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….
TPC,
I’ve been reading all this crap at ZH and didn’t understand any of it until you spelled it out in plain English. Thanks.
From this reading it seems they could, in addition to requiring every quote stay good for at least one second, make it illegal for anyone’s servers to be located on premises. NYX seems complicit; at least in allowing the GS servers on NYX turf…GS alumni over at NYX as well, right?
How is this legal? It’s as if we all know this is going on and no one is willing to do anything about this. We’re all getting screwed by this all so Goldman can keep paying record bonuses when they should be out of business. I want to scream.
Frank,
it certainly seems like a conflict of interest. The SEC should act on this quickly. Unfortunately, it’s so complex that most politicians won’t take the time to make an issue of it because not enough constituents will express interest.
SS,
anyone who understands what these firms are doing can’t be anything but outraged.
Yes, this is exactly right. They are not adding liquidity. Think about this, the fucking computers, while, when things are good, add to profits and percentages, actually lead to the crashes that could “bring it all down”. How about good old quant driven LTCM???????
Get these math nerds out of the business. Or at least severely limit their power. Themis’ idea of 1 second intervals is a great one, in my opinion.
Speaking of the scumbags at GS, here is a good piece about what dirty rotten scoundrels they really are:
http://www.rollingstone.com/politics/story/28816321/the_great_american_bubble_machine
Have a great weekend!
The paper is impressive but gets it all wrong.
Just one example: rebate traders buying and (attempting or) selling at the same price provide liquidity and benefit small traders who happen to place trades at the same time.
Program trading, ditto, when they run the price they give well positioned traders a chance to get out at a better price.
The retail investor is small piece of the pie. Money changing hands is mainly between institutions.
I have been trading over forty years, some of it on the commodity floors, and I take today’s electronic trading environment over the good-old-days any time.
the conclusion is off. more liquidity and trading dampens volatility, and creates more efficient prices, not diminishes it. if prices become too oversold, because of panic, because mutual funds need to raise money, or whatever, value buyers come in and buy. if prices are inefficient, bear stearns is really worth less than 0 instead of 20, then the market is going to get it there quicker. why didn’t people come in and buy bear stearns, because there was no value in the company and they owed more than they were worth. that’s not goldman’s fault, not the market’s fault, it was bear stearns fault for relying on very short term loans (overnight) and assuming they could always get those loans. rebate traders slow the decline, providing liquidity and earning the spread or less, giving time for longer term value buyers to evaluate the company. without them, the move would have been much quicker.
If HFT entail an unfair advantage, why then mutual funds and institutional monies are not deploying counter measures? Can lack of participation and monies on the sidelines be construed as a response?
Res Ipsa Loquitor (‘the thing speaks for itself’)
As noted above, last week Goldman Sachs (GS) went after an employee who allegedly stole some of its latest and greatest program trading software and, in connection therewith, the assistant US attorney general stated in court that he had been advised by the bank that anyone with access to the software has the potential to “unfairly manipulate” the market.
Even if viewed in isolation, the mere acknowledgement by GS that its program trading software creates the “opportunity” for unfair market manipulation should raise sufficient red flags to prompt a preliminary investigation by the SEC and/or the Department of Justice.
But wait . . . there’s more (and it isn’t pretty).
As the assistant US attorney general was highlighting the potential use of the the program trading software to unfairly manipulate the markets, GS issued a public statement regarding the software in question, in an apparent attempt to reassure its shareholders.
In substance, GS offered assurances that there was no cause for concern that the ex-employee in fact would be able to use the software to unfairly manipulate the markets.
“Why?” (and here’s where the plot both thickens and sickens) . . . because, according to GS, the ex-employee does not have access to the same proprietary data base that GS maintains with respect to its clients and the markets.
So let’s understand precisely what GS has publicly acknowledged (albeit, perhaps without intending to reveal quite as much as it has):
1. GS’s program trading software provides the user with “opportunities” to unfairly manipulate the markets.
2. In order to take full advantage of these opportunities to unfairly manipulate the markets, the user also must have access to the proprietary data base that GS maintains with respect to its clients and the markets.
It is profoundly disturbing that the proprietary data base to which GS referred in the context of the potential use of their program trading software to unfairly manipulate the markets specifically included PROPRIETARY DATA REGARDING ITS CLIENTS.
At a minimum, this raises serious questions regarding the potential for “frontrunning”, i.e., that a portion or all of the massive profits generated by GS’s program trading software are the result of algorithms that enable the program to successfuly anticipate trades that will be made by others . . . including clients of GS — an endeavor made considerably easier by virtue of the access that GS has to the propriatary data base it maintains regarding its clients.
The public acknowledgments made by GS truly ’speak for themselves’ — indeed, it is difficult to see how these acknowledgements can be interpreted other than as ‘admissions against interest’.
We’ve learned the hard way just how many financial and other institutions have been allowed (if not encouraged) to become ‘too big to fail’.
By all appearances, GS has been allowed (if not encouraged) to develop a sense of ‘entitlement’ to favorable treatment by the government (the AIG bailout being just one example), which raises the question whether we’ve allowed GS to become too powerful even to be challenged and/or investigated.
One can only hope that the SEC and the Department of Justice are sufficiently alert to “connect the dots” — all of which are in the public record — and also that they are sufficiently independent and empowered to faithfully execute the duties with which they have been charged and the responsibilities which they have assumed on behalf of the American people.
Of course, such hope finds little encouragement in the tragic irony of watching the US assistant attorney general in zealous pursuit of the alleged thief, all the while missing the forest for the trees.
FDIC is having difficulty finding strong banks to take over failing banks. GS is now a bank but without retail banking outlets. How about a shotgun wedding? Wouldn’t it be great if Ms. Bain arranged for GS to deploy some of it trading profits to expand their portfolio of savings and checking accounts, as well as home mortgages, in places like Georgia and Illinois? I wonder if their microsecond trading platform would work pricing home mortgages?
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