Investment Firms Make the Market

As has been witnessed in Real Life on the various stock exchanges around the world, in response to the freezing of Capital Markets for loans, most of the world's Investment Firms have had to deleverage. Many had been leveraged by as much as 30:1 or more, and currently, from my understanding, are trying to reduce their portfolio holdings to reflect something closer to 10:1 leverage. The effect has had catastrophic effects of share values on most of the exchanges, and the NYSE Dow Jones Industrial Index is at or near 8,000, down almost 3,000 points from 11,000 or more which it was valuated at earlier in the year.

In Real Life the "Market Makers" are these Investment Firms (representing everything from Mutual Funds, Hedge Funds, Retirement Account Holding Companies), Investment Banks, and to a much smaller extent, big-time private investors such as Carl Icahn, Prince Alawei, Warren Buffet (who is the personification of the Investment Firm Berkshire Hathaway), and a few handfuls of others who I cannot recall by name. Some Investment Banks and Firms have completely collapsed, and many more are likely to follow (or should if Government Intervention was foregone in the spirit of allowing for Capitalism to run its course).

It is not my intention to go into too much detail on RL, as many of us are observers or professionals in these industries and know full well the causes and anyone of us can see the effects this has had not only on the Financial Markets but in the daily lives of most citizens of The World. What I am setting out to do with this White Paper is describe a scenario by which I expect that the evolution of SL stock exchanges will undergo, and how even just one robust Investment Firm with a strategy that I will now describe can add stability to the SL market in a positive manner.

Currently, by some estimates, 40% or more of the SL stocks currently listed are Investment Firms, many of which are invested in OTHER Investment Firms, which is a recipe for disaster as has been seen in the recent crashes of RL stock markets. This is something we no doubt would like to avoid in SL. Thankfully SL does not currently have mechanisms of Margin Trading, wide markets of Derivatives and Futures activity, or government backed credit markets, which exacerbated the RL market crisis's.

There has been a growing consensus among traders, both large and small, within SL that would like to see more "product driven" companies listed, companies such as Milos Designs (MLS : SLCAPEX), Hi-FIve (HIFI : SLCAPEX), and others that I am sure escape my mind as of this moment. The reason being, even if it is only subtly and intuitively felt by traders, that what we are experiencing in the SL stock market is largely a carousel of capital flowing around in unpredictable patterns that merely reflects the activities of many traders endeavoring in Day Trading, or Share Price Arbitrage, etc. What the call for "product driven" companies is, in fact, is a demand for additional capital to flow into the SL Markets from outside, which is why the second biggest universal desire of all active traders within SL is for "outside money", I.E., an increase in Trader Population, to help add liquidity to markets that can and have been plagued by the effects of illiquidity--massive price swings up and down on comparably small amounts of volume.

While the call for a larger Trader Population would provide some easing to this situation, it is not, in and of itself, the solution.

On SLCAPEX, as has been discussed, CEO's are given the opportunity, through a small percentage of trading commission returned commiserate to volume, to effect The Spread--that being, the difference between outstanding Buy and Sell Limit orders. This is a novel idea, and has its limitations and theoretical complications, and it is also not my intention to denounce this system, support it, or go into the various intricacies of that approach.

What I would like to posit here is my outline of how an Investment Firm, if I were to start one today, would act as a market-maker, and how I think other Investment Firms within SL can, probably already do, and most importantly, SHOULD provide the mechanisms for Market Making. Fundamentally, one of the differences between SL and RL is that in RL the markets and the Not-Living market participants (companies/investment banks and firms) have been in motion for most if not all of our lives, and the SL markets are organisms that are growing from a birth in some cases less than a year ago. Another unique aspect is that the difference in Capital Strength between the Investment Firms and Individual Investors are not nearly as wide as in RL. In RL it would be very difficult for investors on the scale of what we see in SL drive down prices based on their individual trading activity. The safety valve is what is typically referred to as Support Levels. Without going into too much detail, lets just say that these Support Levels have stopped functioning effectively once those who provide the Support Levels--the investment banks and firms--have had to deleverage their holdings, as opposed to the previous situation, lets say, "business as usual", of being able to automatically, with the help of computer trading platforms, snipe opportunities for instantaneous arbitrage or borrow and sell against their unimaginably vast holding portfolios to fulfill the in-comparison very small actions of individual investors and much smaller firms and in many cases the limited activates of companies themselves. Unlike in SL, in RL, companies do not actively partake in the arbitrage of The Spread, or if they do it is very rare. Companies may buy-back shares but mostly it is for their own needs and not to artificially inflate the value of their shares.

Second Life as a whole I think, if given a broad enough scope in which to compare people's real-selves to their online representatives gravitates us toward the areas that 1) We Have Skill and Knowledge and A Constant Driving Interest In 2) Most Importantly, Areas that we may not have direct access to in RL. How this effects the SL Markets is that most people that are interested in the SL Capital Markets are themselves most likely to be the "smartest people in the room" (to use the Enron quote) in most of their RL on this very topic, and once drawn, see the potential to eventually become more and more immersed into The System. This is the most logical answer to why there is a proliferation of Investment Firms--because an active and knowledgeable trader instinctively knows that they can increase their returns with more capital at their disposal. Most people are reluctant or don't have the RL money to devote to depositing vast sums of US Dollars or whatever currency into Lindens, and so the natural progression is to IPO, etc. The reason there is a lack of "product driven" companies is that most people within SL that CREATE products are self-sufficient enough to not need large sums of cash infusion to make a profit from their business, and so never consider the need for "Venture capital". (Or they are satisfied with the level of business they can generate on their own, as SL is mostly "a game" for the widest segment of its users) The few people that have knacks and talent in both areas--knowledge of investing and creative enterprising desire--can be found most notably, again, as CEO's of MLS(SLCAPEX), HIFI(SLCAPEX), VLADA(ISE), etc. The growth of 4 stock exchanges within SL shows that at least 4 enterprising individuals, or groups of individuals, seeing how the now defunct WSE was mismanaged, and knowing that there was no limitation to their ambitions, rose up with their own exchanges. An often echoed sentiment within SL, within the exchanges, the citizenry at large and repeated by outside media is that SL represents the freest form of Capitalism ever seen, and this is most likely true. Theoretically a dissatisfied investor could stake out and begin to create a new Exchange within SL at any moment, and there is very literally nothing to stop them from doing just that. In the end the marketplace as a form of competition for capital (barring unforeseen Linden Lab intervention) decides the survivors, the winners, and the losers. Some have predicted, privately and publicly, that of the 4 now-existent Stock Exchanges that by the end of 2009 perhaps only 2 will remain, and whether that will come in the form of Exchange Consolidation, failure, or some other previously unknown factor is unclear. It is also unknown whether there will in fact be 8 Stock Exchanges, or 18. Second Life has a knack for invalidating all expectations and predictions as to its course and future on a regular basis.

So, given my background and life-long interests in Finance, Government, Economy, and personal knack and skill for writing and creative expression, it is not at all a surprise that I find myself currently employed as a Financial Journalist within SL. This limits me, through moral standards, to not investing in companies individually at the present time, and believe me when I say it is a constant struggle to resist the urge. I KNOW there is no regulating body, aside from the public who I want to respect my acumen and judgment and ultimately appreciate my work, to prevent me from doing so, and it is a personal choice that I make to stick to my moral standard. I believe the SL Stock Markets are better served by an independent and unbiased press without entanglements of financial self-interest. In the month of November, as I had set out to accomplish in October, made an amount of SL income comparable to what I would have made in my RL employment as a freelance journalist, and if SLReports.net grows to a level of advertising and readership of the level I think possible within the next month or two, I can in fact make an amount of income to justify it's role as my current RL full-time employment. This is an experiment that I luckily am in the position to take, but not for long if SLReports.net DOES NOT "pay the bills". There is a dynamic between the attention a project such as SLReports.net needs to get to where we want it to be, and also the dynamic of personal RL survival.

For the purpose of this White Paper, I am going to present the proposition that either my current career track of SL Journalism dries up, or I become critically bored or burned out on it. I do not necessarily foresee it, but let us assume that it becomes the case for whatever reason. And that my next goal would be to create a supra-Investment Firm within SL. This could take the form of a Private Firm--meaning that my own capital resources alone are the source of The Firm's capital resources, or a combination of private resources collected independently of any SL exchange, or even an IPO on one of the SL Stock Exchanges. To simplify this example let us assume that I am referring to all numbers and scale in the form that I am the sole-owner of this Firm.

To reach my personal goal of income of USD$750 a month, I would have to have 15,000,000 shares of stock that pay a reliable L$0.01 per share dividend each month.

Prior to purchasing these shares I would set out to identify a handful of stocks (lets say 6) that meet the criteria of 1) Track record of L$0.01 per share dividend each month, with no foreseeable likelihood of failure 2) A preferred "product driven" company that is not itself an investment vehicle in other companies 3) A company management that is dedicated to innovation, shareholder communication, transparency of operation, and prospects for future growth. 4) A share price that is not cost-prohibitive to my capital reserves in securing its purchase.

It is this fourth criterion that I will now go into, and most specifically, relates to the actions of Market Makers, and the problems of Illiquidity within the SL Stock Exchanges.

What many have lamented, and Bogart Beck, CEO of the Second Life Capital Exchange (SLCAPEX) has addressed recently by strengthening the automated triggering of SLCAPEX Circuit Breakers and pointing to company CEO's roles as Market Makers, is the fact that on the SLCAPEX--as well as the other 3 SL exchanges--is that relatively small buy and sell actions by individual investors and Investment Firms can result in wild price fluctuations up and down. This is mostly related to the lack of Support Levels.

In the building of my Firm's portfolio, I would be purchasing vast sums of shares, which would no doubt raise the "value" of these shares due to the demand that my purchasing would represent. I call this value increase "artificial" because it is being caused directly by my own actions. That would not mean that the shares of a stock that I purchased at the beginning at a low price, say, L$0.70, are worth suddenly L$4.00 if that is the top level that my purchasing activity has Artificially raised the Limit Sell, because there is in fact no "Support Level" provided other than my own trading activity. My activity would, in fact, be aimed at generating income based on the expected monthly L$0.01 dividend, and while building my portfolio, share price would not even be considered other than consideration of my activity artificially raising share values to a cost prohibitive state.

My portfolio would end up being balanced, not on a preconceived notion of HOW MUCH of each of the 6 stocks that I wanted to expose myself to, but the amount of shares that could be purchased of each stock up unto the price level that would prevent my continuing purchase, compared to the arbitrage and availability of one of the other 5 stocks.

So there would be a continually evolving dynamic that I would take into consideration as I made my moves, and it would take a number of days or even weeks to reach the 15,000,000 level spread across 6 stocks. Indeed many stocks on all 4 exchanges have less than 500,000 shares on the open market, so the assumption that I could even LIMIT myself to 6 stocks may in fact be wrong. But for the purpose of this example lets say that I am capable, after this period of days or weeks, to get 2,500,000 shares of all 6 stocks equally, and that in the end the top level I have paid for all 6 stocks would be L$2.00 by the time I capped out on each.

At this point, once I have 15,000,000 shares, I would be satisfied that I have put forth the investment required to, as reliably as possible, assume a monthly income of $750.

Now, as an investor, I would take a daily interest in keeping up with the news, press releases, financial statements, and activity OF THE COMPANY, to ensure that I am not blindsided if a stock fails to pay a dividend one month. I would not necessarily keep track of SHARE PRICE, because given my purchasing; it may take a great deal of time for share price to normalize to a state that is independent of my own artificial inflation. Or it could happen rather quickly, as once my purchasing ends and I stop actively participating in daily trading with that stock, there would appear to be a "crash" in value once others begin to sell, the price only supported by other investors buying activity.

Share Prices are determined by the interplay of trader buy and sell activity, obviously. What is more sublime to understand is the TRIGGERS of this activity.

Why does anyone buy stock?

It is very clear to see why I purchased my shares, and what role share price had in my purchasing activity.

Personally, I have very little understanding for why ANYONE buys ANY stock that does not have dividend yield, other than the expectant rise in share value if a share is deemed "undervalued". But what is value? Is it merely what other traders are willing to BUY the shares for? If so, then there is a vast difference in VALUE for 55 shares of a stock compared to 2,500,000 shares, if placed in a "market sell" or "market buy". It is likely that if I was to place all 2,500,000 shares I had in any one stock on a Market Sell that I would drive the price all the way down to L$0.01, hitting each Limit Buy from the top to the bottom. If I did this at one time, then this would no doubt set off a Circuit Breaker rather quickly, and savvy investors would review their outstanding Limit Orders and adjust accordingly. Sadly not everyone is a savvy investor, or even pays attention to the market on a daily basis. If I am deriving my entire monthly income from my Portfolio, I would no doubt be quite interested in the market and paying attention to it on a daily basis. But my "hold" decision would still be based on my DIVIDEND YIELD, not share price.

The difference up until this point is that I am not acting as a "Market Maker". I HAVE MADE a market in my buying activity, but not in any SALES activity.

Let us assume that all 6 stocks are healthy, and no troubling news or developments have taken place to concern me with their health whatsoever. I have waited a good length of time to allow the market to adjust the prices back down to "normalized" levels of buying and selling activity, and the Limit Buy and Limit Sell on the company trading page have repopulated on both sides of the spectrum. I have until this point not placed Limit Buys or Limit Sells.

Now let us assume that over the course of a few months that a few of the stocks have actually over performed on dividends, and I have accumulated a fair amount of "overage" money that I have not withdrawn from my account. Now I could start to apply this overage money to acting in a Market Maker capacity.

I would approach the situation very carefully, as I would not necessarily want to risk cutting into my reliable $750 monthly return. So I would have to decide how to valuate the stocks taking into account several important components.

1) Current Activity in the Demand Area, such as daily volume and viewable Limit Orders.

2) A valuation of the stock based on Net Asset Value. This is a consideration I would have made during my initial investigation of the stock, and would be continuously keeping myself abreast of, but it is also a quite complicated affair for several reasons. 1, not every stock is comparable to every other stock in NAV. A content creation company may have very low actual NAV because it might not have liquidatable Real Estate, Equities, or Re-Sellable Resources. On the other hand all of those 3 things can only be valuated themselves based on current market rates, so do you base the NAV of Real Estate or Equities on it's retail or wholesale value? 2, NAV is not necessarily "recoverable" in SL in the conventional sense. In any case, based on my intuition (yes, this is where intuition comes into the mix), I would have a fair idea of what I think the value of the stock is.

3) The average and top cost of my original purchase of the shares I currently own.

My Market Maker activity would be designed for multiple goals.

1) To lower the average cost of my original 2,500,000 shares by selling shares at or above this top cost, while simultaneously replacing with shares bought BELOW top cost.

2) To ideally push the "buy" half of The Spread at or BELOW my NAV and Intuition based valuation and push the "sell" half of The Spread to ABOVE my NAV & I valuation.

3) TO make a profit in each transaction. There is no point in either 1 or 2 if I am losing money doing it. So Transaction Fees would also have to be factored into what I would end up setting up as my Spread.

If this Market Maker activity is successful, then I will be making a profit while adding liquidity to the stock, and adding to my portfolio's profit generating performance. The perfect situation would be one where I never went below my original 2,500,000 shares unless I wanted to for whatever reason (decline in stock health, substantial increase in demand as represented by price).

Because it is virtually impossible for all of these activities to go as smoothly as described here, the additional goals of Market Maker activity would be to arbitrage sales of one stock to increase exposure on another one, such as say I had to get 3mil of one and 2mil of one of the others, I could sell the one I'm over on to replace with the under, a new IPO is in the works that I find promising, etc. So there would likely be some incidental "market maker" activity as I try and achieve the balance of my portfolio--meaning the core that creates $750 in income a month--from day one.

Now, for the well-seasoned reader, they are sure to recognize that this is nothing but text-book investing. 101. This is how it is supposed to be done. This is what Warren Buffet does with Berkshire Hathaway on a daily basis. This is what the big investment banks have been doing for over 100 years.

But what I have described is thus far a "perfect world" example, and I realize we do not live in a perfect world, not even in Second Life. I will get to contingencies and challenges and most importantly, the core effect on the overall market my activities would have, in a few moments.

At this point I am still only participating with 6 stocks. And through the course of time what would happen is that while endeavoring with my Market Maker activities other market participants will take Limit positions between mine.

Also, the gap between my Spread is likely to narrow to a minimum of the transaction fees on whatever exchange the stock is listed on, creating a natural minimum Support Level.

So if I chose to expand my profitability, I could use my profits, without cutting into my core $750 portfolio, by expanding my "risk level" by becoming a participant in the Market Making of other stocks that, while I would not be willing to add them to the $750 portfolio, I could start to take advantage of The Spread and profiting from this arbitration. I could choose to do this or not to, depending on how much income I wanted to incur and the opportunity to do so via market volume. Even more likely, I would take considerable positions in IPO's and look to become the Market Maker, especially during the initial phase when they go into active trading.

So my activities in the long run--which would take many many months to reach this point--would have the effect of narrowing Spreads, increasing liquidity, and normalizing the trading platforms.

It would be at this point that I would be functioning as an ideal mirror of how the Investment Firms in RL operated until just recently. The difference being that I would not be leveraging on margin, but instead, be investing 1:1, and as I grew more robust, become a dominant force whose considerable self-imposed Support Levels would DRIVE THE MARKET instead of be at THE MERCY OF the market.

In RL this is the difference in the ability a Meryl Lynch has over the power that an individual investor can yield.

Because there is not currently an Investment Firm in SL that has achieved this level of sophisticated market presence, and there is the limitation of few bellwether dividend yielding stocks that are product driven, all 4 exchanges suffer from the Support Levels that true Investment Firms provide. The Investment Firms currently participating in the SL Stock Markets do not have 15,000,000 share portfolio positions---their exposure to different securities often number in the few thousands. And in the case of SLCAPEX, where the companies themselves are relied upon to be the Market Makers, capital that would either be used to invest in their own business (or invest in others) is being tied up in Market Making activities, further stunting corporate growth in some cases, and leading to the current situation where INDIVIDUALS, not Investment Firms, are creating the vast majority of market swings.

The power of the current brand of Investment Firms is not sizeable enough to normalize and stabilize the market, and the listed companies are rather powerless overall to prop up share prices--which is an activity that I find self-defeating for all the reasons I just mentioned.