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2010-07-14 13:44 by Karl Denninger
in Editorial , 9 references Ignore this thread
Update To July 4th Video *
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In pictures and words.

The original price action is here (top right corner of your screen); I have pulled the original Ticker and have decided the future Youtube's will be linked only through here, and that comments on Youtube itself will be disabled.

There are a number of reasons for this, not the least of which are the "it's all the Joos fault!" garbage I have to clean up on Youtube's comment area.  It's sad that people can't see the forest for the trees and have to look for a boogeyman behind every corner.

A few people also seemed to be unable to recognize the context.  Yes, the original clip appears to show blatantly improper (even unlawful) activity, and as I explain in the video above, Section 9 of the Securities Act of 1934 covers this sort of thing.

But the larger point was missed in the short five minutes (that's what I get for doing short takes, eh?) which is that it is confidence in the marketplace - that it is not just a bunch of computers fighting with one another, but rather is a valid price-discovery mechanism - that is critical to having a healthy securities market in the first place.

This confidence has been severely damaged to the point that even mainstream commentators like Cramer mention it, along with other well-respected tweeters such as this note sent to me this morning:

@tickerguy #marketticker Give it up Karl - those guys would get away with murder. Laws are not enforced, which is why it's a free-for-all.

That's a great sentiment to have about our capital markets, right?  That comment, incidentally, was in reference to this morning's article about all the "accidental" Repo-105-like transactions that are suddenly being admitted to (as the SEC looks at them), rather than having the SEC call people out.  Funny how it is that those "accidents" never are to the detriment of a firm's balance sheet posture, right?

The point is the same, however:

Confidence is all the markets have to sell to ordinary businesses - and people.

Without it the markets are departed by the "ordinary Joe":

"We just didn't want to put up with it any more," says Karen Potyk. She and her husband sold the last of their stock holdings on May 20, moving the money to bonds, certificates of deposit and bond-like annuities.

Small investors' faith in stocks, which surged in the 1990s, has collapsed since the technology-stock debacle and the Enron and WorldCom scandals of 2000-2002. The 2007-2009 financial crisis only made things worse. Now, the pullback among ordinary investors means they are a declining force in a market that is increasingly dominated by professionals.

Professionals?  Well, yeah, I suppose so.  We call a guy with a set of lock-picks a professional too, but when he's tooling around your house at 3:00 AM his title isn't usually "locksmith."

These professionals wield high-speed computers and have figured out how to, in many cases, circumvent the precise letter of the law and regulations - but not the spirit.  They operate in the shadow of what's permitted (and, I believe, well beyond it much of the time) even though the clear intent of regulations such as "Reg-FD" is to guarantee everyone an equal and fair bite at the apple.

Investors talk of a growing disillusionment with big institutions, including corporations, government, banks and political partiesas well as fears about the nation's heavy debt. Some people's confidence in stocks was seriously shaken by the volatility that returned in May. They worry that the May 6 flash crash, when the Dow Jones Industrial Average fell 700 points in eight minutes before rebounding, is a sign that ordinary people are increasingly at the mercy of anonymous companies that trade with powerful computers.

That's because they are.

If Wall Street wants to stop this, then it needs to actually stop it and quit yapping and making excuses.

Orders, for example, could be forced to be valid for two full seconds.  That is, if you expose an order in the market you have to take a genuine risk of being filled not only by those with other high-speed computers, but also by real people trading with their brain directing their keyboard and/or mouse in real time.  With a common round-trip time of ~100 milliseconds for messages nowdays on The Internet, a two-second exposure would allow human reaction time (~1.5 seconds) plus transport of the instruction to have a fighting chance against the machines.  The "fat-finger" mistake would still be able to be canceled - if it is, indeed, a fat-finger mistake.

We could, for instance, require that if you have an imbalanced pattern of orders then you need to be able to demonstrate that you were truly intending to be willing to take execution of either side.  This might be refuted rather easily if, for example, you have 100 contracts offered on the /ES at 1090, 2,000 bid at 1088, the tiny offer gets hit (and you pull the bid) and then a very short while later you show up with an opposite-side identical play.

And we could impose geometrically more-expensive fees as your percentage of cancel-to-execute rises.  First cancel, cheap.  Second, cheap.  Third with no execute, not so cheap.  Fourth, more expensive.  Tenth?  Damn expensive.  This too stops the game - now cancels aren't effectively "free" beyond one or two per order that actually matches and executes.

Of course doing these things (among others) would destroy the "near-sure thing" of picking ordinary investor's pockets via various HFT-linked schemes.  It would mean that you couldn't safely put 10,000 or 100,000 shares of orders into the system as "line standers" then cancel them as price approached.  You couldn't stick a 2,000 contract /ES order out there and cancel it a tiny fraction of a second later - if someone wanted to hit you they could do exactly that, dramatically raising the risk involved in playing this sort of game.  If the risk of losing at these games rises to a high enough level, people will stop doing it - simply because it's too dangerous.

There is nothing wrong with speculation - I do it daily. 

But there is something very wrong with a market that is rigged against the smaller investor by computers that can place 20 orders up and down the bid and offer ladder to "hold their place in line" and then cancel those they no longer want as price moves while you, sitting behind a screen, can't possibly replicate this sort of strategy - you get to stand at the end of the line of all the other shares at the same price. 

It is a documented fact that the cancel-to-execute ratio has shot the moon over the last few years.  These are not small investors issuing change orders, they are high-speed computer-driven algorithms that are "standing in line" and then quickly withdrawing their orders when they don't like the conditions, thereby reserving a trade in front of you, an (apparently legal) way to front-run order flow.  It is impossible for you, the small investor or trader, to compete in such a system as you do not have the colocated machine sitting 5' from a gigabit-level (or better) switch at the exchange itself - your terminal is connected to a brokerage, which must obtain the quotes from the exchange, disseminate them to you, then transmit back to the exchange your price order.  You, as an individual investor, are easily 100 times slower than the "arms race" folks - you can't win in such a game which is no small part of why some of these firms are able to put up "no lose" trading records.  Their "gains", if you're wondering, come from you - a fraction of a penny at a time, millions of times a day.

It's time to stop it folks.

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