Monday, March 31, 2014

Is the Stock Market Rigged?

It has already been promoted on 60 Minutes, but even without the boost Michael Lewis’s new book, Flash Boys: A Wall Street Revolt is guaranteed to be a best seller.

More importantly, it might very well make history.

Lewis is telling us that the stock market, the ultimate free market, is being rigged. He will show how an intrepid group of young people has been trying to restore fairness to the market.

Naturally, the story about how big banks and brokerages are using high-frequency trading to skim a miniscule profit off of every trade has attracted the attention of ambitious politicians.

It is almost inevitable that they will draw up new regulations and portray themselves as the champions of fairness. Unfortunately, unscrupulous traders seem always to be able to find a flaw in the regulations. They will exploit the flaw until they are caught.

Lewis does not tell how government bureaucrats cracked down on market skimming. He shows how people like Brad Katsuyama, Ronan Ryan and Rob Park are changing the system by introducing a trading platform that can eliminate the skim.

More importantly, for my purposes, Lewis emphasizes that markets can only work fairly when their participants behave ethically.

In the excerpt that the New York Times Magazine has published, Lewis emphasizes that when a young Canadian trader named Brad Katsuyama moved to Wall Street he was struck by how offensive the people were.

You may think, perhaps correctly, that the Occupy Wall Street crowd was especially offensive. You may believe that young radicals are extremely offensive. But, if you believe that college students are missing a couple of ethical behavior genes, you must accept that many of Wall Street’s high frequency traders are similarly deprived.

A free market is not a free-for-all. It is not a dog-eat-dog jungle where everyone is trying to rip off or to screw everyone else. Market participants are morally obligated to maintain market fairness. If they reduce it to the lowest common moral denominator—their personal greed-- it will fail.

Lewis explains what Katsuyama found when he moved from Canada to lower Manhattan in 2007:

It was his first immersive course in the American way of life, and he was instantly struck by how different it was from the Canadian version. “Everything was to excess,” he says. “I met more offensive people in a year than I had in my entire life. People lived beyond their means, and the way they did it was by going into debt. That’s what shocked me the most. Debt was a foreign concept in Canada. Debt was evil.”

Katsuyama should have known, and he certainly should know by now, that debt, public and private, is as American as cherry pie. If Americans were living beyond their means in 2007, afloat on a sea of debt, they have, of late, outdone themselves.

In fact, there’s so much debt that no one knows how to solve the problem except by creating more debt.

Katsuyama was working for the Royal Bank of Canada, a place where the culture was defined by, God help us, niceness. The concept defined the way RBC did business:

There was even an expression used to describe the culture: “RBC nice.” Although Katsuyama found the expression embarrassingly Canadian, he, too, was RBC nice. The best way to manage people, he thought, was to persuade them that you were good for their careers. He further believed that the only way to get people to believe that you were good for their careers was actually to be good for their careers.

Again, business involves ethics. It involves doing the best for clients. And you cannot be doing the best for your clients while you are messing with their trades and skimming money off the top to enrich yourself.

One might believe that real men do not want to be nice. They prefer to cultivate their capacity for ruthlessness. Don't nice guys finish second?

And yet, the concept of the gentleman derives from the concept of gentility. Not because it is trying to weaken men, but because no one becomes an adult without playing the game according to the rules. Niceness is about good sportsmanship, and good sportsmanship means respecting the game. If the game is not fair, then no one will respect the results.

The same applies to democratic nations. If everyone believes that both parties are playing fair, the results of elections, even the results of administrative fiat will be respect. If, however, everyone believes that politicians are in it for themselves, or worse, that they are imposing their ideology on an unwilling electorate, democracy will fail.

It is not easy to describe high-frequency trading. In truth, next to no one understands it. That’s why its adepts have been getting away with doing what they are doing… screwing not only the individual investor but many institutional clients.

Lewis makes an excellent effort to describe how the system works:

Broadly speaking, it appeared as if there were three activities that led to a vast amount of grotesquely unfair trading. The first they called electronic front-running — seeing an investor trying to do something in one place and racing ahead of him to the next (what had happened to Katsuyama when he traded at RBC). The second they called rebate arbitrage — using the new complexity to game the seizing of whatever legal kickbacks, called rebates within the industry, the exchange offered without actually providing the liquidity that the rebate was presumably meant to entice. The third, and probably by far the most widespread, they called slow-market arbitrage. This occurred when a high-frequency trader was able to see the price of a stock change on one exchange and pick off orders sitting on other exchanges before those exchanges were able to react. This happened all day, every day, and very likely generated more billions of dollars a year than the other strategies combined.

Since Lewis counts among those who explained the financial crisis of 2008, he is well qualified to explain the connection between the two kinds of market corruption:

The same system that once gave us subprime-mortgage collateralized debt obligations no investor could possibly truly understand now gave us stock-market trades involving fractions of a penny that occurred at unsafe speeds using order types that no investor could possibly truly understand. 


JP said...

The bigger problem is that the Fed is rigging the market by poofing billions of dollars into existence every month through QE infinite, now winding down.

If money streams into the market, the market goes up nicely.

When liquidity dries up, you get 2008.

And, yes the market is rigged in the way he's talking about in this article.

See Jeremy Grantham for more information:

"Over the next seven years we think the market will have negative returns. The next bust will be unlike any other because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before."

Stuart Schneiderman said...

For what it's worth, I agree with you. I appreciate your giving us a link to the story about Jeremy Grantham. He is one of the best and most responsible and most respected money managers.

Lastango said...

Picking up on what JP said, the market is rigged in two larger, more important ways than the three technical avenues mentioned by Lewis.

First, major swings can be forecasted in advance because these are driven by government policy. Insiders are hard-wired into the government, and know when to enter and exit positions because -- in today's incestuous financial/public environment -- the insiders ARE the government. For instance, they know when to exit, cash in on the downswing, and then buy back in a pocket the difference. They know this because the downswing is engineered.

Second, they know when to front-run specific opportunities because they know in advance which entities have the power and privilege to be able to leverage the corporate/government cronyism which has become the source of concentrated wealth in our society.


FWIW, I'll share my perception of the American view of personal debt. Americans are accepting huge amounts of personal debt because, at some level of awareness, they expect to never have to pay it back because society will bail them out. Their debt will be forgiven. The burden transferred from them to the banking system, and from there to the national debt. We have seen this already in the de facto bailout of "homeowners" after the housing collapse, in which people who overbought were allowed to stay in their homes through restructuring and stopping foreclosures. Then next installment of this inevitable trend will be the forgiveness of student debt -- a process already underway.

Who gets screwed? Everyone who has built something up, who has saved. Their wealth is transferred to the banking matrix and the spending class. In the latter group, the winners are the ones who spent the most, who piled up the biggest heap of obligations and then walked away from debt while keeping the goods.

Ares Olympus said...

Michael Shuman's got a good perspective on restoring local investing, to help escape the insane wider markets, and strengthen local communities.

His 2012 speech, based on his book "Local money, local sense" is good:
And more recent interview last week he has many suggestions for people to get better returns, with more control.

It may seem unrelated, but reality as long as we all have to save for retirement, and we all feel beholden to distant investments to get returns for that imagined promised land, we're going to take advice from the same people who profit from market bubbles, profit on the way up, profit on the way down, and profit all around, on OUR money.

So whatever it might mean to reverse the financialization the economy, it must be for individuals to take a greater responsibility towards their investment choices.

I agree with the idea that "financialization" and debt explosion in all aspects of the economy represents the end-game of the globalization racket we've been playing since the end of WWII.

Once you run out of people who are willing to borrow more money, the game will end, but its hard to tell how many more incentives we can create to double-down our debt loads into new instruments.

My heart is still voting with Wendell Berry's sales resistance, but its really hard to pass up free money, no matter how many wolves are at the end of the road.

The Markets need to be regulated to reduce unequal access to information for instance, but common folks need to see their self interest no longer lies with the financial wolves.

Wendell Berry, Conservation is good work, 1992

... If we think this task of rebuilding local economics as one large task that must be done in a hurry, then we will again be overwhelmed and will want government to do it. If, on the other hand, we define the task as beginning the reformation of our private or household economies, then the way is plain. What we must do is use well the considerable power we have as consumers: the power of choice. We can choose to buy or not to buy, and we can choose what to buy. The standard by which we choose must be the health of the community - and by that we must mean the whole community: ourselves, the place where we live, and all the humans and other creatures who live there with us. In a healthy community, people will be richer in their neighbors, in neighborhood, in the health and pleasure of neighborhood, than in their bank accounts. It is better, therefore, even if the cost is greater, to buy from a small, privately owned local store than from a chain store. It is better to buy a good product than a bad one. Do not buy anything you don't need. Do as much as you can for yourself. If you cannot do something for yourself, see if you have a neighbor who can do it for you. Do everything you can to see that your money stays as long as possible in the local community. If you have money to invest, try to invest it locally, both to help the local economy and to keep from helping the larger economy that is destroying local communities. Begin to ask yourself how your money could be put at minimal interest into the hands of a young person who wants to start a farm, a store, a shop, or a small business that the community needs. The agenda can be followed by individuals and single families. If it is followed by people in groups - churches, conservation organizations, neighborhood associations, groups of small farmers, and the like - the possibilities multiply and the effects will be larger.