March 12, 2014


The humans are the minority.

A three-month study of internet traffic by web-security firm Incapsula found that 61.5% of page views were generated by machines. Humans managed only 38.5% of web traffic.

It seems absurd but our own experience bears it out. We receive hundreds of comments on the blog version of these overwrought homilies but the machines are more opinionated than the humans. In recent months, automated “bots” have attempted to post over 1,500 comments. We’ve approved just the handful from actual humans.

Most of you readers with comments use a dark pool. By which I mean you reply to the email version when you opine on our assertions. In this fashion, you avoid displaying your comments where others can game them. Keep those nondisplayed orders coming!

The machines are good. You could at times almost buy that a person penned the prose. Speaking of skilled machines, Virtu Financial Inc., a dominant high-speed market-maker, intends to go public. Virtu filed confidentially, meaning it posted its regulatory filing quietly in December using a provision of the 2012 JOBS Act to omit the meat investors use to weigh business merits and prospects.

The idea behind confidential IPOs was to permit companies to begin legal processes precedent to floating shares without revealing to competitors secret sauces, successes or failures. Some will argue that it’s permitted a decline in quality, but it’s hard to argue quantity. Last year was the best for IPOs since 2007 (and yet so many consolidated through deals or went private that membership in the National Market System barely moved and remains below 3,700 as of Feb 2014).

Back to the machines. With details now populating in Virtu’s S-1, startling facts reflect what we write about markets in these pages. Just 27% of its volume is in US equities, with another 11% each in Europe and Asia. Over 50% of trades are in commodities, currencies and options.

Virtu places trades with machines. It’s an intermediary without customers, trading in securities markets all over the globe. It’s active in every one of our clients, reflecting $1.2 trillion in US market capitalization.

In 2013, Virtu generated $665m of revenue and netted adjusted income of $215m, a margin of 32%. Between Jan 2009-Dec 2013 over a total of 1,238 trading days, Virtu lost money once. How many of us would like to be right 99.919% of the time?

Without diminishing Virtu’s technological prowess, the firm is emblematic of what’s wrong with equity markets (and the entire global financial system – another discussion).

Virtu aims to furnish the best bid or offer for securities buyers and sellers seeking “risk transfer,” another way to describe easy movement from one asset class to another. Most global exchanges now have no underlying liquidity – products. They depend on suppliers like Virtu. By embedding its systems at exchanges, Virtu is able to be in 200 places simultaneously.

It has crafted the ultimate just-in-time delivery system. If a customer comes to the NYSE to buy something, Virtu wants to fill the minimum amount. And when the customer leaves because the best price now resides at the Nasdaq, Virtu is already there, a step ahead.

When Virtu buys one thing, it sells something else, avoiding exposure even for a fraction of a second while capturing tiny spreads. This “real-time risk-management” is how Virtu achieves its otherworldly success. It’s also one reason why almost half of US equity volume is short – borrowed. Who lends it? Your holders.

But the risk-transfer Virtu facilitates is arbitrage, not investment. Its model is predicated on intermediating global equity, currency, commodity and derivative markets. Through owning nothing and moving everything, it earns vast profits without risk.

This is what’s happening in your trading no matter your market cap (unless you’re BRK.A). Global equities, currencies and derivatives are inextricably linked by high-speed suppliers, which depend on borrowing, putting holders in the lending and asset-management business and fostering prices predicated on arbitrage rather than fundamentals. Most market-moves are short-term imbalances, which arbitrage seeks to continuously correct (see green energy firms in February as an example).

It’s an amazing achievement. But virtuous?

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