A Money Murder Mystery: Who Killed the Stock Market?

Shah Gilani

Liquidity, the "life blood" that allows the world's capital markets to function, has been murdered.

Liquidity was choked violently in the bond market by the gloved hands of its erstwhile babysitter – the broker-dealers- but it bled to death in the stock market from a thousand cuts.

We should be afraid. The lurking henchmen who worked as lookouts on "the job" are the very regulators and guardians of the stock and bond markets who should've stopped it.

Worse, they don't understand their own crime.

That's scary enough, but what's more frightening is how the wheels of both the stock and bond markets could seize and come to a screeching halt at any time.

Investors who don't want to be murder victims need to examine the evidence.

Here it is, in black and white with red all over…

Dead on Arrival: One of the Most Important Functions of the Market

Liquidity – the victim in our financial-markets murder mystery – is the ability to buy and, more importantly, sell the stocks, bonds, derivatives, and other financial assets that define the capital markets.

And you want – indeed, you need – to be able to make these transactions without moving prices too much.

If you have to pay up for a stock or bond because there are more buyers than sellers, while the additional cost isn't desirable, it's not the end of the world. At the end of that trade, you actually own the asset.

But if you want to sell that same asset at a time when there are more sellers than buyers – and the price is falling – if the buyers you thought would always be there disappear…

Well, you're dead.

And in the absence of liquidity – meaning the absence of buyers – prices can fall precipitously.

In other words, liquidity is critical for smooth functioning markets. Abundant liquidity has been the hallmark of U.S. capital markets. While there have been corrections and crashes in those markets, most of them were caused by massive selling that overwhelmed normal liquidity.

That's not the case anymore.

There is only normal liquidity on sunny, up-market days.

But on down days – for stocks and for bonds – liquidity dries up quickly. Indeed, it can disappear altogether – literally – in a matter of seconds.

Disappear as in: none. No buyers to be found – at any price.

We saw this exact scenario play out on May 6, 2010, in the infamous "Flash Crash." All stock market indexes plunged that day. The Dow Jones Industrial Average plunged 998 points, about 9%, in 36 minutes. That was the biggest intraday decline in Dow's entire history.

Lots of mini-flash crashes – mostly in single stocks – have happened since.

More are on the way.

The Real Killer Isn't Who You Think

Don't for a New York second believe that some day trader hunkered down in the basement of his parent's suburban London house, whom U.S. regulators want to hang for causing the Flash Crash, is the villain in this capital-markets whodunit.

So what if this trader "manipulated" markets by putting down thousands of sell orders to create the appearance of a virtual Mongol horde coming to burn stocks down?

So what if he then canceled them after profiting when the futures he shorted fell on the market's reaction to his spoofing and layering games?

Truth is, that's done thousands of times every minute of every trading day by the high frequency trading (HFT) desks nestled safely within big banks, investment banks, and hedge funds – and by Virtu Financial Inc. (NASDAQ: VIRT), a company recently listed on the Nasdaq – as well as at trading desks all over the world.

Stock market regulators want you to believe that there are "bad guys" out there who are going to be rounded up for "crimes against the market."

But the regulators are telling us this because they can't ever tell us the truth.

The truth is, the Flash Crash happened because regulators – unwittingly at first, then by aiding and abetting HFT market-gamers – oversaw the gradual, then wholesale, destruction of liquidity in the U.S. stock market. It can and will happen again.

There's only one reason stocks can free-fall: There's no liquidity. If there are no buyers waiting to catch falling assets at even bargain prices, there is no "bottom" to the market.

If there's no liquidity – and no bottom other than zero – investors caught in the next free-fall may not be so lucky, especially if markets don't rebound like they did in May 2010.

Disrupting the Disruptor

That brings us to an important question: Where have all the bidders gone?

Just what has caused this capital Disruptor, this lack of liquidity we're experiencing today?

The answer isn't a secret. And it's not hard to understand.

So-called "modernization" – which unfolded one step at a time – changed how the markets function.

The net result of all those changes is the lack of liquidity that we're seeing today.

Once upon a time, would-be buyers of stocks used to line up to buy shares of the stocks they wanted.

In these ancient times, they sent orders to their brokers, who then sent those orders down to the floor of the New York Stock Exchange (and, later, to other physical exchanges).

Upon arrival, "specialists" wrote, with actual writing implements, the orders down in their leather books. Both buyers and sellers put down orders.

Lots of prospective buyers wanted to have orders down to snap up shares if prices dropped to levels these traders believed to be good purchase points.

On any given day – for years and years, in every well-known stock – there were hundreds of thousands, then millions of shares to be bought on specialists' books on the NYSE, the American Stock Exchange (AMEX) and, later, on the electronic books of market-makers on the National Association of Securities Dealers Automated Quotations (Nasdaq).

The first big hit to liquidity resulted from increased exchange competition. The advent of computers on trading desks, and then personal computers, yielded Instinet (the first private electronic trading network for institutions).

This was followed by a bevy of electronic communications networks (ECNs). ECNs fought and won the right to list, on their trading platforms, the same stocks that once only traded on the NYSE, the AMEX, or the Nasdaq.

With many different venues available to traders and investors, the orders that once stacked up on the books of a handful of specialists got spread around everywhere.

Then came decimalization…

Join the conversation. Click here to jump to comments…

Shah Gilani

About the Author

Browse Shah's articles | View Shah's research services

Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains.Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

… Read full bio