry even if they are robocalls rather than if the auto-dialer connects you to a live human operator. It likely wouldn't matter in any case since the CRTC is not terribly aggressive in pursuing DNC violators, despite reports to the contrary:

According to the CRTC's rules, candidates can't ask for money or volunteers, but they can ask for votes. Auto-dialing must only be used during reasonable daytime and evening hours, and messages must start by identifying the caller as well as a mailing address and a phone number where the candidate can be reached.

None of the robocalls made during Winnipeg's civic election campaign appear to have included the candidate's campaign office address or phone number at the beginning of the message, though most candidates left a phone number at the end.

Officials with the Canadian Radio-television and Telecommunications Commission say they're looking into a small handful of complaints over the last couple of weeks, at least one related to robocalls made by Mayor Sam Katz as part of his re-election bid.

Katz's campaign staff say their telemarketing provider double-checked with the CRTC and was told the ADAD rules do not apply to political campaigns.

But two separate CRTC officials confirmed Tuesday that candidates must comply with the ADAD rules.

This activity is also going on in other cities because it can be so effective, such as in our biggest city, Toronto:

The company called 10,000 people in Vaughan’s Ward 3, collated from municipal electoral rolls.

• About 2,000 people “connected” and stayed on for varying periods, from a few seconds to a few minutes.

• 770 stayed on for a “sustained” period, 8 to 22 minutes.

• An astonishing 550 stayed on for a full hour, asking Del Duca questions about everything from local issues to high car insurance rates. It would be hard to achieve anything like that degree of contact through the time-honoured methods of door-knocking and doorstep-chatting.

Of course this is why they do it: it works. It works because enough people bite to make the campaign effective. This is the same reason that email spam and commercial telemarketing continue despite the fact that they annoy the majority.

There are scattered cases of worse robocalling behaviour by political campaigns south of the borders. In the 2006 and 2008 election years some people were getting upward of 10 or 20 calls per day from the candidates. Often they violated the blackout periods (such as late evening) that apply even to these DNC-exempt callers. Worse, some voters got calls in the middle of the night.

It turned out that these repeated or late-night calls were usually from opposing parties who would splice out of context or fictional messages from the other candidate in the hope that it would turn them against that candidate. By all reports it actually had that effect, since it was only later, after the election when the damage had already been done, that most of the truth came out. As far as I know this type of fraud hasn't yet occurred in Canada.

One puzzling report regarding the O'Brien robocalls is that some people claim they can't hang up on the calls:

Several recipients said they couldn't hang up and use their phones for another call once the taped message started. A YouTube video shows a man apparently trying in vain for more than 20 minutes to hang up on a telephone "town hall" meeting, basically a massive conference call featuring O'Brien.

This type of network behaviour pretty well disappeared in the 1970s when the first stored program controlled switching equipment was widely deployed. On older electromechanical switches it was indeed very possible for a caller to hold the circuit by remaining off-hook when the called party hung up. While it had valid uses -- such as going on hook on the main phone to pick it up from an extension phone in a bedroom -- it was often abused by stalkers, collection agencies and others.

I suspect that in the above report these people didn't go on hook long enough (a couple of seconds) before going off hook again, or another phone on the same line was off-hook or their phones were defective. Nowadays it is typically only 911 operators that have the required network feature to keep a line active when the other party disconnects.

NDA Should Come After the First Disclosure

Many Android application developers have recently been bombarded by emails from Amazon. Regrettably, the way they have gone about this guarantees that this development firm will not be responding. The critical passage in the email is this:

Once you agree to and return the nondisclosure agreement we can begin speaking with you in greater detail about the opportunity.

Requiring an NDA as a prerequisite to the recipient of a business proposal is a good way to kill the opportunity in the bud. It isn't so far removed from telemarketing scams that begin by telling you that you've just won a trip to some tropical resort, and then say: "please send us $500 to cover administrative expenses which we'll refund later." In both cases the unsuspecting recipient of a proposition is asked to ante down before being able to properly assess the merits and costs of the proposition. The correct response in such a case is typically to say nothing, do nothing and walk away.

In the case of any business proposition, the reasons to not sign an NDA are much the same as why a venture capital firm will not sign an NDA with the companies that pitch to it:

• You may be legally bound to not discuss with anyone else what you have learned in the disclosure even if it becomes public knowledge. In other words, you are being co-opted to protect the other party's pricing, features, business practices and other information. This can include not being able to tell, for example, another supplier or service provider what price they will have to beat to earn your business, even if you do not name the competing company or product.
• Regardless of the novelty or uniqueness of matters disclosed to you, you may find yourself in legal chains in your further use of these matters. For example, if you are shown an as yet not well known method for indexing a database, but is one that would not (or should not) meet the "not obvious" criterion to be patented, you may find yourself unable to use that method even if independently implemented by one of your own staff. Regrettably, the same can apply to business methods or other so-called trade secrets that are generally considered to be pretty ordinary.

There are of course valid reasons to sign an NDA in the above cases, but never as a matter of routine. There should always be a strong justification, known and discussed up front, before signing and before each disclosure. The proper way to make progress in these situations is to disclose the opportunity in broad terms before delving into details which expose trade secrets or sensitive intellectual property. Only after a further milestone is reached, and once mutual trust has been firmly established, should either party go further in what they disclose.

In the rare case where more must be disclosed up front, this requires more due diligence in establishing the good reputation (or not) of the party receiving proprietary information. Few companies or individuals are in a position to do well from recourse to the courts after the information is abused by the recipient. The objective is to avoid this if at all possible.

So then, what is Amazon going to disclose that makes the signing of an NDA so important, to them and to us? The rumour is that they plan to launch an Android app store in competition with Google, although I can't know for sure since we have not engaged Amazon on their proposal, even though it is being widely discussed.

I believe they will have eventually have to open up more publicly if they are to gain the volume of developers and apps that they would need on board if they are to be successful. Only then would we consider getting involved. However, their opening sally has put us on our guard because they feel a need to tie our hands or silence our mouths that is greater than their need to openly discuss terms, unlike Google's Android Market.

For us, an Android developer, the risks are greater than any opportunity we can see. That precludes the possibility of our signing an NDA with Amazon at this point, or at any time in the future.


Disclosure: Warning! I am not a lawyer, so please keep that in mind when reading this article.

China's Muscle Flexing

My reaction on reading Paul Krugman's article on China exploiting its globally-dominant position in rare-earth metals was an interesting one: laughter. While I have no especial reason to side with China in this or other trade disputes, I can only smile as they use tactics that other countries have used themselves for decades or even centuries, and in particular the US, which is unsurprisingly where Krugman is located.

The thing is, countries which have a strong military or economic position tend to exploit it to their own advantage. Trade is merely one aspect of that power relationship. The US used its power to do everything from opening up Japan to international trade in the 19-th century to creating the so-called banana republics in Central America to gain favorable access to tropical produce to imposing advantageous (to them) rules on exports of softwood lumber from Canada. This is simple power politics. Yet we are still able to maintain a positive overall impression of the US.

When a new power comes on the scene it is expected that the old powers will squirm at least a little bit. It is good for China, and us, that its per-capita wealth is growing and that the country is now in a position to trade with other countries on a more equal basis. Trade goes both ways, so while we import products from them, we also have a new, large export market. For Canada the situation is not too far different from the one with the US since in both cases the trade partner is big, aggressive and wealthy. Whether it is US petroleum money in Alberta's oil patch or China mulling over Saskatchewan's potash industry, the concerns for us are pretty equivalent.

In regards to the recent dust-up between Japan and China over sea rights, Krugman extends the threat to that which China could exercise over rare-earth metals:

On one side, the affair highlights the fecklessness of U.S. policy makers, who did nothing while an unreliable regime acquired a stranglehold on key materials. On the other side, the incident shows a Chinese government that is dangerously trigger-happy, willing to wage economic warfare on the slightest provocation.

I would suggest that China is no more trigger happy in these sort of dispute that the US has been in the past century; it is simply that China has some newly-acquired muscle and they are not afraid to use it. They are certainly being aggressive, but they are not going to war with anyone. In diplomatic circles this is called "sending a message". I say that it worked: China has succeeded in waking up some sleepyheads around the world, and in Washington in particular.

This sort of muscle flexing by China will continue, and it will be felt in all areas of trade and international business. This ranges from their wide-ranging mining and resource activities throughout Africa -- too often ignored by others -- to what I believe will be an assault on the the high-value end of the economic spectrum as evidenced by their growing pursuit of patents.

The bottom line is that China is a major world power that is increasingly in a position to flex its muscle. Like other powers that came before, they will naturally find that balance point between passiveness and aggressive expansionism since its optimizes their net benefit. That is, they refuse to be exploited as they have so often been in the past, nor will they overuse their military prowess to become an international pariah.

Their muscle-flexing causes perhaps more qualms than would another country since their government does not express the same fundamental themes of individual freedom and democracy. We could ourselves do better at this, yet China clearly does worse. There is good reason to believe that they will do better in the future. I am hopeful that China will in time become a more gentle giant than they are currently exhibiting as their growing pains create frictions with those they rub up against.

Police State Languages, and Businesses

In George Orwell's "1984" the totalitarian state government has created a new language, one based on ordinary English, called Newspeak. They are just beginning to introduce it to the population in the time period in which the novel's story takes place. It is not an optional language; it is positioned to become the state's official language and, over perhaps a generation, it will be the only language to be spoken.

Newspeak, as Orwell describes it, complete with examples, is restricted in both form and vocabulary. It is designed to make it difficult to say things which the state deems to be bad, and conversely making it easy to say the things of which they are likely to approve. Further, since we think in language, people will supposedly find it difficult to have thoughts that are contrary to the state's interests. If successful, the change in language would solidify the state's control over its citizens' minds and lives.

Despite some problems with the realization of such an outrageous idea, it is one that is a common topic in software engineering. Computer languages are strictly formal, with syntax and often semantics firmly based on propositional logic, with any deviation causing errors. Those errors must be corrected for a program to run. This fact makes computer language design quite similar to Orwell's Newspeak. One of the key questions a language designer must consider is whether to accommodate software designers' whims or creativity, or tie the structure down in a way that compels them to design software that meets the language designer's objectives.

This concept was first forcefully introduced to me by Robert Dewar, one of the creators of the Spitbol programming language (a version of Snobol) during a seminar he gave when he visited my university. With a nod to Orwell, he called computer languages that forced programmers to avoid a wide range of common, if sloppy practices as police state languages. The distinction is that in police state languages (which Spitbol most definitely was not) the objective was to make it difficult for the programmer to write "bad" software. Not impossible, just difficult, so that there was a greater likelihood that "good" software would be written.  Modern object oriented languages such as Java can be classified as police state languages since they rigourously enforce a data structure and flow of control that is inconvenient (and often pointless) to avoid.

Conversely, non-police state languages make it easy to write "good" programs and "bad" programs; it's up to the designer to make appropriate choices. Languages such as C are in this category. However, the dividing line between these police state languages and others is fuzzy, and the differences are sometimes subtle.

Beyond philosophical differences there are other advantages and disadvantages to both categories of computer languages that I won't get into here. Suffice it to say that most software designers use both at different times for different purposes.

There are ample analogous situations that can be found in all aspects of human endeavour. A bureaucratic company, and especially the civil services, is rife with police state modes of operation. It seems that the most trivial task requires the filling out of forms, the request for approval from one's manager (who may then seek the same from his or her manager), documenting how every hour of every day is spent, and so forth. These are organizations that make it very difficult to do bad things. They also suck the life out of their employees by destroying creativity, initiative and productivity.

Presumably these organizations are perfectly satisfied with the trade-off. Private sector organizations of this type (think of insurance companies and even, though to a lesser extent, the old Nortel) are vulnerable to competition or a rapid evolution in their markets.

Entrepreneurial companies that are aggressively growing are of the other category. These companies harness the energies of their employees in ways that are a joy to see and experience (everyone ought to have this opportunity at least once in their careers). A couple of local (to Ottawa) examples with which I am familiar were Mitel circa 1980 and Newbridge in its first decade. On the down side there is often total chaos, including frequent changes in direction, such as the trashing of one nascent product or market for something supposedly better or more promising, and no sense that the organization is able to function as a unified entity. The resulting inefficiencies are in one sense horrifying, except that the energies released can still result in prodigious results.

These non-police state businesses make it easy to do both good things and bad things, and there is a lot of individual discretion given to employees to make that choice. It is common in these companies to find few formal processes (just find someone with formal authority to sign a purchase order, as an example), nothing that could be properly called a budget, and often products that get shipped have surprising features that were never specified in advance.

As with computer languages there are market sectors that favour each category of business. Oftentimes a formerly free-wheeling organization will, when times get tough, adopt many of the practices of police state companies. Regrettably we rarely see companies move in the opposite direction, away from police-state practices. Instead they tend to die off.

For a manager in a free-wheeling company, it can be very challenging to maintain any sort of control over delivering to objectives. There is often the desire to institute controls. If you are ever in this situation I suggest avoid the easy out -- creating controls that prohibit bad behaviour -- and instead learn to better direct and maintain the team's energy level -- encourage and reward good behaviour. People aren't computers and trying to police behaviour to too great a degree, even with laudable objectives, is rarely the right choice. Leave police-state languages and practices to the computer language practitioners.

Patent Wars

Von Clausewitz famously wrote that "war is state policy by other means." We can go further and say that economics is war by other means; wealth is power that a country can use to fulfill state policy without mobilizing its military forces. The wealth of corporations, by use of corporate law and trade agreements, complements direct government action in these policy endeavours. In effect the state operates through the private sector by proxy much as two world powers have often funded other countries as proxies to fight their fights in furtherance of their own policies.

Patents and patent law are important parts of economic warfare. It is often a means to extract wealth from other countries by using international agreements to prevent cheaper competitive products that these countries would either import or manufacture themselves. Think of generic pharmaceuticals, genes, machinery, GMOs, among many others. It all works in a manner similar to the way Britain once forced its colonies to import products from British factories even though they could manufacture these themselves from the same raw materials that they exported to Britain. For example, Indian cotton and clothing.

Patents can only be used in this fashion by a country when its citizens and corporations have more and better patents than those countries it wishes to target. This ration can be improved by combining a low standard for granting patents and a judicial system that is loathe to question weak patents. By also allowing corporations a means to request import restrictions by the government on products that are alleged to violate patents, the power of domestic patents is increased. The US today does all of these things.

For this reason I was quite interested to read in The Economist that China is finally catching up to the US with its patent portfolio. The chart they show (from WIPO data) clearly demonstrates the trend. With China's rapid growth, large population and strong national desire to elevate their status among the great countries of the world, this is wholly unsurprising. A good example is their space program. Since the end of the cold war the US space program has drifted, having no clear objective for exploration beyond science. In contrast, China recently announced a new unmanned Moon mission that failed to make more than a small media ripple in this part of the world. The US and Russia are no longer one-upping each other to get to the Moon and beyond, but China is aggressively advancing their space program in a manner somewhat similar to what we saw in the 1960s and 1970s. They feel they have something to prove, and perhaps they do.

With respect to modernization and technological advancement, China is catching up, and patents are only one measure of their progress.

The question for America is not the influx of cheap but what do we do when cheap is gone and China starts to make the expensive stuff, too.

With let up in the trend, the quality and quantity of Chinese patents will pass Europe and the US very soon. As the innovation balance gradually shifts east there will be some profound impacts on the US and Europe, and their private sectors. As this article began, if patents are a battlefield the advantage will shift east as well. Patent law, which currently favours the US due to their larger and stronger portfolio, will, perhaps as soon as 2020, begin to benefit the China more often. Since old patents expire and the majority of new patents will belong to Chinese companies, the winner of more and more patent lawsuits will be won by Chinese companies.

When this happens I think we may finally see patent reform. At first in the US and then, if they negotiate wisely, internationally. If the bar is not set higher so that weak patents cannot be used as weapons in the court, US companies will suffer. Until this happens I suspect that Congress will not change course. However, this is a large ship that changes course only very slowly. Even so it is unlikely to change the outcome, especially so if the US continues to turn out fewer engineers and scientists, or just at a slower rate of growth than the competition.

The Straw That Broke the Market's Back

If you follow the markets you may have noticed the release late last week of the SEC's investigation of May 6th's "flash crash". That was the day the S&P 500 and Dow Jones Industrial Index dropped something like 700+ points in  mere minutes. I remember that quite vividly since I happened to call up a market screen in the midst of that event. I quite naturally assumed that there was a data feed error or some other misquote, but the problem persisted and was visible on other quoting services, and began to appear in live market commentary.

As the report notes (here's a short, readable summary) there was a lot of downward pressure that day for various legitimate reasons. However, this sort of drop should not be possible, or at least very improbable, due to the many checks and balances built into the market and quoting systems. Clearly this was insufficient. The transaction trail led back to the trigger, which was a large E-mini futures trade by a respectable firm that runs mutual funds as a large part of its business. The futures contract was reportedly a hedge against its longer-term investments.

E-Mini S&P, often abbreviated to "E-mini" and designated by the commodity ticker symbol ES, is a stock market index futures contract traded on the Chicago Mercantile Exchange's Globex electronic trading platform. The notional value of one contract is US$50 times the value of the S&P 500 stock index.

It was introduced by the CME on September 9th, 1997, after the value of the existing S&P contract (then valued at $500 times the index, or over $500,000 at the time) became too large for many small traders. The E-Mini quickly became the most popular equity index futures contract in the world. The original ("big") S&P contract was subsequently split 2:1, bringing it to $250 times the index. Hedge funds often prefer trading the E-Mini over the big S&P since the latter still uses the open outcry pit trading method, with its inherent delays, versus the all-electronic Globex system. The current average daily implied volume for the E-mini is over $140 billion, far exceeding the combined traded dollar volume of the underlying 500 stocks.

Although I can't pretend to know or understand the intricacies of the markets events which led to this, I am dissatisfied with this summary. Let me explain my basic reasoning. Think of a sports match such as a hockey game between the Leafs and the Sens. It's a hard fought 58 minutes where the sides take turns scoring, and there are controversial calls and a lot of penalty minutes on both sides. There are heroes and there are goats, which the crowd cheers and boos. Then two minutes before the buzzer, with the Sens having one-man advantage, a quick passing play through the Leafs' defense leads to a Sens' goal and they go on to win 5 to 4 two minutes later.

The question is: who caused the Leafs to lose or, conversely, the Sens to win? Commentators and fans scramble to lay the blame and praise (depending on whose side they're on). Was it the Leaf player who grabbed a jersey in the dying minutes and got a penalty? Perhaps it was the goalie or a defender that made the wrong move? It gets far worse when you broaden your scope further. After all, there were 59:30 minutes of action, both good and bad plays, goals and penalties, before the seminal event. Doesn't any of that count? And what about the final two minutes of play: shouldn't the Sens' time killing tactics get praise or the Leafs' failure to get a shot on goal be panned?

Yet we still focus on the goal scorer and the goalie who failed to stop the shot, which is perhaps just one of a hundred key points during the game. I feel that the SEC did much the same thing by focussing attention on that one trade in their report. As Bloomberg reports:

Jeffrey Hopson, an analyst at Stifel Nicolaus & Co. in St. Louis, said the report is unlikely to damage the company in the long term.

“It’s not ideal PR, but the activity didn’t represent anything unusual,” Hopson said in a telephone interview.

Futures options are typically asset-backed derivatives. Unlike a bet at the track that does not affect the performance of the racehorses, an option does impact the market. Someone, somewhere has to cover the asset that the option is on. If it's on the S&P 500, the asset is likely an index fund which contains a large inventory of real shares in the company that are in the S&P 500. A large futures trade will move the market.

“One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account,” according to the report from the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission.

There are two points here. First, when you trade either an illiquid security or the trade size is a significant portion of the average daily trading volume of that security you are foolish to not use a limit order. This goes for individual investors buying or selling shares of a small technology company, but all large financial firms trading billions of dollars of shares of the world's largest companies. What the purported initiator of that E-mini trade did was in this regard foolish but not improper.

The second and what I believe is the more important point, there were lots of sellers waiting in the wings. That these sellers were programs lurking just below the market quotes does not much matter. The thing is that when the market is going down, conservative investors and also active traders sells when the market goes down, just as they are wont to buy when the market is going up. This is the opposite of many small and inexperienced investors that choose to buy when the market is down and buy when it is up. It is of course more complicated than this -- actual trading strategies are infinitely more nuanced and focussed, even for small investors -- but there is some excellent rationale behind this trading style. It's about momentum: as with a ball that starts rolling downhill, if the market sentiment is negative, it will pick up speed.

That is why all those sell orders were lurking below. Programs had set thresholds on volume and velocity of selling (and the phase of the moon for all I know) that it used to determine downward momentum, and started selling. The selling drops the price, which causes more selling, and so forth on to the bottom of the crash.

The global economy and recent news events played a key role in setting the parameters behind the programs and the mindset of manual trading activity. We should not forget that, just as we should not forget the programs selling that dug the hole deeper. Focussing on any one trade, whether this one or another one, is a distraction. It may have been important, especially since it was a large market order (no price limit) on a high-leverage index, but it wasn't the only player in the game and it was not the only play that day.

I would hope that the real lesson learned is on how to improve the market's circuit breakers -- the real-time checks and balances -- or on better trading constraints before an anomalous event, whether or not they are executed by programs. We need the markets to be more robust than a house of cards.