Markets Are Broken

Jeff  Carter
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Posted: Aug 02, 2012 12:01 AM

The price action in the stock market this morning was more evidence to long time traders that markets as they are structured today are broken. If you follow Themissal, Dan_Dicker on Stocktwits, you will get some good information as to just how broken they are.

Technological innovation isn’t a detriment to making a good market as long as there is good market structure for that innovation to play in. What we have today is an antique regulatory system, that allows an antique market structure to form around it.

On the private side, exchanges are paid on volume($CME, $NYX, $NDAQ, $ICE). Their economic incentive isn’t to provide a horizontal playing field to participants. Exchanges have are out of touch with much of their customer base, and cater to the high frequency traders that do most of the volume.

But, what if we look at just one facet of technological innovation, examine how it got started and what effect a change would have. At CME Group, they use an allocation algorithm. The allocation algorithm takes a percentage of each buy and sell order and distributes it across the bid or offer. How much you get relates to how much “size” or volume you are putting into the book. HFT systems routinely bid and offer for gigantic quantities and pull the order as soon as it starts getting hit. They are so fast, they can go the other way, scratching the trade or even reversing themselves against the book and move the market the other way. Independent traders call this getting “chopped up”.

The idea behind the allocation algorithm was to benefit the little guy. Supposedly, it gave them a chance to get into and out of the market. Instead, what it’s done is hurt the little guy. They have to give up the edge to get into or out of the market.

What if $CME got rid of the allocation algorithm? Then the entity or individual that made the market would get the trade. Algos would have to jump ahead of orders in the book that were better bids or offers than them. It’s called a FIFO system, or first in first out.

I notice that on every order I put into the book at $CME, if I am the best bid or offer, immediately I am joined by an algo. As soon as I cancel it, their order goes away, or gets decreased in size. If they took the allocation algorithm away, the market would reward risk takers, and decrease rewards for price takers and “joiners”.

Independent Traders will never win the speed battle with algo traders. Never. However, there are things that exchanges and regulators can do structurally to make the playing field more level.

The Federal Reserve Action-QE3 Speculation Still on the Table

Today the FOMC released their statement.

Here are some excerpts of germane things you might want to know

Growth in employment has been slow in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending has been rising at a somewhat slower pace than earlier in the year. Despite some further signs of improvement, the housing sector remains depressed.

If you are backing Romney, this is good news. If you support Obama, figure out new and ingenious ways to point fingers and make excuses. We could be in for a double dip as households and businesses gird themselves for the largest tax increase in US history.

Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook

Again, no improvement in joblessness. More stagnation with application of the same policies we have seen over the past years. Europe is a concern.

the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014

If you need to remortgage, no rush. Rates aren’t going higher, and they may go lower.

continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

This is operation twist. Buying the long end of the yield curve to keep interest rates down. This allows businesses to borrow at lower rates when they use debt to expand their operations. Problem is the first paragraph. Businesses aren’t investing.

The Fed is out of bullets. All it can do is watch. I think if there are definitive signs we are sliding into a recession, QE3 is still on the table. Right now the numbers just say, stagnation.