High Frequency Money Printing A Bigger Threat Than High Frequency Trading
Dow Hits Record High, While Growth Dwindles
On Wednesday, most Americans may have been confused by what seems to be mixed economic signals. Wall Street was manic when the Dow Jones Industrial Average closed at a record 16,580.84.
The party began as CNBC rung the closing bell at the New York Stock Exchange in celebration of the news channel’s 25 year anniversary. Excitement and euphoria ensued. Optimism and elation reigned. It must have been how the streets of Seattle looked when the Seahawks won the Super Bowl.
The story on Main Street however was bleak. The same day that Wall Street was popping champagne, the Commerce Department reported growth in the first quarter of 2014 at a miserable 0.1%. Meanwhile, the past few weeks have been littered with news items about produce, meat, and pharmaceutical prices rising. Speaking of champagne bottles, an NBC News article points to chocolate possibly becoming as luxurious as the sophisticated alcoholic beverage due to skyrocketing cocoa prices.
What are Americans supposed to take away from this? Why is there a disconnect between a steaming hot stock market and an ice cold gross domestic product?
Wait… didn’t a prominent news organization just mention something about the stock market being rigged recently?
60 Minutes Spots a Mole Hill; Ignores The Mountain
Late in March, 60 Minutes sparked a firestorm when it televised an interview with Michael Lewis and Brad Katsuyama. The devastating headline? “The stock market is rigged”.
“The stock market is rigged. The United States stock market, the most iconic market in global capitalism is rigged”, adds Lewis.
You may recognize the name Michael Lewis. Lewis is a financial journalist and has authored books on everything from the ‘mortgage-backed bond’ during the late-1980’s ‘Savings and Loans Crisis’, to a 2001 commentary on how rapidly evolving technology would upend long-standing power structures in business, politics, media, etc. His book ‘Money Ball’, about the true story of an Oakland A’s general manager who hires a Wall Street economist to build a baseball team, produced a major motion picture of the same name starring Brad Pitt and Jonah Hill. His latest book ‘Flash Boys’ presents the story which was the subject of the 60 Minutes piece on March 28th.
The core of Lewis’ accusation is that high frequency traders are front running other investors’ stock purchases. The first to figure out how this was being done was a Canadian trader named Brad Katsuyama. While heading a team of investors at the Royal Bank of Canada’s desk in New York, Katsuyama noticed suddenly in 2008, orders that he and his team were submitting we’re coming up “partially-filled” and the stock price would be significantly increased afterwards. Katsuyama himself explains the front running issue best in the following analogy:
“[Y]our family wants to go to a concert. You go onto StubHub, there’s four tickets all next to each other for 20 bucks each. You put in an order to buy four tickets, 20 bucks each and it says, “You’ve bought two tickets at 20 bucks each.” And you go back and those same two seats that are sitting there have now gone up to $25.”
Long story short, Katsuyama linked up with an Irish telecom expert named Ronan Ryan and cracked the case wide open. It turned out high frequency traders (HFT’s) were using complex algorithms to sniff out the trades submitted by others electronically. Than using high-speed network connections HFT servers were beating these trades in a virtual foot race to the seller in cyberspace. The HFT’s would than almost immediately sell the purchased stocks at a higher price.
Cambridge dictionary defines the act of “front running” as such:
“the usually illegal act of a dealer buying shares in a company after they have had an order from a customer to buy a large number of the same shares, which is likely to have the result that the shares will go up in price. The dealer can then make a profit by selling the shares that they have bought.”
This is exactly what Lewis and Katsuyama are pointing out that HFT’s are likely guilty of, in a more high-tech and sophisticated fashion. Notably two days after the 60 Minutes piece aired, an intense debate between Katsuyama and BATS Global Markets president William O’Brien on CNBC completely halted trading on the New York Stock Exchange (with Michael Lewis tag-teaming from the ropes).
HFT Front Running Is Significant But Temporary
Michael Lewis explains the plight of a hedge fund manager:
“I was running a hedge fund that was $9 billion and that we figured that …our inability … to make the trades the market said we should be able to make was costing us $300 million a year.”
Certainly this is a problem, especially for financial institutions who purchase stocks in large quantities, as well as all of us who do business with them. It certainly reeks of unfairness. However truthfully this is the high-powered investor version of what regular Americans experienced with cell phone plan overages.
Throughout the last decade and prior, cell phones finally became more affordable and accessible to the average person. However to enjoy the new innovation it often came at the price of burdensome contracts and excessive overage charges for exceeding allotted minutes and text messages. For anyone who was a part of one of these archaic arrangements (and sorry if you still are), spending hundreds of dollars a year on overages wasn’t very pleasurable. Another similarly frustrating example that many might remember from last decade and prior would be the harsh late fees at video rental stores such as Blockbuster.
As many cell phone consumers know, the era of getting squeezed by overages was not a permanent state-of-affairs. New cell phone vendors such as Cricket and MetroPCS entered the fray and stole market share from the greedy behemoths. Soon the Sprints, the TMobiles, and other big players followed suit with more favorable arrangements. It didn’t require any government intervention, except for those rare cases in which cell phone vendors were insanely excessive. Similarly in a different industry what were originally small upstarts called Netflix and Redbox eventually obliterated excessive late fees and many video rental stores to boot. Blockbuster went into bankruptcy, closed its stores, and is now mimicking both Netflix and Redbox.
Katsuyama left RBC and is today an entrepreneur providing a free market alternative for investors. He started his own exchange, IEX, which promises innovative ways to provide an even playing field, free of any potential HFT front running. A week prior to the 60 Minutes piece airing, IEX received a ringing endorsement from Goldman Sachs executives calling it “a model for a more stable and less complicated stock market”. Like Cricket or Netflix, Katsuyama is providing an alternative and potentially an improvement to investors.
Forget the Stock Market… The Entire Economy Is Rigged
60 Minutes and the media-at-large have essentially blown out-of-proportion a very interesting story concerning some inside-baseball on Wall Street, while ignoring the real scam. The real conspiracy involving Wall Street doesn’t start at some high-powered server in Weehawken, NJ. It starts at a high-powered central bank in Washington D.C. The scam: Wall Street firms and the American economy at large is being flooded with artificially cheap money. The explanation for the disconnect between the record high on the DOW Jones and the low GDP growth is the radical inflationary monetary policy at the Federal Reserve. Inflation tends to cause prices to generally rise, from the price of stock market shares to consumer prices. Financial institutions, which the Federal Reserve lends money to nearly interest free, have an elite and privileged position in being the first to get access to the cheap money and prior to the point in time which prices are driven up.
That’s why Wall Street is living high on inflated stock prices, while Main Street has their purchasing power stolen with higher prices for produce, meat, pharmaceuticals, and other products. What’s worse is this reckless monetary policy misallocates resources and causes deep recessions. Austrian Business Cycle Theory explains that cheap money creates an inflation-fueled boom, and this sort of bubble economy eventually bursts. We’ve seen similar patterns through the history of financial markets, including in recent years. On May 31, 2007, the DOW Jones hit a record high of 13,633. A year and half later, in September 2008, the stock market had one of the worse crashes in history and America officially entered the Great Recession. America is in another bubble, and sound money is part of the solution.
“National credit can never be supported by lending money without security, or drawing in other people to do so; by raising stocks and commodities by artifice and fraud, to unnatural and imaginary values; and consequently, delivering up helpless women and orphans, with the ignorant and unwary, but industrious subject, to be devoured by pick-pockets and stock-jobbers; a sort of vermin that are bred and nourished in the corruption of the state.
This is a method, which, instead of preserving publick credit, destroys all property; turns the stock and wealth of a nation out of its proper channels; and, instead of nourishing the body-politick, produces only ulcers, eruptions, and often epidemical plague-sores: It starves the poor, destroys manufactures, ruins our navigation, and raises insurrections, etc”.
– Thomas Gordon, Cato’s Letter No. 4, Against false Methods of restoring Publick Credit, Saturday, November 26, 1720”= (written in the devastating aftermath of the South Sea bubble).
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