August 10, 2016

Light Speed

Alert reader Raj Mehan at Steelcase forwarded a piece from the Wall Street Journal about traders now aiming with machines to execute stock-market transactions near light-speed.

Why the rush?  Companies take flak for “short-termism” that’s a quarter long and yet regulators and traders and academics extol the virtues of fast trading, claiming it makes markets liquid and efficient.

Just this week I was speaking with a CFO for a public company who yawned at the idea he should care about what priced his stock. “It’s interesting but what difference does it make?”  I’m paraphrasing a longer exchange. It’s a vital point of contention, right?

We’ll come to that in a moment. Watching the Olympics this week – exhilarating as ever – the race for speed in the water is stupefying.  Seeing Katie Ledecky crush the field by five seconds for a gold metal gives you goose bumps no matter your country. And the objective of swimming-speed is winning.

It is for traders too. In the WSJ article by Vera Sprothen, folks from high-speed trader DRW Holdings LLC (stands for Donald R Wilson) said competition in financial markets is accelerating the race. A nanosecond is a billionth of a second. Routers can send and receive stock-exchange data in 85 nanoseconds, which is how much time elapses when a bullet fired from a gun travels a half-inch.

Imagine. You fire at a shooting-range target and before the bullet gets there somebody trades your stock several hundred times.

If I’m making a big-ticket purchase the last thing I want is – snap! – to do it faster. Many of you are investor-relations professionals. Do some investors study your business for a year or two before deciding to buy your shares? When I was an IRO, that was common.

Weighty decisions are not made for light speed.  Therefore, traders are not making weighty decisions. Committing capital over time is a risky gambit. Capital deployed the amount of time needed for a bullet to travel a few feet isn’t so fraught.

It’s also not investment. Understand: The stock market in the USA and ever more around the world too is one in which the first trade to arrive prices the stock for everyone. Many stock-trades are paired with other things such as options or currencies or commodities.  Price one superfast, and race over faster than a speeding bullet to something else, and you can make money by taking advantage of price-differences. That is by definition arbitrage.

The efficiency of markets is best assessed by determining how much arbitrage occurs. There’s a lot of arbitrage in booking a hotel room on line. There’s no arbitrage in buying a cup of coffee at Starbucks (unless somebody at the Univ of Chicago wants to study that question and prove me wrong).

In the stock market, almost half of all volume is arbitrage. It may be the most colossally inefficient capital market ever created by human beings. Back up 20 years and it wasn’t. Just 15% of trading could be attributed to arbitrage, and 85% to investment.  Speed and price-differences now consume it.

Which brings us back to our apathetic CFO. If you don’t care about the market for the backbone of your balance sheet enough to understand it, you should be a private company where there’s less arbitrage.

For IR pros in the 21st century, it’s a huge opportunity. Not only is there confidence in knowing how the market works, but somewhere today there’s an IRO who will, having learned, help change the market tomorrow.

Problems are solved after we first understand them.  Most prices for stocks should not be set at the speed of light. Yet that’s happening.

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