November 16, 2022

The Trouble

I don’t own cryptocurrencies or NFTs or other digital assets. Let me just offer that first.

But anybody, in any market, including the US stock market, should understand the risk of manufactured traffic.

I’ll explain.

You all know about the collapse at FTX, wunderkind Sam Bankman-Fried’s (he’s called SBF and I’m not sure it’s good to be known as an acronym) trading platform for content creators.

Photo 227837967 / Ftx © Zhanna Hapanovich |

I get how and why he wound up using his proprietary trading unit, Alameda Research, to support the exchange’s currency, a token called FTT. I don’t know if its fraud or foolishness. In any case, it’s unethical.

The reason I can wrap my head around at least some of what occurred is because of what’s happened in the US equity market, and how it works. 

Take Pipeline Trading. I wrote about it in 2011.  It’s gone away.

Reason? It was fined for trading against customer orders (editorial note: You can in fact know now if your shares trade at dark pools here at Finra, and from our partner for institutional analytics, PointFocal).

The fine didn’t bankrupt Pipeline but it led to a loss in confidence.  The market didn’t offer the liquidity it purported to have. Orders dried up, the market shut down.

Let me explain further.  At FTX, the hullabaloo is not just that it’s collapsed and gone bankrupt but that SBF’s proprietary trading unit might have been trading against customer orders, with customer funds held in the firm’s own tokens.

Not good.

For the record, many broker-dealers over the years have been fined in the US market by regulators for trading against customer orders. I wrote about it a long time back.

The problem isn’t that brokers take the other side of orders. It becomes a problem if customers don’t know it.  They think there’s more demand for their goods than really exists.

It’s like building a mall and leasing space to retailers. And nobody shows up.  You’ll do anything to drive traffic.

SBF wanted to establish FTX as global leader in digital assets. He needed a lot of customer interaction. And there was. So long as everything from NFTs to cryptocurrencies boomed.  Big traffic played a role in FTX’s $32 billion valuation.

But when a bear market developed in the metaverse, trading diminished, we can surmise.  Suppose customers were quitting or wondering if they needed to pull out of the mall.

I’m leaving out big details but follow me.

Enter Alameda Research.  What if we just…goose the market a little by demonstrating there’s a lot of liquidity, a lot of action here?

Reminder: This is what Pipeline Trading did. But not with customer assets.

We’re led to believe thus far that Alameda Research, the proprietary trader, may have used customer FTT tokens to prop up the market for digital assets at FTX.

Reminds one of the Federal Reserve using fake money to prop up the economy. Cough, cough. I digress.

The trouble is relying on stuff that doesn’t exist. There wasn’t enough customer demand for digital assets at FTX. That demand was coming from SBF.

And the market unraveled, and the tokenized medium of exchange at FTX collapsed.

The US stock market doesn’t use a token. So that’s good news. But it cannot function without proprietary traders taking the other side of customer orders.

You understand that, right? It’s not dissimilar to what was happening at Pipeline Trading except it’s sanctioned in the stock market.

Here’s what I mean.  Over half the volume in the stock market would not exist, save that it comes from proprietary traders, the equivalent of SBF’s Alameda Research. Exchanges are permitted under rules to pay them to buy and sell. They prop up the market.

Rather than using customer assets like SBF did, these same brokers are permitted by the SEC to create stock to use to trade against customer orders. 

I’ve explained it repeatedly but maybe this context will get the point across better.

No market of any kind can continuously offer buying and selling without some form of artifice and trickery. Physics don’t function that way. There isn’t always, at every split-second, a buyer and seller meeting. 

Without these two kinds of it in the stock market we’d have to go back to holding periodic auctions that line up supply and demand like a cattle auction.  Ranchers bring cattle. Buyers from Swift Amour and JBS show up and bid for the cattle.

You can’t manufacture cattle to fill cattle orders. But you can manufacture stock to fill stock orders because it’s electronic. Maybe every electronic market is subject to this risk, from cryptocurrencies to central-bank debt auctions.

Worth pondering.

I’m not saying the stock market will blow up like SBF. I’m saying it shares some DNA.  And every participant in it, from traders to investors to public companies, should understand that half the market’s volume just props up supply and demand.

It works out fine 99% of the time.

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