Wednesday, May 19, 2010

May 19, 2010--11 Seconds of Liquidity

I know I am not smart enough to understand these things, but this still seems crazy to me--

According to a report in Monday's New York Times (linked below), though these operations constitute only 2 percent of all trading firms, between 40 and 70 percent of all stock market transactions occur at so-called high-frequency exchanges.

Forget any images you may have of the trading floor of the New York Stock Exchange, where every weekday on CNBC's Closing Bell hundreds of traders can be glimpsed scrambling around frantically buying and selling securities, these newfangled high-frequency places are much less formal and frenzied and operate largely out of sight..

In fact, a number of prominent ones, if "prominent" is the right word to describe them, are set up in guys' bedrooms. I am not making this up--there are a few hundred such exchanges that run parallel to New York's Big Board, mainly in very small offices and more informal settings around the country. Bedrooms included.

All these boys need (and they are mostly boys) is a high-speed computer setup and the right kind of software. This enables them to trade millions, actually billions of shares in micro-seconds; and, though they mainly make pennies or fractions of pennies for each share traded, if you add up all those mills (one-tenth of a cent), over not much time it can amount to many millions of dollars of profit. Last year, in fact, it is estimated that these traders netted nearly $7 billion. The trading volume is that high.

Regulators and members of Congress have turned their attention to these largely unregulated high-frequency exchanges, brought them out of the shadows, since they were likely in part responsible for the micro-stock market crash on May 6th where the Dow Jones average lost 1,000 points in a matter of a few minutes; and to many watching (me very much included) it looked as if the economic world as we know it was coming to an end.

The high-frequency game is all about speed, what the boys refer to as "extremely low latency." Whatever that means. The intention is to be the first to buy or sell at just the right moment. Shares are traded in millionths of a second, and being even a microsecond late can be the difference between making a trade and losing it to the next high-frequency operator.

In the Times piece, the reporter, skeptical about the larger purpose of these places, wondering in what ways are they useful to the larger economy, asked how they help businesses to form or raise money to expand. The traditional purposes of a stock exchange. To a person, the high-frequency traders claimed that they "provide markets with liquidity."

If true, perhaps they do serve a useful purpose. But then when the reporter got them to tell her how they actually work on a day-to-day basis, she learned that at the end of each day they wind up with no position in the market--everything they bought during the day has been sold. Thus, no actual money needs to be exchanged. They therefore do not need any working capital. It's all about the virtual buying and selling.

How does this add up to providing companies with liquidity if at the end of the day nothing remains? And how, since these guys hold onto a position, retain the stocks they buy on average for just 11 seconds, how does anyone make use of the money generated during those split seconds? Other than just to enable the traders to make a quick buck?

But, as I confessed, I'm not smart enough to understand any of this. Let's hope that Congress is.

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