Unfortunately, not many people have paused in the midst of the current financial and economic crises to ponder the basics: exactly what are financial markets supposed to do? I began arguing in April 2008 (when Bear Stearns collapsed) that the instability in the financial system was very tightly concentrated in only a handful of the biggest firms, due to those big firms’ domination of trade in financial derivatives (a point which has been reinforced just a few days ago by a new report from Fitch Investors Ratings Service, which shows that just five firms JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley held 80% of the derivative assets and liabilities and 96% of exposure to credit derivatives, of 100 companies reviewed by Fitch), and that derivatives actually do less than nothing to help the real economy; i.e., they do more harm than good.
The past two weeks, details have emerged about how Goldman Sachs has used its dominant market position to create computer-directed milli-second trading programs to engage in what is called High-Frequency Trading -- which as far as bobswern has pointed out, is front-running, plain and simple.
Robert Kuttner proposed the obvious solution, by looking at the basics:
Consider for a moment some first principles. The legitimate and efficient function of financial markets is to connect investors to entrepreneurs, and depositors to borrowers. There is no legitimate reason whatever for this to be done by the millisecond. At bottom, the process is pretty simple. The intermediary--the bank, savings institution, or investment bank makes its fees for making a judgment about risk and reward. How likely is the loan to be paid back? How high an interest rate should it charge? How should a new issue of securities be priced? The investor decides whether to indulge a taste for risk or for prudence.
But the hyperactive trading markets and creations of recent decades such as credit default swaps and high speed trading algorithms add nothing to the efficiency of financial markets. They add only two things--risk to the system, and the opportunity for insiders to reap windfall profits.
Therefore, whether or not Goldman's lawyers have figured out how it can engage in High Frequency Trading and stay within the law, there is a strong case that this entire brand of financial engineering should be prohibited. . . There is absolutely no gain to economic efficiency from having prices of securities change in milliseconds, and much gain to the opportunities for manipulation. . . .
. . . it is a mark of Wall Street's stranglehold on politics that the most sensible of remedies seem impossibly radical. One very good way to damp down the dictatorship of the traders, and raise some needed revenue along the way, would be through a punitively high transactions tax on very short term trades. Genuine investors should get favored fax treatment. Pure traders should be taxed, and very short term manipulation taxed into oblivion.
If the financial crisis has proven anything, it is that capital markets have become an insiders' game in which trading profits crowd out the legitimate business of investment. The whole business-models of the most lucrative firms on Wall Street are a menace to the rest of the economy. Until the Obama administration recognizes this most basic abuse and shuts it down, it will be more enabler than reformer.
For those who want more details on how these computer programs operate, and the havoc they are wreaking in financial markets, two weeks ago, Lambert on Correntewire.com linked to the detailed analysis by Themis Trading, Toxic Equity Trading Order Flow on Wall Street: The Real Force Behind the Explosion in Volume and Volatility, by Sal L. Arnuk and Joseph Saluzzi. Quotes:
. . . electronic trading, the new for-profit exchanges and ECNs, the NYSE Hybrid and the SEC’s Regulation NMS have all come together in unexpected ways, starting, coincidently, in late summer of 2007.
This has resulted in the proliferation of a new generation of very profitable, high-speed, computerized trading firms and methods that are causing retail and institutional investors to chase artificial prices. These high frequency traders make tiny amounts of money per share, on a huge volume of small trades. . . .
This paper will explain how these traders – namely liquidity rebate traders, predatory algorithmic traders, automated market makers, and program traders – are exploiting the new market dynamics and negatively affecting real investors. We conclude with suggestions on what can be done to mitigate or reduce these effects. . . .
High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.