If the gut-wrenching market volatility of the past few weeks has made you sick to your stomach , I have some bad news for you: violent volatility is the new normal – or more precisely, the new ab–normal.
After massive market moves last week, the Dow Jones Industrial Average tumbled 419.63 points yesterday (Thursday). And, while t hat may be bad news for average investors, it's something Wall Street wants.
If you're not a day-trader, high-frequency trader, hedge-fund manager, or institutional desk trader, reading this is going to make you mad as hell. But it's something you have to know, understand, and accept if you're going to be a successful investor going forward.
The reality is that in their crusade to manufacture extraordinary personal wealth, Wall Street insiders have engineered volatility into the capital markets.
This change is permanent.
Indeed, the same dangerous volatility that destabilizes markets creates innumerable trading opportunities for Wall Street's proprietary traders. These traders feed off each other and off their banking-industry clients.
The game is simple: Wall Street creates market volatility, some of which leads to panic. Panicked investors, in desperate searches for safety, turn to "experts" for protection. And Wall Street rakes in the profits – not just from their market-crushing trades, but from the investment fees they charge individual investors, companies and nations.
It's similar to how the mafia might trash your business and then offer to "sell" you their protection services.
By increasing volatility in stock, bond, commodity and real estate markets, The Street has created a self-perpetuating moneymaking machine.
Obviously, without the manufactured volatility, markets would be more stable, predictable and better serve economic development and growth. But there are no extraordinary gains to be made in calm and stable markets.
So Wall Street for decades has worked to make market volatility the norm.
Exodus: The Beginning of Volatility for Profit
The roots of manufactured market volatility can be traced back to an obsession Wall Street has with disadvantaging the public while giving itself every advantage it can.
In 1969, Institutional Networks Corp. launched Instinet, the original off-exchange "communications network" designed for private use by institutional traders and dealers.
Instead of placing their orders and transacting on the principal exchanges where stocks traded almost exclusively, Instinet provided its members a competing venue where they could show each other bids and offers that the public wasn't privy to.
The club became so successful (I was member myself) – partly as a result of its exclusivity – that it eventually spawned competition.
In fact, it spawned a lot of competition.
What eventually became known as electronic communications networks (ECNs) proliferated in the 1990s. Eventually the multiple electronic exchanges, fashioned after Instinet and the over-the-counter (OTC) exchange that became Nasdaq, ended up competing for orders from brokers, dealers, institutions and a new breed of gunslingers known as "day traders" .
All of this competition dispersed trading to such a degree that it was difficult to know where to go to get the best price when trying to buy or sell stocks. But Wall Street eventually saw the benefit of the wide price discrepancies across multiple trading venues: It increased volatility, creating new trading opportunities.
Working (Over) the System
Of course, nobody on Wall Street believes you can ever have too much of a good thing. The first result was that big-name trading shops and old-world exchanges bought up the more profitable ECNs. Then they went on to start other private exchanges and trading conclaves known as "dark pools ."
In order to drive business to their trading venues, these synthetic exchanges pay for "order flow" and offer incentives to attract bids and offers for blocks of stocks.
The game, invisible from the surface, is designed to accomplish several things. If you control a venue that generates a lot of buying and selling, you can "internalize" the order flow. That means you don't have to trade outside your house – you match orders internally because you have so many buy and sell orders coming in. And then there are transaction fees.
If you are the "house," you can also take the other side of any trade you want, which has its advantages.
But the biggest advantage these venues have is that they "see" what orders are coming into them. And, regardless of whether or not it's legal, they trade against them and take advantage of knowing the specifics of other pending orders that can be used to backstop losses. I'll get to that is a moment.
Another piece of the market-volatility puzzle was neatly fitted with the advent of "decimalization."
Beginning in 2000, and finally encompassing all stocks on July 9, 2001, trades could take place in increments of one cent. Prior to the implementation of decimalization, stocks traded in increments of eighths. Stocks used to trade in increments of $0.125, $0.25, $0.375, $0.50 and so on. You couldn't buy or sell a stock for $50.01 or $50.05, for example. You would have to transact at $49.875, $50.00, $50.125, or $50.25.
Even though changing to one-penny increments was sold as a way to reduce spreads and transaction costs, the hidden agenda was to increase volatility.
Decimalization didn't make for more liquid markets. It simply encouraged more risk-taking. Trading and holding horizons became shorter. And institutions stopped putting down big limit orders, because traders used those orders as backstops to sell into if their speculative buying didn't work out.
Markets got "thinner" and less liquid as a result of smaller orders being put up. Instead of lowering transaction costs, decimalization increased transaction costs: It now takes a lot more trades to buy or sell large blocks. It also can take a lot more time and expose buyers and sellers to steeper price moves.
The increased number of venues combined with more risk-taking to increase volatility exponentially. It was all working.
But there was still one little problem that Wall Street wanted out of the way.
The New Abnormal
Wall Street finally got what it wanted on July 6, 2007, when the Securities and Exchange Commission (SEC) did away with the "uptick rule." As of that day, it was no longer necessary to wait for a stock to go up in price before short-selling it. Without the uptick rule, short-sellers can short any stock, at any price, at any time.
There's plenty more that Wall Street has done to ratchet up volatility. It has flooded the world with derivatives that aren't regulated, and blessed high-frequency trading. It also introduced innumerable securities and financial instruments that it can arbitrage for healthy profits against unsuspecting institutions and the public.
Not surprisingly, market volatility is now a tradable product. And now that Wall Street has taken us down this path of entrenched, institutionalized volatility, there's no going back.
Don't expect any respite from what's going on in the markets now. On the surface, it's all about Europe, debt, downgrades, earnings, fundamentals and technicals. But underneath all those prime movers are the real shakers, the greasy palms of the markets hidden hands.
Abnormal is the new "normal."
News and Related Story Links:
- Money Morning:
SEC Studies Restoring Uptick Rule That Could Have Mitigated Bear Market in U.S. Stocks
- Money Morning:
The Debt-Ceiling-Debacle: The Surprising Way a Default or Downgrade Could Crush the Global Economy
- Money Morning:
The Bank of America Settlement: The Latest Travesty in the U.S. Banking System.
- Money Morning:
Thursday's Wild Stock Market Ride Spotlights 'High-Frequency Trading' as the Latest Worry For Investors.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.