May 23, 2012

Losing Facebook

What’s green and brown, and rolls? The terrain south of Santa Fe where we rode 103 miles on bikes Sunday, averaging 15.6 mph through 4,500 feet of climbing and insistent New Mexico winds. Icing: We saw the eclipse, glimpsed through a combination of my Droid and some passerby’s strip of roll-film. We were pleased.

Less pleased were buyers of Facebook shares. Another market-structure lesson, IR folks.

Remember the Infinite Monkey Theorem (now also a winery here in CO)? The notion was that infinite monkeys randomly clicking keys of infinite typewriters – dating the era from whence this theory arose – could reproduce our great literary works by accident.

Whether ‘twas to be or not, the Infinite Monkey Theorem tripped up trading at the Nasdaq in Facebook. With trades machinating through theoretically infinite combinations of data points, it was impossible for Nasdaq engineers to anticipate every erroneous outcome. Thus, hypothetical monkeys pounding figurative keys bumbled into an unanticipated event.

Part B. Confusion over who owned what when the music died shouts through a bullhorn at us about the way markets work. Most trades are intermediated using shares that, for lack of a better descriptor, are rented. The buying and selling is often (60%+) not real.

You’ve seen an auction, right? “Do I hear $42?” Somebody raises a finger, and the price of the thing up for auction becomes $42. Is that what the buyer pays? No. It’s a bid.

That’s what most trades have become. Trades have to meet at the best bid or offer. That gave rise to massive amounts of quotes that were immediately canceled. But a whole lot of bids and offers are incremental gambits – shill bids – to just move fragments of liquidity at fractions of surrounding prices. These trades in milliseconds between intermediaries shuffling shares according to complex rules don’t settle.

There. We said it. It’s impossible for shares bought and sold using computerized models trading thousands of securities simultaneously in increments of seconds to settle each time they trade. Positions are netted out at the end of the day by broker-dealers.

In Facebook, this process froze midstream. When the music unexpectedly stopped, it was chaos. Imagine sorting out your dinner tab at a restaurant with 20 different people at different tables – but all the items on a single receipt.

Inevitably, some regulator or congressperson will propose rules to “prevent this from ever happening again.” Such prevention is impossible. Literally. Nobody can calculate every conceivable foible in mathematical markets.

What’s more, this mess is the result of rules that define competition to mean “the best price.” If trades were not forced to match at the best price, and markets were not interconnected by law and machine, we would not have events like the Facebook meltdown.

ASIDE: At NIRI National, attend the Monday session called IR Targeting and Investor Trading Behaviors for panelist David Weild’s view on market structure. See his SEC testimony here.

Our way out of this mess is right in front of, well, our faces. Each market should be free to set its own rules. Why did we connect them, force them all to have the same prices, the same rules, the same behaviors? That’s wildly risky. It’s, frankly, antisocial. Connecting markets by law ensures that weakest links stagger whole industries. Don’t we want the best rather than the worst?

We should aim to lean on the edge of the Wild West. We romanticize the west, but what made it great was its unabashed vibrancy. Living color. Sucking the marrow. Seeking a fortune.

The more we squash, iron, press, force, manipulate, behaviors, the more droll and dreary – and dangerous – the consequent outcomes will be.

Ironic. Facebook, cynosure of social networking, has shown us how we’ve sterilized our markets.

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