THE BIG WALL STREETS BANKS ARE AT A QUANDARY–OR THEY SHOULD BE!

Over the past several decades, more and more securities trading has moved from the actual bricks-and-mortar exchanges to off-site computer warehouses–often far-removed from the bustling Financial Districts.  On Wall Street, a number of smaller exchanges and an assortment of questionable products have been created, and the advent of high-frequency trading (HFT) has expanded the technology demands-both for speed and capacity.

It seems like Wall Street has expanded its panorama, perhaps in order to hide some of its activities and eliminate any sort of paper trail.  Worse yet, the two parts of the puzzle hardly understand one another–not one bit.  Management doesn’t seem to understand its own systems; but, they keep demanding more and more capacity.  And, the technology geeks are not cut from the traditional Wall Street mold; so, they don’t know a thing about how or what their employer does, nor do they care.   In fact, they hardly even speak the same language, literally and figuratively.

Many of the big banks are ancient, even by Wall Street standards, tracing their roots back some hundred years.   And, as their businesses expands, how will they ever compete with their much smaller, more tech-savvy competitors?  There’s just no way that a huge antiquated battleship can outmaneuver a state-of-the-art speedboat!

The inclusion of the HFTs–into the investment marketplace–certainly creates an opportunity for Wall Street to generate revenue; but, it also presents a potential risk for it, as well.  Let’s look at a simple stock transaction, where I wish to sell 100 shares of XYZ, and you wish to buy 100 shares of the same stock.  Our respective brokers would advise each of us of the price spread, which is $25.00-$25.02, between the “Bid” and the “Ask”. Assume that each of us is agreeable to the price range, and in a stable market, each of our trades would be executed, within or just outside that price range.  Brokerage commissions would be assessed by each firm.

Now, HFTs have gone to great lengths to gain an advantage–to make a risk-less profit in between our two trades–and also over competing HFTs.  One penny, for instance, doesn’t sound like much, so what does that mean to you or me?  Once the high-frequency system is set up, however, their operation is pretty much on automatic pilot–and low-cost.  But, that one penny, when the substantial trading volume is factored in, can surely accumulate, and that’s day after day.  But, it also means that someone is meddling inside the market.

That insignificant piece of the overall pie doesn’t mean much to you or me; however, what about when the market is not stable?   During a terrorist attack, a blackout or a natural disaster, generally the entire market–both sides of the trades that are in the queue–are either cancelled or delayed.  And, there have been minor market systems (exchange) failures–or hiccups–over the years.  But, what happens when there is a market malfunction that is of seismic proportions?

Almost five years ago, at 2:43 PM, on May 6, 2010, the U.S. stock market dropped 600 points in just a few minutes.  And then, after just a few more had passed, stocks rebounded to right where they had been before the meltdown.  During that time, 20,000 different trades were executed at prices that were more than 60% higher or lower than where their prices were just before the sudden drop.  This seismic shift was known as the “Flash Crash”.

Perhaps of even more interest, the market price of Proctor & Gamble fluctuated from $0.01–yes one penny–to $100,000–per share.  So, if PG was the stock that you and I were trading,  I might have received all of $1.00 for my hundred shares, and your purchase would have cost you $10 Million.  That’s net of commissions, mind you!

The Securities Exchange Commission investigated and didn’t provide any meaningful insight as to what had happened?  Why?  Or what sort of corrective action might be taken!  The Wall Street banks, the Exchanges and even the SEC have gone along with the expansion products, and the acceptance of high-frequency trading–perhaps blindly so.  A very key point here is that the report, which the SEC provided, cited details in terms of “seconds”; but, the HFTs’ unit of trading was in “microseconds”–millionths of seconds.

So, here’s where the big banks need to come to a decision.  If they continue to engage in HFT, they must realize that they cannot possibly compete with the smaller, faster, smarter HFTs.  Perhaps, they can grant access to those smaller firms within their “Dark Pools”, which are where they place client trades which they have not released into the open market.  If the HFTs do generate revenue from access to those pools, they will pass-on perhaps 15%–as a finder’s fee–to the banks.  But, who takes the risk?

So, the big banks need to look at their Risk-Reward Trade-offs.  Continuing to operate in a market which they clearly cannot be competitive would be foolish.  Doing so as an agent for another firm would barely contribute to their bottom line.  And, it would also divert capital and personnel resources from their more profitable activities.  On Wall Street, a big bank must be protractive of its “good” name, and unnecessary activity in HFTs might very well jeopardize their relationship with important clients–or even the general public.

Lastly, and I believe that this is what the banks final decision should be.  They should wash their hands of all high-frequency trading actions as soon as they can.  The simple conclusion, at least for me, is:  they cannot compete properly;  management truly don’t understand how HFT works; and they can only gain a minor portion of the revenue pie.   But, when the shit really hits the fan–a la May 6, 2010--it would be the big banks, with the deep pockets, that get sued.  No one would bother to go after the small, perhaps lightly-financed HFTs, which would probably all disappear anyway.

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  1. #1 by cheekos on February 24, 2015 - 11:40 PM

    For more information on high-frequency trading, you might try “Flash Boys”, by Michael Lewis. Mr. Lewis, a former bond salesman, is a great story-teller, and has an uncanny ability to convey what could otherwise be technical concepts, but in a moist-entertaining manner. This reads like a novel.

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