The Bill for Broken Markets

Jeff  Carter
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Posted: Aug 03, 2012 12:01 AM

Knight Trading just got a massive bill. Zerohedge has the article here.

We all know something went horribly wrong in various NYSE-traded stocks today between 9:30 am and 10:15 am. So wrong in fact that the NYSE had to step in and cancel numerous trades in 6 symbols. However it did not DK millions of other trades in 134 other symbols, the vast majority of which we assume traded errantly due to the market making of Knight Capital (as admitted by the company), which today saw its biggest drop ever since going public on volume about 60 times greater than its average.

HFT the way it is presently structured is wreaking havoc on our marketplaces.

Electronic trading is not a bad thing. In fact, done correctly it’s great. It allows more people to have cheaper access to the marketplace. But days like yesterday, days like the Flash Crash illuminate the fractured marketplace we have today.

The power brokers today don’t have an economic incentive to change anything. For the average investor, does it matter if a flash crash happens? Depends. If they don’t trade individual stocks, and just don’t trade period, it doesn’t. The daily stock market gyrations are nothing but a sideshow to their lives. They are busy doing other things. They are worried about the macro. The average investor knows if the broad economy grows, the stock market will be higher when they want to sell it.

But, for the people that manage the money of the average investor, the way the market works today is hellish. Imagine how the union pension fund manager feels when they try to unload a position and some HFT algo clips them. Not only does the HFT algo clip them, but their investment bank clips them too! “Hey, but you get to trade commission free.”!!

When big investors begin to lose confidence in the marketplace, an insidious spiral begins to take effect. That has begun to happen over the past number of years.

America was founded on free market ideals. Transparent free markets lead not only to economic freedom, but the core American values of liberty and justice for all. The free market doesn’t discriminate. Everyone has the same chance. Everyone can get ahead.

But today the way the market structures work, we have a caste system. Levels of distribution. When you are at the top of the heap, it’s great. That’s how Goldman ($GS) or Morgan ($MS), or JP Morgan ($JPM) can go entire years without having a losing quarter trading proprietary money. It’s also why the retail guy is getting screwed and now they are beginning to leave the market.

When the little guy loses confidence in public markets, a little more of tarnish is heaped on the values our country was founded on. That’s why people like myself, Josh, Themis, Dan Dicker and others get so mad about the destruction of the marketplace. We know what it could be like. We are very disappointed at what it looks like today.

The speed doesn’t bother me that much. In many cases, one could make an argument that public information gets priced into the market faster, creating better efficiency. But the distribution network that is codified by bad regulation, the co-location rules, the ability to see order flow and the book before anyone else does bother me. That is a byproduct of the speed.

I understand that many humans didn’t provide value to the marketplace in the old days. Like many of the algos today, they were simply leeches. The traditional NYSE market maker system wasn’t perfect. Our human pit environment in Chicago wasn’t perfect. However, because we were in a human environment, it was much easier to police them. In many cases, they got tossed out. But the regulators and exchanges haven’t kept pace with the electronic innovation, and don’t have the intestinal fortitude to do anything about it. Their pocketbooks are tied together.

Electronic trading should level playing fields. It should inspire confidence in the marketplace. We should have more transparency and better information. Instead, it’s destroying marketplaces and destroying American confidence that they can get a fair shake on anything.

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tip of the hat to Abnormal Returns