One of the funnier DMs I got recently was, “what the hell does enforced beta mean”? Admittedly, this is understandable, because a lot of the Ven lexicon comes from the (over 200 now!) posts that contain more nested references than a season-disk set of Family Guy. Looking back through the past few newsletters, I have talked about enforced beta, “magnet” effects, fundamental flow, and more, and realized I should probably give a cohesive reference point to assist with the reading of future posts.
So I’ll zoom out and construct my view of the current market from stage 1. (See: The Theory of Liquidity 11/23/22):
There comes a point in every seasoned red-button/green-button pushing practitioner’s life where they lean back in their seat, pause, and wonder how the smorgasbord of rules, regulations, and structured products that makes up our behemoth of a financial system ended up this way.
However, when boiled down to its simplest elements, the system is essentially made up of three pillars: equity, currency, and debt. Equity provides liquidity to hope. Currency provides liquidity to bargaining — our transactions must be denominated in something. The most important pillar, and what underpins it all, is debt, which provides liquidity to trust. The systems of law and government provide a safeguard of enforcement to trust, but trust without liquidity cannot scale — there is no society without it.
Finance, in a sense, is a philosophy in this purview — one of how to quantify risk and transfer it (and therefore properly compensate for it with interest.) To throw Investopedia into code is kind of missing the point, and results in a lot of what you see in the “crypto ouroboros problem”:
(Yeah, I called Vitalik “late”, watcha gonna do about it.)
Interest is the base unit of compensation for risk. One of the “Ven Commandments” is artificially subsidized cost of capital has risk-transferal externalities, which is why I frequently talk about the problems with “zero interest rate policy” (ZIRP) and where the compensation for risk must be derived from. Inherently, we know there is no such thing as “zero risk”: you can be Brian Johnson, the “don’t die” oddity with “18 year old benchmarks” at the age of 40, then go outside and get hit by a bus. So how can there be debt that’s issued at a true “zero rate”, beyond the “risk-free” rate that the dollar assumption requires? Obviously, this creates the kind of mania we saw at the end of the 2010s and in peak COVID in terms of the sheer speculative fervor that went every which way. But we can go a little deeper here.
Originally, I wanted to major in comparative literature, then my parents told me that I shouldn’t waste my time doing something like that and to choose a better major if I wanted to go to college, so I ended up doing a theoretical math degree. The joke was on them in the end, I spend my time writing a newsletter and arguing about Houellebecq on the internet, and don’t use my degree at all. Anyway, I digress.
The point of that exposition is that I think of “markets” in a progression similar to literature’s stylistic progression. You have the “Victorian” era: the idea of debt driving value. You can see the relics of this era today, as a central Federal Funds rate is still what the entire financial system revolves around. (Of course, it’s patently ridiculous to think that the complexities of the universe can be distilled into one base rate — there is a reason I think about central banking as a religious concept, to some degree (See: Is Central Banking a Religion 5/17/23):
Belief in systems can be rooted in rational thought so long as the system is constructed logically, as mathematics and legal methodology attempt to do. The belief that a set of humans will take the right course of action consistently is more along the lines of faith.
Are policies such as inflation targeting, rate adjustments, and BTFP logically sound and checked powers, or are we just trusting a secluded group to take the right course of action?
This is also why, historically, bonded labor has been criminalized, and ensconcing someone in debt at a predatory interest rate is rarely collectable through enforcement. Debt is the lens with which the original financial system was imagined. “Finance”, in this school of thought, was defined by how liquid the transferability of the actual interest payments on the debt was and quantifying the probability of default.
Then comes the “modern” era, where we started to have an equity driven market. Equity, as outlined prior, is hope — inherently, it’s forward looking rather than looking to be properly compensated according to what you’re owed. Thus, we start to price things in future cash flows — what our equity is expected to generate — and the concept of valuation by “fundamentals” arises and defines the meta. There’s probably no more seminal advocate of the modern era than Warren Buffett, though it’s quite curious that his best returns came when he just bought AAPL like everyone else, as we transitioned out of the modern age.
I write a lot about “postmodern markets”, and that’s what I define the ZIRP era onwards by. The defining trait of postmodernist finance is recursion, which is why the quantitative revolution is necessary to have scaled alongside it in lockstep. The core is positively Baudrillardian:
First, you have the core business. It creates a product that is valued by society. Next, the abstraction of money comes in. This allows liquidity creation — if I sell socks, what am I going to do with unlimited socks? After currency comes the cap stack. We “value” the business to allow ourselves to offload risk on others. There’s no real way to properly value this risk: “fundamentals and valuations” exist as marketing, as every banker knows you price the deal at what you have to to get it done. Finally, we have the security as it’s traded now, where the activity is totally abstracted away from any sort of reality whatsoever and collectively trades in a manner that resembles a toy model GTA stock market rather than as a reflection of reality: a pure simulacrum.”
My favorite example of this is to consider how Starbucks stock trades in real-time. If we are trying to value the movement in a modern framework, how exactly does the sales at the store down the street tie to the volatility you see when you open your iPhone app? It’s absurd at its core to connect the two. Postmodern value is thus liquidity as a value — the fact it trades means it will trade, and this is valuable in and of itself. Thus, even the fact that Bitcoin has nothing really “to” it doesn’t mean the value is zero, just that the valuation will be determined by whether the demand for liquidity comes from the ask-side or the bid-side, and it will fluctuate accordingly.
It's a logical progression: future cash flow improved the liquidity of the debt model, and liquidity provided increased efficiency to the equity model. That’s the thing about postmodernism: much like the Deus-Ex trifecta of endings, there’s nowhere for it to really go other than perpetual control in the hands of those that “make” the markets (the “Illuminati” ending), a technological reset back to the dark ages (the “Tracer Tong” ending, or merging with a future AGI (the “Helios” ending.)
But how do we trade this? Because, after all, there is profit in volatility, irrelevant of the efforts of others (to use Howey parlance.) This is where my terminology comes into play:
A core function of HFT is the ETF create/redeem process and consequently the arbitrage that keeps baskets in line with their underlying. “Passive drift” thus refers to when you see things trading, but all the volume is algorithmic balancing between basket and shares. “Actual volume”, on the other hand, refers to any trade that isn’t part of the arbitrage complex. Why I talk about spread width so much is, naturally, when it’s not just bots, the bid/ask will widen.
Then we get to types of flow. “Fundamentalists” (think big pension fund managers, etc.) drive fundamental flow:
The vast majority of money that moves in and around the market is based on the philosophy that whatever is invested in will create future cash flow rewarding current shareholders, who hold a right to their share of the output. When this money sloshes around, it creates market impact, which in turn creates trading opportunity. Note that these investors generally operate with a philosophy that they don’t want to react to day-to-day market movements. They are in it for the cash flow created over time and the movement in share price that will reflect that. So we want to focus on what will motivate them to decide that they want to demand liquidity and increase or downsize their positions.
Investing is driven by valuation — taking snapshots of a company’s performance over time and stringing them together to estimate future outlook. The question valuation asks is very simple: given an investment in a company, what do I own now, what am I expected to own in the future, and how much is it worth at present value?
These are the people who react to earnings and drive the volume, and why you don’t want to just buy dips because something went down. As I wrote about NVDA ER,
A particular form of active manager is the “Scary Jerry”, where, upon any uncertainty, they are smashing the ask and crossing spreads to get out of a position and driving prices arbitrarily lower than they should purely through the size of their trade being larger than the market can support at current price levels.
The golden rule of trading is to not bet against the size, and all of the size is all in on AI, NVDA, and nobody wants to find out what happens if it doesn’t work any more than people want to figure out how we’re going to pay off the national debt. That’s the thing about (3,3), if enough people want to kick the can down the road, you can do so endlessly. Betting on the big short is missing the big picture that the precise timeline is unknowable unless you have an idea of what the catalyst is.
When real people are selling because they’re freaking out, or adjusting these positions of massive sizes, you either must call a bottom perfectly or wait for them to finish selling and catch it when it turns. They don’t care about book depth or even pristine execution: they want their liquidity and they want it now.
But most flow isn’t fundamental — we know these people don’t care about intraday moves, which is why their volume clumps up around ER and other catalysts. Reversals come when there’s technical flow, like what happens at my adored 10 AM EST close. Technical flow is trades that are the result of some quantitative execution that’s agnostic to any “reason” why the trade is being placed.
This is where the concept of enforced beta truly arises — it’s the indicator of when technical flow is driving the market rather than passive drift. “Beta” is just a measure of how much a stock is moving over time relative to the market. Enforced beta thus happens when fundamental flow turns to technical flow turns to passive drift, and the stock goes back to trading as it’s “supposed” to rather than when the book depth isn’t algorithmic. Hence, again, the bid-ask spread widening and tightening. Dispersion and correlation, then, effectively gives us an approximate ratio of how much volume is composed of passive drift versus technical flow.
Postmodern markets are a constant state of semi-quantifiable flux — the enforced beta regime gives us a moving pool of liquidity, with “real” volume and “passive” volume as a sort of dissociative construct, like the oft-cited White Barn. The prior mantra of “past performance does not predict future results”, then, becomes incomplete as we scale down in time frame and zoom in — rather, past volatility does predict forward volatility, but the exact timing is unknowable.
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