Blog # 24 – Are the markets rigged? Is the Pope still in Rome?

Ok, kiddies, are you ready for another bumpy ride on the good old Financial System Roller Coaster?  As you may recall, last week we were discussing how old Tom Piketty just nailed the “Secret to Success,” so this week let’s move on to good old Michael Lewis and his new best seller, Flash Boys. This resourceful young feller has already written an expose or two on the exciting Financial Sector and a couple of other sports, as well.  His book, The Big Short, described Wall Street’s wonderfully insane machinations with sub-prime mortgages which led to the crash of 2008.  Actually, Michael Lewis’s books are fun to read.  They, of course, tend to be a tad technical, but as he writes as a suspense novelist might, he makes the eye-glazing detail of finance interesting.

Flash Boys deals with another aspect of Wall Street genius, the proliferation of stock exchanges, dark pools, and High Frequency Trading (HFT).  Many people still think of the “Stock Exchange” as the huge floor in the New York Stock Exchange on Wall Street where a bunch of guys in funny grey jackets with pencils sticking out of their ears and caps are hollering prices and symbols and generally performing their function of making markets for the various stocks of companies listed there.  Turns out that’s not how it works anymore!  Today, there are not a couple, but over a dozen exchanges, and the funny looking, very excitable guys have been replaced by “matching engines” inside computers, plus the Big Banks all have their “Dark Pools,” in-house computers, to handle large buy and sell orders from their customers.  Lay on top of these new computerized markets a bunch of high frequency trading outfits, and you have a situation which is ripe for exploitation!  Most of the new exchanges are not on Wall Street, but in northern New Jersey.  Wonder if the Guv gets a piece of the action?

Lewis’s Flash Boys takes us through the means used by the High Frequency Traders to enable them to “front-run” investors normal trading.  Front-running means getting information faster and faster to be able to “see” other traders’ intentions sooner than anyone else to be able to game the system.  It becomes very complicated but microseconds become very important in receiving market data ahead of others.  Banks and HFT firms pay the exchanges handsomely to locate their computers right next to the exchange computers.  

HFT dude minding his computer adjacent to the exchange computer
HFT dude minding his computer adjacent to the exchange computer

One enterprising feller even buried a fiber optic cable in as straight a line as possible from the Chicago Futures Market back to the New Jersey Exchanges, in order to speed the information faster.  In theory, if one has the info from the futures market, he can see where the stock markets will go next.  

Unfortunately, all this speed in transmitting information is enabling high frequency traders to buy and sell as intermediaries, taking basically no risk by having no position in stocks at the end of the day, while siphoning billions of dollars a year from the markets.  Concurrently, the big banks are skimming more billions off the top using all manner of slights of hand.   

Finally, what story of financial malfunctioning would be complete without the groups calling themselves “conservatives” (what they are conserving is not clear to this old hound dog) finding malfeasance in government meddling being involved?  Well, in this case, they may even have a point because in 2007 the Securities Exchange Commission (SEC) implemented a new rule called Regulation National Market System (NMS) which required a mechanism — National Best Bid and Offer (NBBO) compiling all bids and offers for all US Stocks to be in one place.  That place, inside yet another computer, was called Securities Information Processing (SIP).  Totally confused yet?  The new rule, with all its bells and whistles, was well-meaning and sensible and intended to provide fair pricing and liquidity to the markets, but by the universal natural law of unintended consequences, actually caused more fragmentation of the American stock market, and stimulated a huge amount of stock market trading (because of a little loophole in the NMS which failed to specify the speed of the SIP).  Hence, those sneaky old HFT’s set up their own version of the SIP, faster and better, so instead of creating equality, NMS institutionalized a more pernicious inequality (Michael Lewis’s own words).

Additionally, probably not all of the SEC’s actions are meant to be completely benign.  As is the case with too many govamint agencies there is a bit of a “revolving door” effect as staffers seek and obtain jobs within the industries they had been charged with regulating.    

The result, concludes Lewis, causes the Stock Markets to be “rigged” for the benefit of insiders in an unsustainable manner.  Who woulda thunk it?  Flash Boys details the formation of a new Stock Exchange named IEX with the ability and willingness to provide an equitable trading place for investors.  This new “fair” exchange is of course not being welcomed wholeheartedly by the incumbents (who have a ton of money to lose if the markets become more equitable), so it’s not clear that it will be able to survive the “system.”  You can “goggle” it and see how it is doing currently, and we’ll all hope for the best!  Matter of fact, we better hope (and those prone to praying had best get with it, too) that this modest effort at reform of the financial markets will be very successful and be replicated often!!

PS:

Regarding that fiber optic line (there’s also a bunch of microwave towers strung along the same route) from Chi Town to Jersey, it brings to mind the message sent by old Sam Morse on the first telegraph line strung from the Supreme Court in D.C. to the B&O Railroad Depot in Baltimore, Maryland, “What hath God wrought?”  Today some wag might exclaim, “Look at what a bunch of shysters have done with ‘What She hath wrought’!”

This in recently

  • A study by the Russell Sage Foundation found that the net worth of the “typical” American dropped 36% from 2003 to 2013, from $87,992 to $56,335.  Meanwhile, the average net worth of a US household in the 95th percentile grew 14% to $1,364,834 (very accurate guesstimating).  There you go again — selective choice of parentage pays off.  
  • Hey, remember the F35 fiasco from last week?  Well, pap just read where the average major pentagon acquisition comes in 40% over budget.  We just heard that NASA is planning to “outsource” its future space exploration — Yikes!
  • One more for fun — in 1952, corporations accounted for 32% of federal tax revenue.  As of 2013, it was less than 10 percent (vox.com).  Can you believe that they are griping about the high corporate tax rates we have?

BUT — there’s good news!

As we also reported last week, millennials are thought to be the most fiscally conservative generation since the Great Depression.  Read this past week that they aren’t investing in the stock market — those kids may be smarter than they look.  

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