Michael Lewis' latest I

As I mentioned a few days ago, I have been looking forward to the receipt of Michael Lewis's latest book, on cryptocurrency and the downfall of Sam Bankman-Fried. This will be the first in a series of three posts that will discuss passages in the book that stand out for me. None of these posts will constitute a review of the book, nor will they add up to one,

I now have it in my hot little hands. With some synchronicity, SBF took the stand in a courtroom on Thursday, Oct. 26, on his own behalf as a criminal defendant. This already tells you that the trial had not been going his way: defense counsel would have gone to a great deal of trouble to keep him OFF the stand were it not time for a desperate Hail Mary sort of play.

But today's task is to quote a passage in the Lewis book about him that stands out. And here is one, from chapter three. Lewis gives an example of what is known in finance as "market making." Market making is not the same as "running an exchange," although it is a strategy that can be adopted wherever there is an exchange. Specifically, it is a strategy that involves creating a spread between one's buy price and one's sell price. Lewis's example: a full-time trader at a Wall Street firm walks into a room full of interns and says, "I got some dice in my pocket. Anyone want to make a market how many?"

Lewis says a bright but perhaps less-than-brilliant intern might say (having by this point in his internship learned the lingo), "Two at five, one up." "Two at five" means that the market making intern is willing to bet that the trader has some number of dice in his pocket between two and five. He is "buying at two, selling at five." The phrase "one up" defines the stake of the bet. If the trader has fewer or more than the number of dice in that range, then someone taking the bet can win one dollar for every die by which the market maker's range is wrong.

So: intern A says "two at five, one up." Intern B decided to take the bet on the up side. If there turn out to be seven dice there, then Intern B wins two dollars from intern A. Intern C might decide to take the bet on the down side. His maximum payoff would be two dollars, if the pocket turns out in fact to be empty of dice.

The great thing about market making is that (when it works) it is self hedging. If you take bets on both sides, then -- even should you be wrong -- your wins on one side will make up for your loss on the other. Intern A can make a bet with someone who says the pocket is empty, and make another bet with someone who says there are 7 dice there. There are in fact seven dice there. Our market maker will receive two dollars from the empty-pockets speculator, then hand the same amount to the savvy seven-dice speculator.

Indeed, Lewis says, the "two at five" sounds reasonable. "After all, the trader probably had some dice in his pocket -- otherwise why would he be asking? And if he had more than five dice in his pocket, surely you'd see a bulge."

But ... why did the trader ask this question of interns. Why did he offer an opportunity for such a market maker? That is the question traders have to ask themselves all the time. Is there adverse selection here? Is this, in other words, a case in which the person offering me an opportunity is someone from whom I ought to be running in rational fear? Accordingly, the question interns ought to ask if an experienced trader asks them is: what lesson is he trying to teach me by asking me to make this market?

As Lewis tells the story, another brighter intern "bought at five." That is, he took the upside of the bet. Then the market making intern looked on in horror as the trader "pulled from his pocket sacks that contained a grand total of 723 extremely tiny dice." It would have taken a heck of a lot of "selling at two" to make the hedging aspect of market making work here.

So Lewis here well explains market making, the hedging nature of it, the risks of it, and the tactical issue of adverse selection. Not bad for one page of prose.

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Jamesian Philosophy Refreshed

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