Monday, May 26, 2014

Wall Street's new scam that robs us all of billions

Michael Lewis is a national treasure.  I love his deeply researched and elegantly explained books.  He has written a new book, "Flash Boys" about what happens inside the computers of the stock exchanges.  Great book.

We all know by now how the financial industry set up the Great Recession by inflating the value of homes with fraudulent appraisals, creating incentives for liars loans, and using these very bad home loans to create extremely complicated and deliberately hard to understand mortgage backed securities and other derivatives, all of which ended up creating an economy built on bad credit and greed, and created an unstable situation that imploded, costing the middle class trillions of dollars and millions of jobs.  Of course, nobody responsible for the catastrophe went to jail, they made billions, and they are still out there, still doing what they do, which is focusing on the only thing which is important to them - making fortunes for themselves, and creating new ways to rob billions of dollars from the middle class.

"Flash Boys" shows us how they have created a new scam to rob us all.  This time it is High Frequency Traders who are the stealthy thieves.  They have robbed billions from pension funds, mutual funds, money market funds - the moneys that are the investments and savings of us all.  How?

I didn't realize that there is no longer a single Wall Street market where stocks are bought and sold.  Apparently there are over 40 actual places where stock transactions happen.  They are massive computer banks where the transactions take place.  They take place at computer speed, i.e. in thousandths of a second.  

Since they happen at computer speeds, they are only understood by people who create them, computer people and those that manage their activities.  So what?  Isn't it obvious that when you hit "enter" to buy a stock it creates a computer transaction?  Sure, but what happens in the few thousandths of a second between when you hit enter and you end up owning some stock?  What happens is what the book is about.  It turns out a lot happens.

As I understand it, the purchase is sent to a stock exchange somewhere, and the purchase finds a selling price and completes the transaction.  For a small investor, that is pretty much the end of the story, I guess.  

But for an institutional investor, a manager of a pension fund or a money market fund who buys 100,000 shares of a stock the story is much more complicated.  They send out an order to buy a huge amount of stock, it goes into one of the stock market computer banks, where the order is noticed by the computers of High Frequency Traders (HFTs).  Once they see what the big investor wants, they capitalize on their super fast computer processing programs to get ahead of the sale, buy stock at the lowest price available, and turn around and sell it at a penny or so more to the big buyer.  The big buyer buys it at a fraction higher than they should have had to pay because the HFT stole money out of the pocket of the institutional buyer.  And of course all of this happens in very tiny slices of seconds, microseconds, and is invisible to the buyer.  This is called "front running", getting ahead of the purchase to buy low and sell high in pennies.  

So what?  It's only a penny a stock, right?  No, it is billions of dollars stolen from mutual funds, pension funds, the portfolios of the middle class.  It is a computer generated form of "insider trading", acting on information that one has before others can know it. It is a foolproof way to suck money out of the transaction without actually making an investment and taking a risk. It's theft. 

The details are fascinating and the story is wonderfully told by Michael Lewis.  There are extra twists and turns and ways for the HFTs to steal money, and it is worth the read if you are interested.

There are a few big problems with this activity.  First, of course, it is immoral thievery from us all.  

Second, their activity adds nothing positive to the financial system.  It does nothing to help sellers and buyers get together and generate the financial system of capitalism.  Rather it games the financial system to create fool proof ways to suck billions out of the transactions of buying and selling at the heart of the financial world.  

Third, and perhaps worst of all, it becomes something that the smartest kids end up doing, making fortunes as thieves rather than going to the moon or cleaning up the environment or transforming the world in positive ways.  They end up being gamers of systems where they can very cleverly find loopholes and flaws in the systems of money, and they brilliantly find ways to suck wealth out of the financial system, rather than become those who create wealth by creating new and better goods and services.  

It is a national tragedy.  It is a continuation of the crisis of greed that created the housing bubble that popped and ruined so many lives, which we are still digging our way out of.

And, oh yes, another big problem with the HFT created stock market?  It has created an unstable market, one that is too volatile, one that periodically crashes uncontrollably, one that becomes chaotic beyond the ability of even the super smart HFT gamers and their super sophisticated incredibly complex programs to keep sane.  There have already been "flash crashes".  More to follow.

If I understand it correctly, New York Attorney General Eric Schneiderman is investigating HFT activity.  It will be interesting to see if that goes anywhere.  There are billions of dollars the HFT folks stand to lose if the game is up.  It won't happen easily.