Juggling Dynamite

The Flashcrash of May 2010 was just a warning shot. As public markets have become the private casinos of a select few with technological weapons of mass destruction, the risk to investors and the global financial system have become overwhelming. The fact that the exchanges now make the bulk of their profits from high frequency trading, is the reason this madness continues to grow. Last week the Indian stock exchange was the latest market to “flash crash” as shown in this chart.

This is all quite simple to stop through the implementation of a financial transaction tax for minimum holding periods and a widening of the minimum bid-ask spread. Until that is done, madness and mayhem will continue to dominate. I disagree that it is just that the regulators are not vigilant enough. This is like saying that we don’t need laws that ban certain activities so long as you hire enough police and park rangers to keep an eye on things. What?

In my view this laissez faire grab-revenue-from-anywhere mentality is part of the move over the past 20 years toward legalized gambling. Most governments now collect a huge portion of their tax revenue from gambling as we all turn a blind eye to the social costs of this frequently self-destructive behavior for patrons. Condoning High Frequency Trading is actually worse than casinos, because with HFT dominated markets, it is not just those who “play” that are putting themselves at financial risk. Everyone who is trying to use public markets for investment purposes are left in harm’s way. The exchanges and prop firms are choosing to reap quick bucks with wanton disregard for the public health and security.

High Frequency Trading (HFT) deeply concerns Erik Hunsader, founder of Nanex. He worries that today’s investors, our regulators, — heck, even the HFT algorithms themselves — don’t fully understand the risks market prices face in the brave new era of bot-dominated trading.

For instance, Hunsader estimates that HFT algorithms are responsible for 70% of all completed transactions on our exchanges, and for 99.9% of all exchange quotes.

The pictures of trading floors you see on TV, where the people in bright jackets appear frantically busy in making their trades, have no bearing — claims Hunsader — on the actual trading action. The real action happens across fiber-optic cables, on racks of servers in cooled rooms; where an arms race defined by cable length and switching speeds is being waged

The reality is that the machines have taken over. When you buy or sell a security, the odds are extremely high the other side of the trade is being placed by an algorithm — one that cares nothing for the fundamentals of the underlying instrument. It simply is looking to make a quick profit, oftentimes measured in fractions of pennies. And this has vast repercussions for the stability and the fairness of our financial markets.

Because of speed advantages, HFT algos can see and react to prices faster than you can. Ridiculously faster. A second on the clock, to an HFT algo, is an eternity.

The deep pockets of the firms employing HFT algos combine with this speed to move asset prices around, sometimes wildly so, faster than most of us can comprehend. In the time it takes for your “real-time” quote system to refresh, an individual stock could have traded many percentages up and/or down — and you would have no idea.

See this clip for a good discussion of these issues. (ps. at the end of this clip he suggests individual investors can buy his trading service as a way to try and compete against the machines. I disagree with this idea of “if you can’t beat ’em join ’em” when it comes to HFT. That way lies madness.)

Mohamed El-Erian, Pimco CEO & Co-CIO, discusses the 7.8 percent unemployment number, and says “the rally can only continue if the fundamentals take control.” Here is a direct link.

We are living through a period of wide-spread crazy. Sure there have always been reckless factions in the world. But today the affliction is mainstream. A good many people see what is happening and know that it is likely to end in more financial pain and human suffering, but most say that they are opting to play along anyway. The most common justification given, is that current monetary policies are nuts but so long as the music is playing one has to keep dancing. Famous last words of Chuck Prince who was head of Citigroup as the firm imploded in 2008: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said on the eve of his firm’s collapse.

There is a similar lemming-like sentiment at the moment in investment managers and strategists. Many are ignorant or self-deluded. But even the ones who know better have decided that it is a fool’s game to fight the Fed–better to throw client capital like craps at the casino and cross your fingers. The risk of destroying capital is trumped by the risk of looking like they are missing out on short-term gains–regardless of how fleeting.

I can think of a thousand analogies for this mentality. Driving fast on spring ice, hoping you can gun it over open water. Huddling in a burning building ’cause it’s warm. Just because people chose to do it, doesn’t mean it’s prudent, wise or not likely to be deadly. It’s a matter of when–not if.

The fact is that valuable risk managers are hard to find. Hard to find because it is hard to do. Sticking to rational controls and insisting on favorable odds requires discipline, on-going care and attention. Periodically it requires self-sacrifice. To be useful and worthy of trust, one must do what is best for those whom they are charged to protect, rather than what is easiest, self-enriching, consensus or short-term popular. This goes for parents. And it goes for politicians, trustees, business owners and asset managers.

Over the past 15 years, reckless policies in the western world have facilitated the extinction of prudence. We are all paying for that now. Given the thinking still dominating, it seems most will continue to pay for a while longer still.