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5 Things To Ponder: The ‘Market Is Rigged’ Edition

  • Written by Syndicated Publisher No Comments Comments
    April 9, 2014

    The big story last week was obviously Michael Lewis’ new book “The Flash Boys” which brought to light the potentially negative impact of high frequency trading (HFT).  This is not new news.  I first started writing about this very important issuein June, 2011:

    Program trading accounts for as much as 70 percent of the market volume on a daily basis.   While not all of the volume is nefarious it certainly goes a long way to explaining why the average investor really doesn’t have a “snowball’s chance in hell” to out maneuver the hedge funds and High-Frequency Trading (HFT) firms on the street.  Wall Street has been allowed, by the SEC and with the assistance of the exchanges themselves, to set up a system whereby the average retail investor is the sheep set for shearing on a regular basis.   It isn’t a wonder that the number of retail investors is slowly dwindling away and someday in the not too distant future Wall Street will be taken over by SkyNet and the firms can trade between themselves as they will have removed all of the capital from Main Street.

    Is HFT really good for the markets? Does it really provide a necessary function of increasing liquidity? Considering that the financial markets have operated successfully for over 100 years, was an increase in liquidity really needed? Or, was HFT transformed from a benign concept into an intentionally malevolent “profit generation” scheme by the financial elite?

    I am certainly in favor of increased efficiencies derived from technological innovation. However, such innovations must be closely monitored in order to ensure they are not used in ways the undermine the financial system. While I don’t have the answer, my simple view is that the financial markets should remain a fair, and equitable, playing field between all market participants. When it isn’t, and all the players at the casino eventually figure out the games are rigged, they leave. That is an economic fate from which there is little recovery. However, that is just my opinion.

    This week’s “Things To Ponder” is a collection of views on those questions for you to consider.

    1) Shocked. Shocked. by Zachary Karabell via Slate

    The debate about whether these practices are benign or harmful to markets is entirely necessary. Personally, I think that the advantages enjoyed by some high-frequency traders are incompatible with fair and open markets and should be curtailed substantially—perhaps entirely.

    But there is another danger here that is getting only minimal attention: that regulators, who once again are accused of being slow to respond and insufficiently vigilant, will go to the other extreme and attempt retroactively to criminalize behavior that it was fully aware of and did nothing to prevent until public opinion shifted.

    2) The Hidden Danger Of HFT by Ian Fraser via QFinance

    Not only is HFT legalized front-running. It is also a socially worthless activity that amplifies market movements, increases market fragility, inflates asset price bubbles, and naturally worsens market crashes. And as we saw with the ‘Flash Crash‘ of May 2010, it can also fuel market mayhem.

    One of the high speed traders’ most outspoken critics is Charlie Munger, vice-chairman of the US insurance group Berkshire Hathaway. In an interview with CNN in May 2011, Munger said:

    “I don’t think the rest of us have anything to gain in having massive trading between computers which  try to outwit one another with their algorithms.  To the extent that one succeeds, the rest of us are all paying …”And in a speech at the Institute for New Economic Thinking’s Berlin conference on April 14, the Bank of England’s Andy Haldane said that, at best, high speed trading creates a “mirage of liquidity”:

    “One reason [high frequency traders] dominate volumes is because they submit huge volumes of quotes in the market, the vast majority of which are never exercised. The firms cancel them before they are ever exercised … And currently [in the US equity market] for every order executed, 60 are cancelled. So what’s going on here?“One thing that’s going is that, although there are loads of quotes on the screen, if you try and hit them, they have disappeared before you can ever transact as you would wish. There is a mirage of liquidity…

    Some have said this ‘quote stuffing’ is imposing an externality, in terms of bandwidth, on slower traders … the ‘flash crash’ was no one off. In the period since, although less publicised, there have been hundreds of mini ‘flash crashes’.”

    joint report published by the Securities & Exchange Commission and Commodities Futures Trading Commission (CFTC) in October 2010 concluded that the May 6, 2010 ‘Flash Crash’ was fuelled when HFT algorithms “began to quickly buy and then resell contracts to each other — generating a ‘hot-potato’ volume effect as the same positions were passed rapidly back and forth.” In other words, the algorithms ran amok, and caused the market to tank.

    3) BATS Admits CEO Lied On CNBC via ZeroHedge

     Via WSJ:  BATS Global Markets Inc., under pressure from the New York Attorney General’s office, corrected statements made by a senior executive during a televised interview this week about how its exchanges work.BATS President William O’Brien, during a CNBC interview Tuesday, said BATS’s Direct Edge exchanges use high-speed data feeds to price stock trades. Thursday, the exchange operator said two of its exchanges, EDGA and EGX, use a slower feed, known as the Securities Information Processor, to price trades.

    The distinction matters because high-speed traders can use powerful computers and superfast links between markets to outpace traders and trading venues that rely on slower market data, such as the SIP.

    This leaves us with two possibilities, either:

    1) The CEO of BATS has no idea what his firm actually does and is merely happy to earn an impressive amount of money skimming off the rest of the population of market traders no questions asked, or;

    2) The CEO of BATS is a liar and is merely happy to earn an impressive amount of money skimming off the rest of the population of market traders no questions asked.

    4) What Michael Lewis Gets Wrong About HFT by Matthew Phillips via Bloomberg

    Here are 3 things Lewis gets wrong:

    1) HFT doesn’t prey on small mom-and-pop investors. 

    2) Speed trading isn’t hugely profitable.

    3) HFT’ers aren’t Wall Street insiders. 

    This is not to say that Lewis’s book has no merit, or that the market isn’t messed up right now. Lewis puts his finger on a lot of what’s wrong: The competition regulators hoped to induce through new rules over the past decade has led to a fragmented market rife with perverse incentives and far too much complexity. Speed traders have certainly benefited from the new ecosystem, and there are undoubtedly bad actors among them. But it’s too much to say that as a whole, they’ve rigged the market. Vilifying them misses the bigger picture.

    5) HFT Is A Growing Cancer by Charles Schwab via Schwab

    High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets. It’s a growing cancer and needs to be addressed.  If confidence erodes further, the fuel of our free-enterprise system, capital formation, is at risk. We can’t allow that to happen. For sure, we still believe investing in equities is a primary path to long-term wealth creation, and we believe in the long-term structural integrity of the markets to deliver that over time for individual investors, which is all the more reason to be vigilant in removing anything that creates unfair advantage or undermines investor confidence.

    Bonus: Why Markets Always Crash by Morgan Housel via The Motley Fool

     “Markets crash all the time. You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime. Those who don’t understand this will eventually learn it the hard way.”

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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