A word on trading: We expected money to move after options expirations, but changes to program-trading plans came early, on July 14, we observed in the data. So with expirations July 15-16, markets were shellacked when money shifted to other assets. The past two days have given us massive arbitrage around this shift and ahead of tomorrow’s volatility expirations. Thus, the week could end on a rough note, we fear.

Switching gears, you’ve heard of Direct Edge? It came out of Knight Capital Group and has for many years operated Electronic Communications Networks, or ECNs, called EDGA and EDGX. One was for active algorithms, the other for passive black-box trading systems, in essence.

In 2008, Direct Edge traded Eurex, the operator of the International Securities Exchange, a 31.5% stake for the ISE Exchange. Started ten years ago, it was the first all-electronic options exchange, and it’s one of the globe’s biggest such, offering electronic trading in options for more than 2,000 equities, ETFs, indices and foreign-exchange products. Eurex is itself owned by the German and Swiss exchanges, the Deutsche Borse and the SIX. Direct Edge is partly owned also by Citadel Derivatives, Goldman Sachs and Knight.

With the advent of two new Direct Edge full exchanges tomorrow, EDGA and EDGX, the ISE Exchange will be blended in and discontinued.

Why does this matter to IR? You need to know what’s happening out there. Direct Edge routinely handles nearly a billion traded shares daily. Its platform best serves highly automated volumes in multiple asset classes. It commands about 12% of total equity volume. Its growth mirrors the explosion of global high-frequency trading in equities and other asset classes.

Like other trading innovators, Direct Edge sees growth opportunity in the evolving nature of trading. Both NYSE Euronext and the Nasdaq operate two options exchange each, and midcontinent rival Bats Exchange got approval in February this year for an options exchanges. Direct Edge hopes to offer simultaneous trading in many things – currencies, commodities, stock loans, futures, options, equities.

Why operate exchanges rather than alternative trading systems? It lowers clearing costs, expands data revenues from the consolidated trading tapes (exchanges get a better share than ATS’s), and opens doors to more products for traders.

For IROs, it’s a window into what’s behind price and volume. These are things you have to know now. Markets are fragmented and trading is spread across asset classes. It’s akin to the digital book market. Amazon is now selling more hardback books via the Kindle than in print. That’s how customers are consuming books.

How are customers consuming your shares? One big key to longevity in the IR chair is becoming the source of data and information about trading. We can’t control how traders use liquidity – but we sure can become expert at understanding how it works.

And from that knowledge comes the power to change markets. Or least understand them — and that’s both cool and valuable these days.

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.

The SEC last week sued Goldman Sachs for misleading investors about certain collateralized debt obligations during the subprime mortgage meltdown. We’re not a news rag so we won’t regurgitate the facts and accusations. We’d observe, as did a fine Wall Street Journal blog at Deal Journal yesterday, that the investors supposedly mislead were the world’s most sophisticated CDO investors, that Goldman lost money, and that the disclosures about these swaps that always require two parties with opposing expectations of outcomes were of monolithic proportion. Up to and including acts of God, everybody party to them knew the outcome could be good, bad or ugly.

Which leads to trading last week. Options expired April 15-16 when markets gyrated. Markets were up a hundred points the day before, April 14, then down a hundred points. Today, April 20, volatility futures expired, and short-term trades between stock and index options last week and volatility moves today could pay with little time decay or risk for the savvy trader. There was actually more fundamental buying on April 14, the up day, than fundamental selling on April 16, the down day, data indicated. It’s not always about the news. There is no better proof than what happens under the skin of the market with monthly expirations.

So what’s it mean? Market structure tells us that money thinks the Goldman accusation is hooey.  And speculators were taking advantage of disruption in the markets around expirations. It’s been a fantastic run in the markets since expirations in March when we told you that risk hedges were perhaps the largest we’ve seen. Traders bet big on equity gains from March 19 to April 16, and the move paid off. And the dip on April 16 had little to do with Goldman Sachs.

We promised examples about using market-structure analytics, so we’ll leave you with one. Before its analyst day recently, a large public company wanted to set expectations. We could see reticence on the part of active money to pay up for shares. Speculators were working hard to foster intraday trading ranges, which meant that investors had uncertain views (speculators often know). Thus, meeting expectations alone would be positive, despite high expectations this spring for outperformance.

The stock rose a dollar the following day. Real or Memorex? Often, traders create momentum around analyst days – not difficult in this age of anonymity and electronic trading. But data showed that real money indeed paid $0.75 cents more. Price held up even during the recent market pullback.

It’s darned cool in the IR chair not having to guess if your trading activity is real or noise. As is using that information to make management wonder how in the world you know the stuff you know.

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.

Everybody’s got an opinion on why the market is yinning and yanging. We, I believe uniquely in IR, look at market structure first. That is, we see the trading data and behavior, and then from it we ask, “Why did that happen?”

Most everybody looks at what happens and infers that these are the causes for market activity. But, here’s the thing: money moves for three reasons today – investment behavior, speculation, and risk-management. It’s easy to get it wrong from the outside looking in. Thus, we think there’s greater accuracy in drawing conclusions from the evidence than in applying the evidence to your conclusion.

We saw a large rift form in the equity markets on February 2. Trading and investing activities were subordinated to risk-management flows. These are orders managed by software systems that respond to instructions and data about market risk. It may have been prompted by Greece’s problems. Perhaps American jobs data, or central bank woes in Argentina, where inflation was 17% in 2009. Maybe something else.

But that would be looking in from the outside. Inside looking out, here’s what happened: Systems executing orders for defensive reasons rose up in mass. It’s like a crack in the continental crust that squeezes out the stuff that forms mountains. Except here, it was risk-management volume – both buying and selling – that extruded from the rupture. When it ripples through nearly every issue like a fault line, you may be fairly certain it’s macroeconomic, not about your stock or story.

In fact, from the completion of monthly expirations on Jan 20, to February 4, we saw strong indications of risk management trading. It was similar to what we observed on October 1-2 last year, when the markets nearly fractured, and akin to the “healing” volumes in March and April 2009.

There are certain entry points where these volumes can be found. Among them is Goldman Sachs. When GS appears with large volume increases in 80% of issues (but you won’t see it in trading volumes), it’s a curious thing, and it affects all other behaviors. If you try to isolate whether it’s buying or selling, it’s impossible. All programs do both. So it requires seeing the activity in relation to other activities in order to understand what form of behavior has changed conditions in the markets.

Goldman isn’t alone. In fact, most times these volumes hit the markets through “sponsored access,” one of the activities that the SEC considers a gateway for exploitation. We don’t know if that’s true or not. We do know that in three different significant instances in the past twelve months, sponsored access has helped the markets heal.

We call these events “synthetic weaves” in the markets, stitching up a gash in the market structure. It leaves big question marks. Who’s behind it? Where is the money coming from? Why does it buy and sell seemingly unrelated issues en masse? Is it helpful or hiding a chasm ahead?

We can posit ideas in response, but who’s to say? We surmise, however, that economic data are secondary to the supply and pricing of currencies. And we can think of only one force with that sort capital capability.

Why does it matter? It’s a great way to clear the crowd out from around the water cooler. People quickly go quiet and start glancing at their watches when you let drop “synthetic weave in the equity markets.” Also, it helps explain why your business isn’t properly valued by trading markets.

TRAVEL UPDATE: I’m in Kansas City today joining Joe Ratterman, CEO of BATS, and Jeff Albright, head of equity trading at Waddell & Reed, for a NIRI panel on how stocks trade. Thursday Jan 21, I’ll be at the NYC NIRI meeting with Professor Bob Schwartz of Baruch College, Jim Ross from NYSE Euronext, and Donald Bollerman of Nasdaq OMX to “demystify the markets.” See Events & Articles at modernir.com for more, and join us.

Last Friday, money moved from equities to derivatives as options expired. News perhaps influenced the shift, but on the whole, trading was a sum of reactions. These shifting sands haven’t changed much since June last year. Despite the reasons why not, we hoped for more rational enthusiasm in the New Year. Instead it’s more of the same. Money isn’t acting, it’s reacting. Market behavior is determined by other market behavior. There’s no goal to outcomes, except to adapt.

That part isn’t surprising. Capitalism is the profitable adaptation to change. Now, around the globe, the mortgage markets, the banking industry, a large portion of the automotive business, the insurance markets in substantial part, a growing portion of the health care sector, the breadth and scope of risk management, and the chief medium of exchange, the dollar, are defined by something other than profitable adaptation. What’s left is tick-by-tick trading. No wonder that’s what we’ve got.

Speaking of trading, Mary Shapiro said last week that the SEC may soon prohibit “naked access,” a somewhat voyeuristic term for renting out your courtside box seat at the equity market. It’s better termed sponsored access, because you’re using somebody else’s seat.

Shares today move at bionic speed. That renders ponderous trading moot at most times. It consigns small floor brokers and old-fashioned one-customer-at-a-time orders to the backwaters and eddies. So imagine you were on Main Street and all the big-box retailers in the suburbs emptied the town of customers. Then somebody came and said, “I’m going to run eighteen-wheelers down Main Street. I just need your store as a loading dock.” That’s sponsored access.

Sure, some sneaky forces use it. But the SEC is yet again regulating to capillaries to the harm of arteries. An example: KeyBanc Capital Markets, a full-service broker-dealer and money manager offering research and underwriting but no algorithmic trading, in October began using SunGard Assent for sponsored access, algorithmic trading and access to dark pools. Keybanc can’t compete on the trading floor. Assent gives them the access, speed, risk-management and trade-optimization tools they lack.

Assent itself is a product of market evolution. Assent was formerly Andover Brokerage, a provider of trading systems under the HammerTrade brand. We used to consider their volume proprietary day trading.

The SEC and others, including Goldman Sachs, think sponsored access might increase risks. If we have lots of it and the markets have behaved well, where’s the evidence? We have seen data that suggest to the contrary how sponsored access may have crucially forestalled a global equity retreat October 1-2 of last year. Risk-management, we observe, is often a primary purpose for sponsored access – not its biggest shortcoming. Sponsored access provides a means to move large liquidity fast and within market rules. This is essential to offsetting slippage in other asset classes when you’re managing risk.

Perhaps an exception will be granted for the Keybanc form of sponsored access. Yet, that’s the root problem at all levels – at least in the USA. We are about uniformity. That’s what “created equal” means. Our form of government is supposed to reflect uniform justice. Instead, it’s a gigantic collection of exceptions.

I’m moved to reference Section 15A-6 of the SEC Act. It’s for broker associations like FINRA, but the principle applies:

“The rules…are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information…to REMOVE IMPEDIMENTS TO AND PERFECT THE MECHANISM OF A FREE AND OPEN MARKET…to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers…or to regulate by virtue of any authority conferred by this title matters not related to the purposes of this title…”

Perhaps the SEC should return to basics. The best way is not to do, but to undo.  IR professionals and the business of forming capital and fostering creative, productive enterprises would benefit. Investors would again find equity markets a place to leave money for the long term with an expectation of a return.

We’re moving the Market Structure Map to a blog, to invite comments (so please comment!). Don’t worry, we’re not about to start tweeting. But I do like the interactivity at the blog. We’ll dual track with the email awhile, then move to alerts about the weekly post.

In the Michael Jackson movie “Just Do It,” the legend is backed by a cadre of dancers in one scene, who, through “green screen” technology are replicated so that it appears to viewers to be a vast dancing army.

Vast Dancing Army would be a good name for a rock band. And Green Screen might be at work in the equity markets. Is trading real, or replications that create an illusion meant to mimic reality?

It’s an important question. Ben Bernanke said yesterday:”We use our interest rate tools to try to meet our mandate — full employment and price stability.” A tagline on the European Markets WSJ update today read: “Traders said stock-market sentiment remains positive, buoyed by rising faith in a global economic recovery.”

The Fed can’t prestidigitate jobs, resulting in full employment, or magically materialize price stability reflective of balanced supply and demand. It can only toy with monetary tools to produce a facsimile of that outcome in the behavior and availability of money. Markets can only reflect whatever factors affect the behavior of money.

So, do markets reflect rising investment and production, or just a facsimile thereof? And if so, what’s that mean to your stock price a week or a month or a year from now? These are the questions that matter to IR. Alas, monetary factors, and the traders’ responses to them, carry more weight at the moment than your business fundamentals.

Here’s an example. On November 12, we saw a marketwide hedge reset in equities. Quite literally, it was a seismic ripple through every shape, size and form of equity. Institutions use risk-management systems and software to modulate risk relative to economic factors and monetary policy. These systems use the same data, so the effects are similar. And they invariably happen ahead of options expirations, occurring this week.

Electronic trading is initiated to rebalance mixes of securities. Not just equities, but other instruments ranging from debt to treasuries, to commodities (which can now be traded daily in Exchange Traded Commodities vehicles), and currencies (which can also be traded in ETCs). So on Nov 12, these assets were tweaked. On Nov 16, when LEAPs – long-term market futures – converted, institutional asset managers did not renew their portfolio insurance at the same levels, and instead put some money into equities.

Boom, the market shot up. We saw the same thing around LEAPs expirations on July 13. It’s eerily similar.

The question is: what’s real? Is this a response to fundamentals, or a reaction to monetary policy?

The data tell us it’s a Green Screen. We’ve seen aggressive fundamental money in the markets recently. But on the whole, volumes are muted. Electronic volumes were way up – but part of that is risk management and part is money that’s been on the sidelines and is now desperate to make up for lost time before year-end.

On the whole, the stuff that’s given us 60% gains in the market this year – hedge fund traders and gigantic prime programs using free money – is shifting out of the markets. Goldman Sachs, we’ve noticed, is trimming volumes on its trading desks. There is a dearth of “commission recapture” execution, or trades that occur in response to research. Active money hitting markets on electronic platforms is tactical, not strategic.

We follow data. The data suggest that there’s less here than meets the eye.