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The Truth Behind the Tragedy of High-Frequency Trading
It's no wonder the public is scared to invest in stocks. They believe the game is rigged.
It is, and I'm going to tell you who's behind it, what's really happening, when it started, where the sinkholes are, why they're there, how you can play in the short run, and how America can get back to investing in a successful long-term future.
The bad news is the problems infecting our capital markets are all systemic. The good news is that they can be eradicated one by one, if not all at once (which won't happen).
Today, we're going to look behind the curtain of high-frequency trading.
It's a nasty bug in the system and has long-term consequences, including the potential to kill the markets.
First of all, high-frequency trading isn't just what you think it is. It is much more than you know, and is in fact part of the fabric of the markets.
High-frequency trading (HFT) is known to be a game that specialized firms and trading desks play. Here's what most people think they know about high-frequency trading.
The HFT crowd uses super-fast computers to execute trades across different exchanges. There are 15 exchanges in the U.S. and more than forty "dark pools" (private trading venues that serve as de-facto exchanges) where shares can be traded.
Part of the problem is that there are so many trading venues trading the same stocks, but that's another story.
Here's what the high-frequency trading game is really about.
The Real Story Behind the Knight Capital Trading Fiasco
Oh, you are going to love this.
That whole Knight Capital fiasco last Wednesday, when a software glitch caused them to flood the market with thousands of unintended orders, it ain't exactly what you think it is.
Sure, they tripped over themselves in the dark pool where they were trying to compete.
But somewhat interestingly (okay, a LOT interestingly), the competitor that drove them to "upgrade" their trading software, which malfunctioned and caused them to actually bid-up share prices erroneously and then buy them at inflated prices, was none other than, wait for it…
The New York Stock Exchange.
That's not the whole story, or even the good part. Oh, it gets better. A lot better
Knight claimed a $440 million trading loss on Wednesday resulted from their computer glitches and sunk the company (at least for now; I'll get to that).
Well, according to Nasdaq (this was on its site: nasdaq.com), it wasn't a trading loss at all. Knight paid Goldman Sachs a $440 million fee (commission?) to take the errant shares Knight had bought on Wednesday morning off its hands.
Now, I don't know what Goldman did with those shares, but my guess is they held most of them and sold them on Friday when the market soared a few hundred points. Of course, that's not a "prop" trade. Knight is a customer of Goldman's (it is now…).
But who cares?
Goldman Sachs ripped a customer for a $440 million fee, virtually bankrupting it in the process, flipped the shares it bought from Knight to "help" them (and first of all, probably overly hedged itself… as in enough to be net short… the large stake it holds in Knight's convertible preferred) for a tidy profit, and then probably shorted the stock (before "helping" them, and themselves to their little fee) before the stock collapsed, then probably gave it its "lifeline" (that's a guess, and I'm being sarcastic, but it's possible). And maybe we'll find out where that lifeline Knight got on Friday really came from) before buying a ton of Knight's shares back on Friday before hearing (of course… before) that several big firms were looking at buying Knight.
What's my point in the above LONG sentence? Who cares! That's all business as usual at the Golden Vampire Sachs.
That's after-the-fact stuff.
What's more interesting is why all this happened in the first place.
Here's what you probably don't know…
Underfunded Pensions Undermine the Entire Economy
The difficulties facing retirees aren't just their problems. Underfunded pensions weigh down everyone's retirement expectations and America's future growth prospects.
Kicking the can down the road on this one has involved everything from outright lying to misrepresentation, bordering on fraud in the way pension plans calculate their liabilities.
If long- term solutions aren't implemented, the U.S. economy will experience a secular decline, equities will plummet, and millions of Americans of all ages will suffer.
While huge problems exist in private pension plans, public-sector plans — those slated to provide retirement benefits to public-service employees of state and local governments -face exponentially larger problems.
Here's a look at what the problems are, who's responsible for the mess we're in, who's going to have to fill in the deep holes, what the bad news is when it comes to fixing pensions and what the worse news is if they aren't fixed.
A Multi-Trillion Dollar Hole
A recent S&P Dow Jones Indices study highlighted record levels of pension underfunding at publically traded companies in the U.S.
At the end of fiscal year 2011, according to S&P, corporate pension plans were collectively $354.7 billion underfunded based on obligations totaling $1.676 trillion and assets of $1.322 trillion.
In addition, S&P noted that OPEB promises (Other Post Employment Benefits) such as health related benefits and life insurance were $233.4 billion underfunded.
To some extent the private sector's pension woes are ostensibly offset by the more than one trillion dollars of cash sitting on corporations' balance sheets.
But the problem with that cash is that it's not being earmarked for pensions.
Managers are stashing cash for any potential global rainy days ahead, for strategic acquisitions and as a cushion against an expected peak in the earnings cycle. But none of the officers or executives of any corporations sitting on mounds of cash have indicated any intention to fill pension holes with their coveted cash hoards.
On the public sector side of the pension plan dilemma, things are exponentially worse.
The Real Villain is the One Behind the Curtain in the Libor Scandal
There's nothing like pulling back the curtain on the fraud that's center stage in the Libor manipulation scandal and finding the levers are really being pulled by central banks.
It's not about the banks doing what they did. The revelation is this: Central banks are the biggest impediment to free markets and the reason capital markets have become casinos.
And until the tyranny of their grip is broken, the majority of public investors are going to rightfully sit on the sidelines and long-term economic growth will be impossible.
The Libor scandal is just a sideshow. There's nothing new there.
Banks manipulated Libor (the London Interbank Offered Rate), the benchmark for over 800 trillion dollars in interest rate-sensitive loans and financial instruments, to jack up profits on trading positions they held.
Bankers scheming, lying and cheating for bigger bonuses at the expense of anyone in their way…that's news?
No, but here's the real inside scoop…
The Markets Are a Stacked Deck in a Rigged Game…But I Can Teach You How to Win
The markets are broken.
And what has to be done to fix them likely won't get done. That's because the folks capable of fixing them are actually captives of the folks who like them the way they are.
That's the bad news.
The good news is, if you understand what's wrong and who's responsible, you can actually make a lot of money playing the game the way it's been set up.
Let me explain.
First of all, what's happened isn't by some grand design. There is no great conspiracy to screw the public. (Not this time.) Rather, incremental changes in various corners of the capital markets manifested innumerable unintended consequences.
The net result is this: Our capital markets aren't functioning for the greater good of the economy and the nation. And the public is getting screwed. But you knew that.
The markets have become a kind of stacked deck in a rigged card game.
A game being played by a bunch of whispering pros against mostly deaf, dumb, and blind amateurs (yeah, I'm taking about too many people you know) in a shady casino overseen by pit bosses who work for the house – which is owned by the pros who set up the game in the first place.
I'm not going to break down what the incremental changes were that got us here. I've done that over innumerable articles I've written for, Forbes, Wall Street Journal's MarketWatch and right here.
This isn't about how we got here. This is about proving where we are now by means of a kind of grand supposition that hopefully is going to open your eyes. It's probably going to scare the you-know-what out of you.
Earlier I said the public is getting screwed, but you knew that.
How do I know that you know the public is getting screwed? Most people are out of the market. They are either on the sidelines or out of the game for good. They know the markets are a casino, and most people have come to realize that they have no idea what the game is, let alone how to play it.
And that, children, is the unhappy ending.
Precisely because the public is so leery of losing their shirts and knickers in the strip poker club, investing is a thing of the past.
Long-term investing is dead. Long live short-term trading.
Is The Rally For Real…Or Just Part Of the Games Bankers Play?
The markets are rallying, again. Will this time be different? Or is this just another head fake?
The truth is the current rally is not surprising given what's coming out of the G20 meeting, what's likely to come out of the Fed's Open Market Committee meeting today and Jamie Dimon's Congressional testimony yesterday.
But things aren't what they appear to be. What's happening behind the scenes is far more important than what's being said publicly.
So, investors better understand what the real game is here and how to play it.
To do it, we need to work backwards.
Jamie Dimon, CEO of JPMorgan Chase, has repeatedly said under oath that his bank isn't too big to fail.
That fact that he's implying it's okay to let a bank the size of JPMorgan collapse and enter bankruptcy in the event of "a moon hitting the earth" (admittedly unlikely) or potentially huge losses from something like bad bets on derivatives, is a flat out lie.
Of course, that lie can't be proven unless the bank was to actually fail, so it's unlikely that Mr. Dimon could be brought up on perjury charges. But it's still a flat out lie.
JPMorgan Chase and all the big U.S. banks are too big to fail.
And in that lot we can also cast all of Europe's big "universal" banks. They're all too big to fail in a very real sense because they are all interconnected.
Between the crossover of portfolio holdings, interbank lending mechanisms, derivatives bets and counterparty exposure, all of the big banks suffer from real contagion calamity concerns.
As a result, the breakdown of trust anywhere impacts trustworthiness of banks everywhere.
Mobile Wallet Technology: Warming up For the Battle Royale
The mobile wallet movement is inevitable. But so are the bumps in the road.
If there's anything that's going to delay the mobile wallet's future on a global scale rivaling, well, telephony itself, it's going to be because there are so many players and stakeholders tilling the same soil to sow what they hope to reap.
The fact that so many giants and would-be giants are trying to make their networks and systems-in-development the standard mobile wallet platform ensures a battle royale.
The development race will be just that, a race.
But, in the end there will only be a few competitors and everyone else will cease chasing the Holy Grail and fall in under one or another network.
But, because we're investors seeking an edge and know that by the time the end-game is resolved the big money will have been made, we are looking for a "heads-up" on where to place our bets early.
A Mobile Wallet Heads-Up: This Will Be Critical
The answer to that will be evident by watching whose systems and networks offer the best interoperability.
It won't be just about who owns the rails that tomorrow's locomotives will run on. If there are a lot of different sets of tracks headed towards the same destination, what will matter will be how many trains travel each track and pay what tolls .
The way to gauge who is laying the most attractive tracks will be visible in terms of which systems offer the most intersections from which dead-end travelers can reverse course and join the mainstream path to everyone's desired destination.
That's where interoperability will be critical.
Who will build their systems and networks to best and most easily allow parallel ecosystems to merge, or converge, onto a set of easily accessible shared tracks.
The shakeout will result in some spectacular losses.
So, it's better to be on the right side early on than to take your lumps and invest what's left in the final contestants, all of whom will continue to fight for dominance for years to come, if not forever.
But, it's not just the end-game winners we're seeking, though they will emerge and we will be invested there long before the finish line is in sight.
Mobile Wallet Technology: The Giant Killers in the Weeds
When it comes to the revolution in mobile wallet technology, Isis Mobile Wallet is a collaboration between some super-heavyweights.
This is a monster worth watching.
The idea behind Isis is to allow users to pay with "preferred" credit or debit resources available through their Isis-enabled phones by tapping or waving their devices at NFC (near field communications) terminals in participating merchant outlets.
Isis-enabled phones are being manufactured by additional partners Research in Motion, Samsung and Sony Ericsson.
Card.io is a mobile phone application (available at the Apple App Store and as a Google Android app) that allows users to receive and make payments by letting them (in the case of making a payment) enter an amount they want to charge on their app, for what they want to buy, and holding the card they want to use up to the phone's camera lens, which logs the card and processes the transaction.
Received payments can be channeled directly into the user's checking account, savings account, or PayPal account. Card.io charges a hefty 3.5% (of the transaction amount) fee and 15 cents per transaction.
Another mobile solution to not having a credit swiping machine in your pocket is offered by Square.
Square, named after the small square magnetic tape data reader that you plug into your phone's audio jack to convert encoded data from the tape on the back of cards to an electronic file, was started by Jack Dorsey, creator of Twitter.
Electronic data from the magnetic strips on the backs of cards is encrypted automatically, sent to Square's servers and rerouted through the Global Payments Network. You sign the electronic receipt with your finger, which is then sent to you via SMS or email. Now anyone can accept credit cards for anything.
There are lots of start-ups and up-and-comers wading aggressively into the exploding mobile wallet space. Some of these companies will become giants and some will go the way of the dodo.
But, one thing's for sure, the winners will be worth investing in.
Why Facebook Stock is doing a Faceplant
Forget all the hype.
And you can even forget that I told you Facebook was a hyped-up offering, and that I would sell my shares if I was an insider, and that I definitely wouldn't buy the IPO on its first trading day.
Did you listen to me?
If you didn't, and you own Facebook stock (Nasdaq: FB), here's what you have to worry about.
The Facebook Stock Concerns
First, did you get your confirmation? Probably by now you did.
But the problems that NASDAQ OMX Group had sending out electronic trade confirmations in the heat of trading on Friday were staggering. (They eventually went "manual" on the opening day of the biggest tech offer ever on the biggest tech exchange in the world… how ironic… manual.)
There's nothing out there, nothing anywhere about who or how many people did or didn't get confirmations or when they got them. There's nothing out there because the exchange is panicking, and if thousands of confirms, or tens of millions of shares, are up in the air… well imagine what could happen.
Heavy Betting in the Middle of Mayhem
There's going to be a lot of very heavy betting over the next few days, weeks, and months on what's going up, what's going down, and what's going around:
- How far will Facebook IPO price go?
- How far DOWN from here will JPMorgan go, with the FBI and DOJ now sniffing around?
- How far AROUND the globe will the fallout be if Greece loses its game of chicken?
If you don't have the stomach for what's going to feel like an out-of-control rollercoaster ride, sideline yourself.
If, on the other hand, you like a lot of action, welcome to Mayhem – the preamble month to what will likely be the Summer of Some Discontent.
That is, unless you like rapid-fire trading.
Which, by the way, is not just fun, but can be very, very profitable. I'm in, and so are the subscribers to my Capital Wave Forecast. We're gearing up for some heavy betting in the weeks and months ahead.
So, what's front and center today? You know. The big three headlines: Facebook, JPMorgan Chase, and Greece. Are you sick of hearing about them? I'm not. I like trading the headlines.
Here's my "heads-up" on the big three headlines.