High frequency trading, butter and billionaires

Join the team as they discuss ideas from the recent Value Investing Congress held in Las Vegas.

Join the team as they discuss ideas from the recent Value Investing Congress held in Las Vegas.

Please download the podcast here,

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For the next couple of weeks we'll be transcribing the Doddsville podcast. Please let us know in the comments if this is useful so we can decide whether to continue doing so. We're publishing the transcription as is. There will be errors, but we hope it's valuable nonetheless.

High Frequency Trading, Butter and Billionaires. Welcome to the Doddsville Podcast for Thursday the 15th of May 2014. Join the team as they explain how High Frequency Trading works, why there is a Butter boom and more.

GS: Welcome to Doddsville I am your host Gaurav Sodhi, joining me today is analyst Jason Prowd, welcome Jason.

JP: Morning Gaurav, morning everyone.

GS: And a special guest today our esteemed editor John Addis, welcome John.

JA: Koma tha.

GS: What is that?

JA: That means how are you doing in Sinhalese. I promised Michelle that I would do that.

GS: Yeah, I know you are rather fluent with your Sinhalese that's true.

JA: I can also say.....

GS: Please don't, John its been a while since we have had you on, besides learning an obscure foreign language what else have you been up to, anything you wish to share, any tales?

JA: Not really, I did say that at the weekend I almost got to Kos Harbour, but that is about the most interesting thing that has happened so far.

JP: So is it because it didn't go pass the conceptual stage or because you drove half way and turned around?

JA: I didn't get past the conceptual stage.

GS: In that case I have almost done an awful lot of things. Jason you had a longish drive yourself that went past the conception stage and into the actual moving stage and on that drive you were telling me that you listened to a fantastic new book, tell us about it?

JP: Yes, so I listened to Flash Boys the new book by Michael Lewis who is a brilliant finance writer made famous by Liar's Poker his kind of inside story of investment banking in the 1980's and this is his most recent tale and its about high frequency trading, which is something that is getting a lot of coverage in the press now and particularly because of this book and this book is really good because it takes a very dry subject, high frequency trading and the intricacies of a financial market and tells it through the eyes of a couple of key players in that industry and it really illuminates how much of a problem this has potentially become and how much of the market now makes up, I didn't realise before listening to this book that high frequency traders makes up 60 to 70 per cent of all volumes in U.S equity markets and 99 per cent of all orders.

GS: Lets just take a quick poll here, John had you ever heard of high frequency trading before this book had come out?

JA: Yeah, the flash crash was basically high frequency trade, algorithm trading, so if you have heard of computer based trading or the quants in the investment banks they are the ones who were working more and more in high frequency trading.

GS: So I was like you I had heard about it because of the flash crash which was this very large but short lived crash, I think it was 2011 it happened?

JP: Yeah, 2012 really amazing stuff so P&G, so Proctor and Gamble shares traded from between 1 cent and 100,000 dollars.

GS: Wow.

JP: In the space of a few minutes.

GS: Is that right, wow.

JP: And so this sort of highlighted that, whoa potentially there is something strange going on here and no one still really knows why it happened, the exchanges sort of fumbled around for an excuse and blamed some kind of technical error which is kind of the reason everyone gives them and they don't know what happened. And that sort of highlighted that, okay so there is people out there doing this strange type of trading where they are using algorithms to try and infer what people are going to do on the stock market and running down the optic fibre cables quicker than other people to get there and execute their strategies. But then themselves aren't aware of what they could do and you have, its not just one person doing this its thousands and when those thousands of people interact with all their different trading strategies we end up with a flash crash. And that is probably where the problem with high frequency trading occurs, I mean the argument for it, I mean there are lots of people out there arguing for it.

GS: Before we get to that Jason, you gave a sort of description of what it actually is in that last sentence, is that accurate. So let me tell you what I think it is and maybe you can tell me how wrong I am, so from what you have said it sounds like it's a computer based strategy where the fastest trader tends to benefit. I am not sure why speed is so important here, I am not sure why everyone strives to be the closest to the exchange, why fibre optics actually determine returns, and can you explain that?

JP: Yeah, so essentially they are acting on a type of arbitrage and so lets rewind the clock, imagine its 1970 you could actually do a type of high frequency trading, you could be in Chicago at the futures exchange and you might have a friend who works on the floor at the New York stock exchange, they might … now this wouldn't be allowed but they could give you information or you could pass information back and forth and this would allow you to have that information either in Chicago or in New York before the market knows it. So you can act upon information quicker than anyone else, we have just accelerated that process so rather than it happening over phone lines or face to face its happening over optic fibre cables and its happening via pieces of data. So it's still advantageous to get information first, it's just the time required to get it is now in the millionth of seconds not minutes.

JA: Well isn't one of the key things not just the speed but what the speed allows you to do. So in other words to determine before orders actually hit the market that those orders are coming through and then act on that information and profit from it?

JP: Correct, so high frequency trading strategies fall into sort of two categories, there is what I would call basically front running where you are just getting information about an order that is heading to a certain exchange before other people, and to me that looks like the most dubious form of high frequency trading that should be banned.

GS: Just explain what front running is quickly?

JP: So that is acting in front of the market with non-public information, so you know someone is going to do something and you have got that information, they don't know you have got it and you are able to exploit that information.

GS: How does high frequency traders turn into front runners, if the only advantage is in speed how do they get the knowledge of other peoples trades?

JP: So they get it by buying order flows from your average stock broker, so let me explain Gaurav. And most people aren't really aware of this. So in the America there is a whole bunch of different on line brokers say like, E-Trade [0:06:56] Trade, etc. Now those companies sell their order flows so when you click and buy some P&G shares they sell that information to high frequency traders, those high frequency traders are able to act on that information before that order gets to the stock exchange.

GS: Wow, okay.

JP: So that to me looks like out and out front running.

GS: That is front running that is exactly what front running is, yeah.

JP: So that is a big part of it, the other part of it is essentially sophisticated and computer based or mathematics based trading algorithms where they sort of pin the market with these strange little orders, so 100 shares here, 1 share here on all the different exchanges. So in the U.S there used to be only two or three exchanges and now there is nearly 15 plus a whole bunch of private exchanges and they pin each of these with little bits of information and they add that into their model and that allows them to be very sophisticated about inferring what people are going to do. So that is not really front running but its using speed and you know mathematics computing power to their advantage, so they know, okay so if someone is picking up 100 shares on this exchange and they keep picking up a 100 shares maybe they want to buy more of that particular share, so then what the high frequency traders can do is then go and buy up all those other shares available on all the other exchanges and put them back up for sale at a slightly higher price before the original order which picked 100 shares but wanted 1 million, heads down the other cables to other exchanges.

JA: So if Jason can catch his breath after that monologue.

JP: Well, yes.

JA: We should probably explain one of the key stories in the book and for listeners you might want to go to the New York Times Magazine on their website who had an extract from Michael Lewis's book and it explains how Bruce [Catiama] who is like the hero … the main protagonist in the book, explains how he first realised there was a problem so he was a trader at RBC, he put orders through, he would see what the market depth was and then place an order and as soon as he placed an order that market depth appeared to sort of … so the shares that he wanted to buy just disappeared and he spent a long time and built a team establishing what was going on and ran a whole series of tests over a period of months. And he realised that there was 6 or 7 exchanges and if he put his order through to BATS one of the exchanges in the U.S that order would be fulfilled completely and if he put his order through to other exchanges so say BATS and the NYC or NASDAC then the more exchanges he lodged that all with the less chance he had of getting the order fulfilled. And it was his investigation of the problem that triggered this book, and he found that what was happening was his order when he sent it through to all the exchanges was effectively being sold to the high frequency traders who then traded on the information exactly as Jason explained, that his order might have been an indication of a bigger order and they would then manipulate that to make money from it.

JP: And by happens stance that his orders to this first exchange were getting fulfilled, but it just happened to be that where he was placing his trades from was closest to that exchange and because it went there first there was no opportunity to glean information before it got there. So he came up with this quite sophisticated model where it could time delay that execution of orders so that all the orders went to the exchanges at exactly the same time and that actually got around some of those high frequency problems so he could back to executing trades again.

GS: It seems to me the central problem here is exchanges and brokers selling their audit data, how can that be legal and if its legal cant it just be made illegal and the whole problem disappears?

JP: That's a good question, so it could be made illegal I would say that is very very unlikely to happen, so all of the investment banks and the people who execute trades have argued quite successfully that order data is their property. So once you place an order they own the information and are able to on sell it and they are making hundreds of millions of dollars selling this data, they have got a very strong incentive to argue that it's their property.

GS: That seems like an extraordinary case to me, is it a bit like credit card companies saying that your transaction data is there's and therefore there's to sell?

JA: I would say so.

JP: Yeah.

GS: Is that what happens, do credit card companies sell transaction data too, I don't know if they do?

JP: Well no but they use it within their own banks, or it would be like Amazon, you know Amazon own your order history data, right and then they use that to sell you more products. So there is lots of precedence for this.

GS: Okay, John you are actually writing a story about this for Share Advisor, what is the big problem with high frequency trading okay so big institutions may have trouble fulfilling some of their orders at their price, what other damage does this do to markets?

JA: Okay, well there is a number of aspects to that I suppose, the first one is that we have heard about these dark pools so I think the reason why dark pools have evolved is because the more that you trade and the bigger the size of your orders the bigger a problem this is for you. So this is a far far bigger problem for the big fund managers than it is for the small retail investors like us. We are getting skimmed but the percentages are so small that it barely makes any difference, but if you are trading tens of billions of dollars a year worth of shares then that adds up to a substantial sum of money. So Bruce [Catiama] actually developed this product that Jason was referring to that sent the orders out at the same time so they were fulfilled at the same time. And they called that thought and they went off and sold this to all of the big traders in the U.S to solve the problem and that's how he started his business and now runs his own exchange. For us I don't think … for retail investors it's a big issues, its something that is really annoying to know that the markers, when you were ever doing an economics class they will talk about what is most perfect market, well there is no such thing as a perfect market but the thing that gets closest to it is a stock exchange. And when you read about HFT you realise that it's far far from perfect and this activity could be stopped quite easily and would have absolutely no affect really on ordinary lives, it would just mean a load of mathematicians wouldn't make a few hundred million bucks a year at the customer's expense.

JP: I mean the irony is that computer trading was supposed to decrease the chance for intermediaries to skim money between a buyer and a seller where actually what's happened it's created a fantastic new way for a new intermediary to make even more money and that's kind of problematic. I mean I don't really think it's the amount of money skimmed off each trade that is an issue even though they estimate they are pulling profits of somewhere between 100 and 200 million dollars a day from high frequency trading.

GS: Wow.

JP: That's not the core issue, the core issue is that the flash crash, that kind of thing where …

GS: Marketing integrity is jeopardising it.

JP: Yeah, and that is a real issue if people cant trust that, (1) if they want to go and buy some shares that the market is not going to do something crazy in the interim, that becomes problematic and I think that the HFT community itself isn't even aware of the kind of snowball that has started here and we could see more of these kinds of things which then threaten the kind of workings of a public market.

JA: We should say that its less of a problem here than it is in the U.S, so in the U.S on an average day HFT might account for 70 per cent in all turnover and probably, well I think 99 per cent of all orders, I mean because what you are allowed to do in the U.S which you are not really allowed to do here is that you are charged not on the basis of trades but you are charged on the basis of orders, a combination of orders and trades. Whereas in the U.S you can basically put as many orders in as you like and you are only charged on the basis of trade, so you can do all this price discovery and have the computers chucking out orders all over the place and not be charged for that, whereas here you are charged for that. So there is far fewer orders per trade here than there is in the U.S so that does have a tendency to limit the problem. And that's why here I think, I mean the ASX has said that HFTs accounts for about 25 per cent of all volume and about 65 per cent of turnover, HFT turnover is actually finished at the end of every day. So it's less of a problem here.

JP: I wonder if it will become more of a problem, so part of what drove it in the U.S was competition amongst exchanges so you went from having 2 to having 13 exchanges in Australia, you cant really have high frequency trading when you only have 1 exchange, we now have 2 with [0:15:48] coming on the market 8 or 9 months ago and there is talk of other exchanges coming into the market and the express purpose of these exchanges coming into the market is not to encourage competition even though that's what they publically claim, it really is it facilitate high frequency trading. Because the stock exchanges themselves make most of their money from this so they are not about, yeah sure they lower the cost of the trade but they make most of their money from selling data and allowing high frequency trader to co-locate within their facilities. So the NASDEC for example makes 80 to 85 per cent of its money from high frequency trading now, they are basically facilitators for high frequency trading, they are not necessarily on the side of the investors or the buyers. And this is information that I don't think anyone really wants to think about too much, that if the public market its entitled to make money however it chooses but if people that are using the market aren't really aware of how and what is happening when they are placing an order. And this book just had countless stories of senior banking executives not being aware of what was actually going on, and this book was published at the end of March, its talking about stuff that was happening in late 2013 where people just had no idea this kind of stuff was going on. And one big pension fund manager just said, look we have calculated how much this has cost us, its costing us or costing you, you know the American people who we are entrusted with your retirement savings, tens of millions of dollars a year in non-executed trades. And the same issue could happen here for Australian super funds for example, you know we might be small retail investors and we are thinking, okay we are going to hold stock for long term but attacks that just clips all the time adds up over time.

GS: And it strikes me that the problem is quite a diabolical one for the exchanges themselves because they are making these super profits from an activity that actually undermines their sole reason for existence?

JA: That's right.

JP: Hence liquidity Gaurav.

GS: It's difficult for them to do anything about it because they are making so much money, but if they continue to do nothing then eventually it will destroy what …

JA: Well it will push more and more people into dark pools.

GS: I think, so yeah.

JA: And brokers will start trading with each other rather than through the ASX.

JP: Yeah, and I think the dark pool thing, the investment banking fraternity has done quite a good PR job on this, so yes theoretically dark pools were created to allow large blocks of stock to trade and without high frequency traders coming in and clipping the ticket in practice the complete opposite has happened. So dark pools have been crated expressly to allow investment banks own proprietary trading in desks to trade against their own clients. So you look at the data on dark pools, right …

GS: And dark pools very quickly are just, well trades that don't go through and exchange I should say, right?

JP: Correct, so say I am a client of Goldman Sachs and you are a client of Goldman Sachs Gaurav and we both have stocks in Telstra, I want to sell them, you want to buy them, we could exchange that, Goldman Sachs would organise that for us without having to go through the exchange.

GS: There is no intermediary?

JP: The interesting thing about the data and dark pools is, well each of the investment banks dark pool and they make up a tiny fraction of the overall market, so say Goldman Sachs dark pool makes up say 2 or 5 per cent of the overall market, over half of their clients trades are being put through the dark pool. Now what's the chance that the best possible price happens to always be available from another Goldman Sachs client, its actually very low and because they don't have to disclose the trade execution information back to the investor the investor is kind of blind to whether it was a good deal for them or not. They have just got to kind of trust that Goldman Sachs have acted in their best interests and have no data really to verify it.

GS: Well let's go back to this idea that high frequency trading adds to liquidity and that's the great benefit of it, it seems to be, well it certainly does add to liquidity. John you mentioned that over 90 per cent of trades in the U.S are from this activity and in Australia I think you said a quarter of all trades come from high frequency trading, take that activity out and the markets do suddenly look a lot less liquid, isn't that a problem?

JA: Its not genuine liquidity though because almost half of all HFT trades exist for less than a second. So to me that doesn't sound like genuine liquidity.

JP: There is no extra capital been put into the markets its being … its almost perfectly hedged on both sides, so a few of the high frequency trading firms have boasted in court cases that they have never lost money, not a single trading day where they have lost money.

GS: That extraordinary.

JP: So they are basically selling both sides of the trades, it's not really creating liquidity. The other argument is that high frequency trading reduces spreads, so the price between buyers and sellers. Now of course this is true if someone is coming in and clipping the ticket 20 times between me and you selling a stock, I don't see how that is beneficial, the argument is, oh its great we now have lower buyer sell spreads but only because someone is profiteering the gap. Its not because real buyer sell spreads have come in anywhere its because someone now is sitting in between capturing more of the money and making the spread smaller, I cant say that is helpful to anyone.

GS: Now the other point I wanted to raise was that up until now the super stars of investing have been the hedge fund managers, the David Ironhorns of the world, the George [0:21:21] of the world. It sounds like high frequency traders or the silent ninjas of the finance industry if you will. They sound like they are actually taking an enormous slice of the profit pie that no one seems to know about it, is that true to infer that there are billionaire high frequency traders that we have never heard of?

JP: I would say so, so Lewis said that he found it particularly difficult and especially when he was talking to Brad [0:21:45] about getting information, that's the most difficult bit Brad had was finding people who knew anything about the industry because everyone was on the take and no one wants to talk, but there was some really interesting anecdotes. So someone who worked in one of the investment banks in part of it, just said oh look the wealthy guys, the traders their name used to be Charles and on Saturday or Friday night they would get in their helicopter and fly up to the Hamptons, their name is now Vladimir and they get in a private jet and fly back to Europe for the weekend. So it was like you can only work out how much money they are making by how much money they are spending, and they had one of the characters in the book install computer systems and he had no idea whey these people wanted faster computer systems, he just knew it was a brilliant business. He said, look every time I went back to them and said, oh there is this new thing that came out last week they said, right we must have it now we will pay you as much money as you want to make sure you install it in the next half hour, and he was like this is brilliant. Now they were spending millions of dollars just upgrading their computer systems every couple of weeks because you make a lot more money if you have the best technology, and so the only real information that we have is there has been a couple of court cases and this is where the information is likely to spill out. So high frequency traders suing each other, and it came out that one of the guys was on a base salary of 20 million dollars a year and took home 100 million dollars the previous year, high frequency trading so this is someone sitting at a desk, they are not running at team, they haven't really built a business and they are clearing a 100 million dollars a year.

GS: And that is actually money taken from the investment community, right.

JP: Correct.

GS: That's the important thing, this is not alpha gained from skill this is almost theft?

JP: Yeah, almost exclusively the high frequency trader would argue there is a skill in developing algorithms to predict where people are going to trade and that is probably true, and that part of high frequency trading I have a bit more sympathy for other than the bit where they are just buying order flow from the stock exchange and running down the cable faster than everyone else.

GS: That is clearly criminal right?

JP: Yeah.

GS: John after hearing all of that and as a retail investor yourself are you satisfied that its safe for retail investors to wander off into the investment world, does it put you off buying shares at all?

JA: No it doesn't, I think is probably a net game for retail investors.

GS: Is that right, okay.

JA: I know it sounds strange but …

JP: What.

JA: Yeah, we are all getting skimmed and its all quite good for us and I think that is because the level of skimming that is occurring is so small it's not to really matter. You can actually protect yourself against it a little bit by making sure that you don't place orders at market prices, you always put a price limit on which I think is good investing practice anyway. So when we make a recommendation at a particular price then when you want to buy and follow that recommendation put that price into your order and don't go above that price and that will offer you some protection. But in terms of the benefits this activity does increase volatility and if you have got charts that show relative volatility over the past 40 or 50 years its increased substantially and I think for investors like us who are not interested in short term price changes that allows us to buy stocks more cheaply than we ordinarily would have been and be able to sell them perhaps a bit more expensive than we ordinarily would. So by in large I think it's a good thing.

GS: That's an interesting point, so it generates inefficiency for us to exploit …

JA: Yeah.

JP: I think that is a really good point John because high frequency trading obviously wouldn't make any money if the prices were static, so they have a really strong incentive to encourage volatility and I think you are right we can potentially exploit that to our advantage. And also long term investors aren't trading very often, I mean if you are a currency trader this will stress you out if you are buying CFDs and you are stressed about high frequency trading it could destroy you. But if you are buying decent businesses at cheap or fair prices and holding onto them for years it doesn't really matter in the long run whether you pay 1 cent more for a stock.

GS: So there has been a lot of cries that the markets are rigged, that the small investor loses out, that the game is stacked against them. You are saying that the markets are rigged, the game might be stacked against them but you can still do reasonably well, you don't have to be concerned about this sort of activity?

JP: Yeah, because the main advantages of a retail investor having a long time horizon and not having to respond to short term price movements still remain, and yes if you are a prop trader at an investment bank this is bad news for you, if you are a retailer investor with a long time horizon this is worrying potentially but as John said maybe it creates opportunities that wasn't there before.

GS: Now this book Jason do you recommend it?

JP: Absolutely.

JA: Anything that Michael Lewis writes is fantastic, but if you don't want to wade through the book there is a couple of good pieces on Felix Salmon's blog, so he used to blog for Reuters last week, he wrote one … his first piece was [0:26:46] of HFT which is a good summary of the industry arguments, I think they are incorrect and then Joseph Stiglitz responded to them and outlined all of the reasons why that was rubbish and that is … they are both worth reading it gives you both sides of the argument.

GS: Onto our final segment long or short, gentleman you are probably not aware of this but there is a boom in butter, some people say there is a butter bubble going on. Well butter sales are at 40 year highs all around the world.

JP: What's happened?

GS: Margarine has been marginalised.

JA: Fat is back.

GS: Fat is back, well there is some truth to that so all these new health researches points to the fact that fat isn't as bad as everyone originally thought it was.

JP: Brilliant.

GS: And butter is now seen as a healthy product, a natural product that in moderation is perfectly fine, margarine is seen as a manufactured good, they are artificial and nasty. So margarine sales have collapsed all around the world and margarine makers are not turning their attention back to butter, so the question here is is this a butter bubble, is this a temporary boom in sales for a particular fad or is the return of butter here to stay. John what do you reckon?

JA: Look I am a big fan of butter I think butter is an essential ingredient in any good kitchen.

GS: Every Englishman would say that wouldn't they?

JA: And good quality butter is well worth the price, there is noting more joyful than a good slice of bread with some nice expensive lovely, creamy, milky, yellow French butter. It's just spectacular … or Danish. But I am a big fan of butter.

GS: Jason you and I have …

JA: If I ruled the world I would ban margarine.

GS: Its not that bad is it, I don't mind margarine. So John is going … to be clear John you are going very very long on butter?

JA: Yeah, I mean who knows what the price will do but I think butter is going to be around for a long long time.

GS: Jason?

JP: This is the best story I have heard, I love butter I am with John a 100 per cent on this. I am absolutely very long butter and if it's better for me and delicious that's the best news.

GS: You and I Jason have both discovered this Danish butter Lurpak, right?

JP: Yeah, look my parents if you are listening will be really disappointed with me not buying Australian butter, they give me a hard time every time they see it in the fridge, but yeah the stuffs great.

GS: I can't understand how it's so good but it is genuinely delicious.

JP: Extra salt.

GS: Yeah, it must be.

JP: Have you heard the stories about how red wine is good for us?

GS: Don't get me started, don't get me started. I think this is the sort of trouble we have with health research and food research is that is reacts differently to different people and the studies are never consistent and that's why I think these sort of things tend to generate fads that will eventually be overturned because the research will no doubt change and lead to a change in fashion. So I am probably a bit more sceptical about butter than John or yourself, but I complete agree about its deliciousness …

JP: That is a really interesting point Gaurav its kind of like short term research extrapolation, so like we see in the stock market where we look at like current earnings and just …

GS: Yeah, that is exactly right.

JP: We look at current research and say this will be true forever and then …

GS: Well you can't blame us for thinking that science is supposed to be the truth, right it's suppose to be a discovery …

JP: Or cumulative and progressive, like those are the key things that ….

JA: You don't establish a truth that is verifiable and repeatable for evermore, it's only true for a particular moment in a particular study.

GS: Oh come on no one looks at gravity and thinks, right gravity, yeah that is true for now but in 200 years it might be …

JA: Well you can't say that for certainty aside from the fact that we can't actually properly explain gravity.

GS: I know that is the way scientists would look at it but for the people who use science, for the punters who use science and don't have to deal with it every day I think science equals truth and that's why these scientific studies have huge impacts on all sorts of other ….

JA: The scientists would actually be a lot more cautious about how they promote their findings, it's the journalists who are the ones who take those studies and say, wow butter is great for us this is going to make a great headline. That is where the problem lies it's not really with the scientists who tend to be very cautious by nature.

JP: Well in the market its right if you look at health claims around cereal products they didn't use to have … you know how cereal boxes in the supermarket now all have like 7 essential nutrients or whatever rubbish written on the front of them, they didn't use to have that, as soon as they put it on the front sales went up 50 per cent. So people know the scientific claims have a huge impact on people's behaviour.

GS: Okay, so we have got two longs on butter, I am more sceptical I am going to go short butter and we will come back in a few years and re-visit this butte phenomenon and see what has changed.

JA: See if Jason and I are still alive.

GS: Clogged arteries might take care of that.

JP: It would be a delicious way to go.

GS: Alright let's move onto our next long or short, Jason lets begin with you this time, billionaires. Now they are sometimes celebrated as the absolute pinnacle of success, they are people who supposedly have succeeded so much in their field that they have been rewarded these grandiose amounts of money, is that the way we should think about billionaires as absolute success stories, are they people to admire and people to emulate or are billionaires representative of corruption what do you think?

JP: Wow, I think like all things it's a little bit more complex than that and we have a tendency to over play peoples impact on their own lives and down play luck, so I would say that is the first bit. And if you look at any of the lists of the richest people in the world, sure some of them have built world changing businesses, there are people like Warren Buffet, Bill Gates, Zuckerberg if you think Face book is world changing, or up there on those top lists there are a lot of retailers. But what you also see is a lot of inherited wealth, so someone where someone's parent or grandparent built a business like the Walton's with Walmart or the Mars family with Mars Bars they are all in the top lists, in fact I think the Walmart and Mars Bars fortunes would be number one and two in the world.

GS: I think the Walmart …

JP: If the family was held as one group.

GS: Correct, yes.

JP: So yes some of its there because of business building, a lot of its there because of intergenerational wealth, some of its there because of luck, I wouldn't just automatically think, hey look there is a billionaire they have done something fabulously wonderful for the world they may just have been in the right place at the right time or in the kind of business where you can make billions of dollars. So for example retailers are over represented in the top 50 richest people in the world, you have people up there who are like Zara, H&M and Louis Vuitton and all these different things where …

GS: But that tells you more about retail as an industry than the individuals I would say?

JP: Yeah, it tells you something about the business model, right the same as why there is these IT software type businesses like Larry Olson and stuff up there.

GS: And fund managers as well, these businesses require very little capital, can be rolled out very quickly and can be replicated easily so they tend to generate big returns for the people who own them?

JP: Correct.

GS: It sounds as though you are sitting on the fence a little bit there Jason, I am not quite sure whether you are …

JP: Well I am saying it's not the case that all billionaires are just corrupt and it's not the case they are all wonderful business builders, and if you look at any lists of really wealthy people its probably half, half.

GS: Okay, we have got a fence sitter John, what say you?

JA: Oh, dear it's a tricky one I mean we are running a risk of talking about capital … in the 21st century …

GS: Yes, we are running a risk of that, yeah.

JP: I bought the book, I haven't read it yet.

GS: I have no intention of reading it.

JA: Everybody has bought it and nobody has read it. 600 pages I don't think so.

JP: It was nearly 700 I was looking at it.

GS: Do you know that book is at the top of Amazons book sales list including fiction so it's bidding everything.

JA: Its astonishing isn't it?

GS: Yeah.

JA: And when it came out in France which I think was in September or October last year it barely made a ripple.

JP: Well all know this.

JA: Yeah, to me I think I would probably be long billionaires and mainly because one of the things that book seems to indicate is that … and quite a lot of research too is that billionaires tend to get their way politically which means once you establish yourself with a few hundred million its probably going to make it a lot easier for you to get to a billion. So I think long billionaires there is probably going to be more of them, in terms of whether its good or not I would say its more important to try than it is to succeed, I think we are better off as a society if people try and build big businesses and start things than we are in having billionaires just control so many markets that they do.

GS: Don't you think that a lot of the fortunes of the world had been built by nepotism monopolies and rent seeking, I mean take the worlds richest man, well he used to be the worlds richest man I think Carlos Slim from Mexico.

JP: Ironically he is not very slim.

GS: No, thank you Jason. Now this is a guy who has built his fortune on the collective stupidity of the Mexican Government who has handed him one of the most lucrative monopolies in the world, the Mexican telecoms monopoly, handed him a lucrative cable monopoly and a television monopoly. I mean he would be remarkable if he wasn't in the top 3 richest people in the world, he has done nothing to deserve his wealth.

JP: I think the key problem though goes back a step further and it sort of goes to what John is saying and that's about intergenerational wealth transfer, so Carlos Slim although he didn't start life a billionaire, he started life a lot better off than most Mexicans he went to university, he had a reasonably wealthy family and I think that's where the problem starts. So its not about, I mean everyone's favourite libertarian Milton Freeman always used to argue its not where you end the economic race its where you start and I think that is where you create a lot of problems. You need equality of opportunity not necessarily equality of outcome.

GS: Sure no ones, I am certainly not arguing for that I am saying there are lots of relatively wealthy Mexicans and they don't end up owning these monopoly businesses, somewhere along the line Mr Slim has become very lucky and I make no implication about that, but he has become very lucky in getting these monopolies and that is the source of his wealth. If you look down the list of billionaires and awful lot them are monopolists, guys who own licences or monopoly markets, they are rent seekers basically.

JA: Reg Kermode for example.

GS: Well I wouldn't …

JP: I don't think he is a billionaire anymore like cab charges share prices have been falling pretty quickly.

GS: I haven't done this myself yet but I would like to go through or someone to go through the list of say the 50 or the 100 most richest people in the world and I would bet that at least half of them are rent seekers and the other half come from retail, IT and funds management. Anyone outside those industries …

JP: I think that is spot on.

GS: I mean in the theory of capitalism being a billionaire should be almost impossible because competition should limit the returns to any business and if it was left to run the way it should run I think that would mostly be true.

JP: You win the match and then you reap the tournament that's the way it works.

JA: That's it, that's the problem with competition is that there is an eventual winner and once you get to … and this is [0:38:21] argument essentially is that once it returns to capital are greater than the rate of economic growth then all those people who have inherited wealth are able to prevent competition.

GS: Well it looks like we have a semi-consensus then. We are not going to be putting up portraits of billionaires in this office are we John?

JA: Definitely not, no.

GS: Anything else we would like to mention, John you are staying in Sydney for a while?

JA: Yeah, I will be here for a couple of days but I have got to go now because I have got a meeting next door.

GS: Okay, well we better call it a day then. Jason, John thanks very much for joining me and for everyone else thank you for listening.

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