I didn’t start out with much interest in the stock market—though, like most people, I enjoy watching it go boom and crash. When it crashed on October 19, 1987, I happened to be hovering around the fortieth floor of One New York Plaza, the stock market trading and sales department of my then employer, Salomon Brothers. That was interesting. If you ever needed proof that even Wall Street insiders have no idea what’s going to happen next on Wall Street, there it was. One moment all is well; the next, the value of the entire U.S. stock market has fallen 22.61 percent, and no one knows why. During the crash, some Wall Street brokers, to avoid the orders their customers wanted to place to sell stocks, simply declined to pick up their phones. It wasn’t the first time that Wall Street people had discredited themselves, but this time the authorities responded by changing the rules—making it easier for computers to do the jobs done by those imperfect people. The 1987 stock market crash set in motion a process—weak at first, stronger over the years—that has ended with computers entirely replacing the people.
– Michael Lewis, Flash Boys
While we welcome the recent surge in attention directed toward high frequency trading courtesy of Goldman’s endorsement of what we said in 2009 even if with a 5 years delay (at least Michael Lewis got a book deal out of it), perhaps the biggest irony is that attention is once again completely misdirected.
Judging by the escalation in various probes and investigations by the FBI, the DOJ and, amusingly the SEC, the primary issue under focus is that of whether or not the market is “rigged”, i.e., whether HFT is legal or not. Well, of course it is legal! After all that was the whole point of redoing Reg NMS in 2005 – so those who would soon become HFT billionaires and the financial backers of the HFT lobby, would get a stamp of approval by the various regulators and legislators, completely clueless about what they would usher into the world of trading, and thus a green light to engage in riskless frontrunning of orderflow. Frontrunning which scalps pennies and subpennies, billions and billions of times.
The red herring was also planted: “we provide liquidity“, the ‘Flash boys’ screamed when we first shone a light on their practices in 2009, and are still screaming now that the entire world is looking at them, adding that only thanks to HFT have trade commissions collapsed to record lows, so it must be wonderful for the retail investors, right.
Wrong. Because not only does HFT not provide liquidity when it merely frontruns big order blocks, and all the other time churns hollow quotes with zero intention to execute but merely gauges how all the other HFT algos in the market operate leading to an unprecedented explosion in quote stuffing, layering and churn which together with the complete inability of HFT to provide real liquidity – or take prop risk with limit orders against the trend when there is no bid block to fruntrun – was also the reason for the May 2010 flash crash when the market literally went bidless for several seconds, but the reason why trading has gotten so cheap is that indicated HFT liquidity is a mirage with zero order book depth: something all the major institutions have realized and have long since moved to dark pools when intending to trade large orders.
In fact, the only reason the bid/ask spread has collapsed as much as it has, is because the retail investor is the last hope of the dying “lit” (and rigged) markets, which have nearly cannibalized themselves out of all profitability if not existence (there is a reason why there has been an unprecedented surge in exchange M&A in the past three years), and exchanges are hoping to make up in volume (“oh look how cheap trading has become”) what they will never regain in hefty fees. To be sure, commission-free stock trading is coming next in the last desperate attempt to lure the retail sucker who still hopes to “get rich quick” despite a rigged market. Of course, this simply means that equities will soon join the world of FX and bond traders, where there are no commissions, but simply a bid/ask spread. Perhaps we should look to the certifiably rigged FX market to see what a bang up job HFT has done in “lowering transaction costs” there too?
Which brings us to the topic at hand, because it is not whether or not frontrunning by HFTs is legal – it certainly is based on current laws – but what the trade off is to a market in which, as Michael Lewis correctly observes, computers have entirely replaced the people.
The answer is simple – unprecedented fragmentation and instability: a market that is not only rigged, but far worse: completely broken.
- It is this that should be the focus of regulators, legislators and enforcers, sadly of whom are part of the rigged market spiel.
- It is this that we explained, showing empirical evidence, in July of 2010 is the basis of why the flash crash of May 2010 occurred, in “Scientific Proof That High Frequency Trading Induces Adverse Changes In Market Microstructure And Dynamics, And Puts Market Fairness Under Question“… An HFT-driven flash crash that we predicted, correctly, would happen in April of 2009.
- But most ironic, is that it was this that none other than Shearson Lehman Hutton warned would happen in January 1988, just months after the Black Monday market crash so deftly described by Michael Lewis’ up top.
Irony points that it was the same Shearson that was making millions with “program trading” when everyone was enjoying the ride up and only saw it fit to “warn” about electronic trading after the event that saw a quarter of the entire market cap wiped out in hours (sorry HFT – you too will be the scapegoat after the next crash, as we laid out previously).
Double irony bonus points that it is this same Shearson Lehman Hutton whose well-known spin off would, some 20 years later, nearly cause the end of western civilization as Hank Paulson’s 3-page term sheet knows it.
Triple irony, of course, is reserved for the fact that it is now none other than Goldman Sachs which is stepping into the shoes of Shearson Lehman and warning the world about the dangers that are looming unless market structure isn’t promptly overhauled.