April 9, 2014

The Recovery

It’s all in the recovery.

That’s the philosophy put forth by a friend of mine for dealing with unpleasant facts.

I think the chief reason for the recent swoon in stocks was not anemia in the job market but a sort of investor outrage. You can’t troll a trading periodical or blog or forum without wading through rants on why Michael Lewis, author of the bombshell book Flash Boys on high-speed trading, is either guilty of torpid whimsy (a clever phrase I admit to swiping from a Wall Street Journal opinion by the Hudson Institute’s Christopher DeMuth) or the market’s messiah.

What happens next? Shares of online brokerages including TD Ameritrade, E*Trade and Schwab have suffered on apparent fear that the widespread practice at these firms of selling their orders to fast intermediaries may come under regulatory scrutiny.

What about Vanguard, Blackrock and other massive passive investors? Asset managers favor a structure built around high-speed intermediation because it transforms relentless ebbs and flows of money in retirement accounts from an investing liability to a liquidity asset. Asset management is about generating yield. Liquidity is fungible today, and it’s not just Schwab selling orders to UBS, Scottrade marketing flow to KCG and Citi or E*Trade routing 70% of its brokerage to Susquehanna.

It would require more than a literary suspension of disbelief to suppose that while retail brokers are trading orders for dollars, big asset managers are folding proverbial hands in ecclesiastical innocence. The 40% of equity volume today that’s short, or borrowed, owes much to the alacrity of Vanguard and Blackrock. The US equity market is as dependent on borrowing and intermediation as the global financial system is on the Fed’s $4 trillion balance sheet.

Hoary heads of market structure may recall that we wrote years ago about a firm that exploded onto our data radar in 2007 called “Octeg.” It was trading ten times more than the biggest banks. Tracing addresses in filings, we found Octeg based in the same office as the Global Electronic Trading Co., or GETCO. Octeg. Get it?

Now Getco is merged with Knight and on the floor of the NYSE as KCG Holdings. Goldman Sachs is selling the old Spear Leeds specialist business to IMC Financial Markets, a high-speed trader out of Amsterdam and Chicago. Virtu is a designated market-maker. Only Barclays on the floor isn’t a bona fide fast trader. But lots of firms route to them (iShares?), and they may share rebates.

The cat’s out of the bag. Stuff is at best fishy out there. What now? As the founders of this republic observed, humans are more disposed to suffers ills while they’re sufferable than to exert the energy necessary to right wrongs. So, probably nothing.

But there’s been a ripple. As the DJIA dropped 300 points Apr 4-7, the behavioral culprit was bottom-up money. Thoughtful participants were rattled.

A subtle insinuation may spread, because the act of observation alters outcomes. To wit, we saw a glob of limit-up/limit-down trading halts yesterday. At 5p ET. The market was closed and LULD circuits don’t break after 3:30p ET. Huh? Probably a test – but why?

The point: Confronting problems always comes with consequences, which ought not but tends to prompt human beings to avoid confronting problems. Whatever follows in days or weeks – say a market shudder – remember that it’s all in the recovery.

PS – Come join us at the Philly NIRI chapter tomorrow morning!

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