MUST READ: THE REAL FORCE BEHIND THE EXPLOSION IN VOLUME AND VOLATILITY

There has been an enormous amount of chatter in recent weeks about program trading and the problems and inequality it causes among firms and small investors. Readers of Zero Hedge are well aware of the problem as the blogs author, Tyler Durden, has done an incredible job shedding light on this relatively unknown area of Wall Street. Regular readers likely know that I am not always fast to cast judgment on potentially guilty parties, but as the evidence mounts it is quite obvious that something is horribly wrong and it begins with Wall Street’s most powerful firms.  As John Mauldin says. this is truly outrageous.  Mauldin’s latest weekly newsletter sheds light on this complex topic in an insightfully simple way:

I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called “Toxic Equity Trading Order Flow on Wall Street.” Basically, they outline why volume and volatility have jumped so much since 2007; and it’s not due to the credit crisis. They estimate that 70% of the volume in today’s markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn’t get to play. This is a game only for big boys who can afford to pay for the “arms” needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn’t affect you? That “tax” is paid by mutual funds, your pension fund, and every large institution.

Frankly, this is outrageous. The more I read the madder I got. And it is going to get worse as computers get faster and software more intelligent. We need rules to level the playing field. Themis suggests one simple one: just make it a rule that all bids have to be good for at least one second. That would cure a lot of problems. One lousy second! In a world of microseconds, that is an eternity.

Goldman Sachs went after an employee who stole some of their latest and greatest software this last week. The US assistant attorney general said in the courtroom that the software had the potential to manipulate the market. Imagine that. I am shocked. There is gambling going on in the back room? Gee, commissioner, I had no idea.

All this “algo” (algorithmic) trading also gives a very false impression of volume. If you are a fund and see 10 million shares a day traded, you might feel comfortable that you could hold one million shares and exit your trade easily. But if 80% of the volume is false “algo” trading, that volume isn’t really there. You may have a position that will be a problem if you want to exit, and not know it.

“High-frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.” (Themis Trading)

We are literally talking billions of dollars here. The SEC needs to step in and stop this, and soon. This is a lot more important than the salaries of investment professionals, for which the Obama administration today suggested new rules, which would allow the SEC to oversee salaries at member firms. Seriously? They don’t have enough to do already?

I have attached the white paper from Themis for you to read here.  It’s eye opening to say the least:

Toxic_Equity_Trading_on_Wall_Street_12-17-08 –

You’ll notice the volume and VIX explosion in August of 2007:

Volatility has skyrocketed. The markets’ average daily price swing year to date is about 4% versus 1% last year. According to recent findings by Goldman Sachs, spreads on S&P 500 stocks have doubled in October 2008 as compared to earlier in the year. Spreads in Russell 2000 stocks have tripled and quoted depth has been cut in half.

Most important in all of this is that it is hurting millions of institutions & small investors in order to line the pockets of the ones with the biggest and best computers.   These big firms don’t really care which way the market is moving so long as they take their cut on the spread.  Meanwhile, millions of investors are being forced to suffer through 4% daily swings.  Risk management is hard enough for those running algorithm based trading platforms.  For someone with a Dell and an ETrade account it is damn near impossible in a market as volatile as this. I’ll highlight this again:

High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

It’s time to even the playing field.  As citizens of the U.S. and the global economy it is our duty to constantly question our government and demand the truth and equality that they promise when they run for office.  This sort of underground theft is not what we voted for when we elected officials to govern our markets.  Take a second to email the SEC.  I already have – more than once:  tradingandmarkets@sec.gov

For more on this I would head over the Zero Hedge.  He’s all over it….