I’m not sure that’s funny. But it segues to the stock market. So let me tell you a story about a severed foot in a sock.

Nets have been cast wide to discover what went wrong in the markets last week. There were hearings today before the House Subcommittee on Capital Markets. There have been wringing regulatory hands. Scott Patterson postulated in the Wall Street Journal that a Black Swan waddled through, courtesy of a tail-risk-timed futures bet by a Santa Monica hedge fund.

Looking at client data, the reason why the mystery cannot be solved is because there is no mystery. Our conclusion about trading on May 6-7 after studying prodigious data: In the absence of value and real buyers and sellers, machine-driven markets may collapse. This indeed is tail risk or a Black Swan – severe divergence. But markets functioned as machine markets will, and it was nobody’s fault.

Here’s why. High-frequency systems generally furnish shares and hold no positions. When they trade with each other, the trend of the crowd – general market sentiment – is magnified, be that fear or greed. High-speed trading systems don’t represent a thoughtful search for value; they’re the other side of the trade. Period. And if high-speed systems are BOTH sides of most trades, market reactions can be extreme.

This is how Accenture can briefly trade for a cent. Registered market makers put in wide bids and offers so they can transact between. If you intend to trade inside the best bid or offer, you might, for a $50 stock, set your offer at $100 and your bid at $0.01. If your bid suddenly becomes the only one and some panicked body enters a market order to sell, the trade will execute at one cent. Blaming traders for getting out of the market is like excoriating the signal man on the track for stepping away from in front of the train.

Most days, there is no trend. There is continuous reaction by speculative systems to actions from risk managers and investors. Passive, high-frequency market-making is speculative no matter what anyone says. It’s trading for trading’s sake. Period. When speculators encounter markets devoid of actual buyers, sellers, or risk managers, extreme bids and offers set prices. And the Dow drops 1,000 points in minutes.

We’ve been saying since 2008 that the market is a synthetic construct susceptible to a giant tear in the continuum. Regulators and even the exchanges are looking in the wrong place for answers. Rather than asking who screwed up, we should be saying, “Holy cow. The foot in the sock is severed.”

For a brief, terrifying period on May 6, we stared cold truth in the face: Nobody saw widespread value, even as the market dropped 1,000 points. That should wake us up.

Our markets don’t have any clear value. There is something radically wrong when liquidity is the only thing propping them up. Here’s an analogy: picture four people at a card table. One has a large stack of dollar bills. The other three are poised. Each time the one lays a dollar on the table, the other three slap to grab it and the fastest keeps it. When the dollars stop coming, the game dies.

Now consider what happened yesterday. Markets popped back when Europe devalued its currency. That’s what pumping $1 trillion worth of Euros into the system is. When markets respond favorably to devaluation, prices reflect inflation, not value.  Our global market and economic construct is predicated on liquidity in place of value. Sooner or later you run out of liquidity and the whole thing crashes down. No amount of printing and dumping more into the system is ever going to fix it.

That’s the bad news. There’s good news too. We saw vast disparity in client data. There was no discernible pattern, because it was, to quote funny man Jeff Foxworthy, “pandelerium.” But here’s the interesting thing: we saw strength in the market structure of clients with firmer commitment from informed money. Value matters. Resilience stems from value in the eye of a beholder, not from automated quotations.

We’re at what Barack Obama would call a teachable moment: The sustainable basis for healthy, vibrant markets is the infinite variety and intelligence of the opinions of buyers and sellers transacting with currencies of constant value.

If we want our IR jobs to count for more again, our governments must stop this insane, insatiable stream of liquidity from central banks. Yes, it would hurt for a bit, but imagine the grand and verdant vistas of value beyond the shadowy valley. We’re all in this muddy liquidity puddle together, be it with Yen, Euro, Dollar, Sterling, Loony or whatever.

Let’s put our foot down about this. Or we’ll be left with a severed one in our stocking. Again.

Speaking of power outages, starting April 22 equity markets developed voltage problems. IR professionals, we’ve got two words for when you meet the CFO in the hallway and she asks, “What’s up with the stock market?”

Risk Management. What two words did you think we were going to offer? “Risk Management” is why the same stocks that were up yesterday can be down today. We saw surging European and Asian inflows April 22, and a reversal of the same inflows on April 27.

From the IR chair, it’s flummoxing. Your nearest peer, in the same industry, about the same market cap, doing similar things, reports results on April 22 and beats expectations and soars 10% in a day. You then report the same good results almost pound-for-pound, a handy beat. And your stock declines three percent.

What gives?

Time for those two words: “Risk Management.” Large portfolio trading schemes such as pension and investment funds may hold an array of securities. Let’s say euro-zone bonds, currency futures, US Treasuries and US growth stocks. Suppose these investments are protected with risk metrics software from SAS, and trading-desk level systems from prime brokers JP Morgan and Deutsche Bank. These systems are designed to monitor and maintain portfolio risk and return within certain parameters.

Greece’s bailout is approved. The systems determine that this will strengthen the US dollar, thus weakening inflows to US equities from European and Asian sources. The systems themselves execute automated trades, complete with offsetting derivatives, to control risk.

This behavior causes a domino effect. The same securities the system said to buy last week are now the ones it sells. That triggers other limit orders and stop-losses, changes the nature and size of passive market-making trades, and attracts statistical arbitragers finding fleeting imbalances. And because ONE variable in the overall risk-management schematic is different – maybe a risk metric is the ratio of dollars on reserve at the European Central Bank, which has just returned a bundle of them to the US Federal Reserve – it over-corrects.

The next day, the system tries to rebalance the overcorrection, producing a spike in US securities again. Commentators bray about renewed enthusiasm for US economic growth, which in fact plays almost no role. Leveraged ETFs had just today adapted to yesterday’s big risk-management change. Now those are out of balance.

Suddenly, inefficiencies abound. Passive market-making systems aren’t getting liquidity to the right spots fast enough. Stat arbs are executing simultaneous offsetting trades in ten different market centers, creating the illusion of movement where none exists.

And the next day, the risk-management system tries to rebalance again.

This is how you get great volatility in markets designed to function smoothly and efficiently.

You don’t need to explain it in detail to your CFO. But you should be able to say, “We have integrated global markets. Our results, which were great for our active investors, now are secondary to global risk management. That’s the reason we’re under pressure. It’s a portfolio problem.”

But portfolio problems are our problems too. What’s the answer? We invite your suggestions. Meantime, be sure management doesn’t take it personally. It’s not always about you.

Meanwhile in Europe, Morgan Stanley launched a lending book for European Exchange Traded Funds (ETFs) today. Here is the key to understanding financial reform currently mucking up Congress. It encapsulates everything that’s wrong with today’s capital markets.

You may think we’re overstating it. Nope. This is the Grand Unified Theory tying all manner and form of derivatives together, and illustrating how high-frequency trading fits in this puzzle.

It’s not Morgan Stanley’s fault. The bank didn’t create the rules. The story today at UK financial publisher IFA Online about the ETF launch concludes: “Morgan Stanley says by providing a constant supply of manufactured inventory, ETF borrowers can benefit from lower borrow fees than current market rates, and greater availability of ETF supply.”

Broker-dealers under existing rules use a create-to-lend process with ETFs. They borrow shares of the underlying components of an ETF, then use that inventory to create new shares of ETFs for trading. Then those new ETF shares may be lent out for shorting, because the broker-dealer can pass through liquidity from the borrow market for the underlying securities – stocks comprising the ETF – to those shorting the ETFs. Voila, instant arbitrage opportunity.

This process increases liquidity, which is good, except that a market thirsting for liquidity has a value problem, not a supply problem. Supply-growth also spawns derivatives that have no underlying assets. That’s like a single batch of residential mortgage-backed securities carved into multiple tranches of collateralized debt obligations that don’t represent the full underlying value.

It’s also what happens with our money. Member banks of the Federal Reserve may use Tier 1 and Tier 2 capital to create money on their books in what is called fractional lending. That’s derivative capital – something for nothing. Similarly, dollars issued by the Federal Reserve in support of US-government backed obligations are derivatives disconnected from either the assets of the country or its productive capability to meet and service those obligations. Just like the CDO market that collapsed in 2008.

Now add in high-frequency trading. As TheStreet.com writer Don Dion observed in August last year, “Both bona fide market makers and proprietary traders are seeking out the fastest way to hedge trades, create units and maximize ETF trading capabilities.”

ETFs are assigned a lead market maker like Morgan Stanley, which fashions the first units and delivers the underlying mix of stocks to the sponsor in exchange for them. After that, it can sell shares of the ETF to buyers and hedge with equivalent mixes of underlying shares. By balancing out these two and fashioning more ETF units, then doing these same things at high speed, trading trumps investing and arbitrage becomes the goal, rather than capital formation.

Making money on the spreads between residential mortgages and their collateralized derivatives is a form of arbitrage. Do it a bunch and make a ton of money.

When the Federal Reserve issues debt obligations for the government and then increases the supply of cash, it is arbitraging the value spread between the earlier debt-denominated dollar and the later, cheaper version. When ETF creators and investors buy and sell the ETFs and the underlying securities, it’s arbitrage.

And when all these things are happening simultaneously, nobody knows the real value of anything anymore. No ratings agency can accurately assess risk because no single instrument represents the full picture.

The Federal Reserve, according to statistics at its web site, was counterparty to primary dealers for transactions totaling $12 trillion of US Treasuries and mortgage-backed securities in 2009 alone. It also says that trading in government obligations averaged $570 billion DAILY in 2007. The Fed provides no current statistics, but by comparison, daily dollar volume in NYSE and Nasdaq stocks combined is less than $100 billion.

If we want this something-for-nothing, derivative problem to stop in the private sector, the government needs to get out of the derivatives business itself, first. The very body wanting to regulate this activity is the one fathering it all.

That’s the Grand Unified Theory of derivatives. It’s the notion of creating something from nothing. Something for nothing subsumes our society, our markets, our financial instruments, and our currency. The chief propagator of this policy is the government itself.

This should get our attention across the spectrum of interests, from Left to Right. We can’t treat symptoms like Goldman Sachs and expect the disease to disappear. We need to rip out the root, which is, frankly, the Federal Reserve Bank, the limitless source of manufactured ETF-like paper from government. That’s the cancer killing our markets and pointlessly enriching banks.

Speaking of derivatives, the dollar retreated today, and US equities rebounded. We all want it to be about investing. Commentary everywhere today polished bullishness to an economic sheen. But that won’t make it reflect reality. Money keeps buying short-term love because the direction of the dollar is like a blacksmith’s bellows on equities.

Tomorrow starts three days of expirations. We saw speculative trading spike last week, while European money returned on Feb 10. Traders had already discounted Greece’s woes and had gone searching for alpha. There are too many reasons for traders to pursue global statistical arbitrage (and regulators keep giving them more). Translating, that means it’s fun trading similar instruments in opposing fashion in different places to profit on spreads and timing, and not much fun investing in stuff.

What changes that? Funny you ask. We want to hate banks. We’d like it all to be Goldman Sachs’s fault that our economy is bloated on derivatives. Those blasted Wall Streeters and their nefarious schemes, like borrowing money at 15 basis points from the Fed, then using it to buy Treasuries paying 350 points of interest. Taking TARP cash and trading with it. Manufacturing reserves and using them to float atmospheric notional value swaps for obscene fees.

All that may be true. But banks don’t set interest rates on Fed money. Banks don’t decide, “Hey, let’s go con the Fed out of some cash.” Banks don’t determine the size of the money supply. Banks don’t write reserve rules. No, while we’re all tarring and feathering sellside CEOs, the folks spraying gasoline on everything and playing toss-the-match can be found at the Federal Reserve.

If we don’t want our stock markets to behave like roulette wheels, we must stop playing with Federal Reserve house money, which is cheap and artificial – or shall we say, derivative. Primary dealers from Barclays to BofA march as the Fed orders. Don’t think those folks who OK’d 100-cents-on-the-dollar payouts to AIG counterparties are aw-shucks hayseeds who got jobbed. They knew what they were doing. We should be asking why, rather than railing at the foot soldiers. We may not like the answer, but it’ll be true.

Speaking of money, I personally put cursor to Excel workbook and tallied 2009 earnings before non-cash items and taxes for seven of the primary dealers – the eighteen big US, European and Japanese banks commissioned by the Federal Reserve to make orderly markets in dollar-denominated US obligations – and came up with $185 billion. With a ‘b.”

From whence came these profits? Who deployed cash in the capital markets? It wasn’t institutions and individuals. The US government deployed about $3 trillion. Lord only knows how much came from other global central banks.

Lesson of the day: Governments create money. Goldman Sachs is not responsible for it. Banks work with what they’re given. If they get a gigantic mountain of cash, you can bet they’ll work with it.

If we want more investing and less trading, we might dump all that snow on the east coast atop the Federal Reserve and put the fire out. Unless Whistler offers a better deal.

If you wondered why your trading seemed odd that day, there’s a good chance it had to do with inscrutable black-box risk metrics run by major sellside firms helping the buyside modulate macroeconomic risk.

Oh, for the days when buyers and sellers set prices.

Volatility contracts expire tomorrow, Dec 16, and the usual index, treasury, currency, bond and other futures and options contracts cease Thursday and Friday the 17th-18th. Also, Christmas week, the S&P 500 futures, the SPL/SPX contracts, convert, and a new SPL series is added.

What do these mean to the IR job, and how do they work? SPLs and SPXs are options to buy or sell the S&P 500 index at future dates. They can be used as an asset for margin, as protection against risk, for trading volatility, for synthetically adjusting portfolios to mimic the S&P 500 without buying the actual elements – all kinds of things. How the market behaves around these expirations is like seeing the attitude of money rather than hearing the words it speaks.

Here’s the key: contrary to prevailing notions, derivatives are not an evil tool of wicked free markets. Derivatives are always an effort to deal with price and risk uncertainty. The more widely they’re deployed, the greater the risks and uncertainties. Risks and uncertainties are greatest in speculative markets and highly regulated markets. In both instances, the role of value in setting prices is obscured.

IROs and execs, these features matter. Imagine going up the down escalator. This is the nature of the capital markets at present. Too many factors are interfering with natural price-setting mechanisms. In order to explain what seems inexplicable about your share price at times, it’s necessary to understand how the value of money and the effects of risk-management work in equity markets.

We continue to say that the single largest problem now is Federal Reserve policy. Central bankers believe that the supply of money, which represents an exchange of value, can increase, even if there is no exchange of value. On corporate balance sheets, these conditions would result in a reduction to retained earnings, a dilution to equity, a writedown of asset values, or a journalizing entry affecting net worth in some way.

But that doesn’t happen in Federal Reserve policy. Inevitably, a bubble forms someplace.