I do not believe that financial markets make the economy more efficient. The analogy I use is Earth. If it were reduced to the size of a basketball, it would be smoother than a billiard ball. However, at a human scale, there are mountains and oceans we can exploit….

The guy talking about making markets more efficient is thinking of something like rolling rocks down a mountain to power useful work. This indeed makes the Earth smoother, wearing down mountains and filling in oceans. But … [that] bears no resemblance to what people really do. They’re more likely to build a hydroelectric dam that holds water back, that is it keeps the system farther from equilibrium, not moves it closer.

Aaron Brown, Red-Blooded Risk

(I rearranged his words a little bit.)

No-arbitrage conditions are so often assumed in economics papers that they’ve come to seem magical.  As I read more books by arbitrageurs, the obvious has become apparent:  real people have the job of making financial markets equilibrate.

Given that companies are trying to raise funds for their projects by offering shares of the profits on public exchanges – which is the state of things* – it’s not at all obvious that various mathematical balancing conditions should come about.  It takes hedge funds and stat arbs spending their days looking for profit opportunities to smooth these markets out.

For example, take high-frequency traders.  They learn the nitty-gritty trading rules (aka market microstructure) and look for tiny opportunities to hold a security for just a little longer (intraday) and then sell it for more than transaction cost a wee bit later.  Effectively they act as a short-term warehouse holding the security in between the person who wanted to dump it and the person looking to pick it up.

Knightridge Capital and Jesse Livingston both advised traders not to fight the market, but to go where it wants to go.

As with most ways of making money, to extract it over the long term you have to make the world more like people want it.  (So I believe.)

* but not necessarily the way things would have to be done.  For example I could just call people up and ask them if they wanted a share of my company; or I could auction shares on eBay; or I could post a message on Craigslist to get local people to meet up and talk together about various people buying various proportions of the company.