30th August 2012
Specifically, it is clear that in a number of areas the market is skewed in favour of a number of investment heavyweights. This does not, in most cases, amount to illegality, but it destroys the myth of equal participation.
Destroying the level playing field
Today's Wall Street Journal highlights the ability of high frequency traders to pay to access information ahead of time: "When the Institute for Supply Management releases its index of manufacturing activity next week, the headlines from the report will flash to traders at what their eyes tell them is 10:00 am. But unless they are subscribers to a new low-latency feed provided by Thomson Reuters, they'll actually be getting it late-and depending on how they're positioned, it could be too late."
Those investors with superfast computers and the requisite algorithmic-trading software needed to read and act upon the low-latency line's digitalized information will "inevitably be the first to trade on the news" says the article. "The advantage these high-tech traders enjoy is measured in just millionths of a second, but it will be more than enough time to beat competitors who instead must rely on news services that generate headlines from the Business Wire release."
Henderson Global Investors has recently highlighted the problem of ‘algo-sniffers', super-fast computers that seek out slower computers in the process of buying or selling shares: "These algo-sniffers aim to recognise what is happening and exploit the slower computers. Alternatively, a ‘spoofer' makes deliberately fake offers to lure other computers to ‘show their hands', before cancelling the offers."
Algorhythmic trading has already been responsible for a number of ‘flash crashes', when systems have gone wrong. The problems at Knight Capital illustrate that it can backfire on its protagonists as well.
The downfall of Merrill Lynch
So a personal investor may be at a disadvantage simply from the speed of their computer, but there are other significant transparency problems at work in the market. A piece in the New York Times talks about the influence of Pxyis in Merrill Lynch's downfall and eventual takeover: "Barely visible to any but a few inside Merrill, Pyxis was created at the height of the mortgage mania as a sink for subprime securities. Intended for one purpose and operated off the books, this entity and others like it helped Merrill obscure the outsize risks it was taking."
It was not clear to the market that Merrill Lynch had these difficult assets on its books: "In the third quarter of 2007, for instance, Merrill reported that its potential exposure to certain subprime investments was $15.2 billion. Three months later, it said that exposure was actually $46 billion. At the time, Merrill said it had initially excluded the difference because it thought it had protected itself with various hedges.
But many of those hedges later failed, and Merrill, the brokerage giant that brought Wall Street to Main Street, soon collapsed into the arms of Bank of America."
The trouble with transparency
Even now, it appears that banks only reveal what they are pushed to reveal. Today brought new revelations from Barclays (and not just the appointment of a new chief executive, which serendipitously buried the news on the SFO investigation):
"Barclays said on Wednesday that the Serious Fraud Office (SFO) started an investigation into "payments under certain commercial agreements" between it and Qatar, confirming an earlier report.
The Financial Services Authority (FSA), Britain's financial watchdog, is already investigating the bank and four current and former senior employees, including finance director Chris Lucas, on whether sufficient disclosures were made about the fees it paid in a 2008 capital raising."
Depending on the outcome of these investigations, it could be argued that the banks simply disclosed as much as they knew at the time. However, again, it seems that banks are reluctant to reveal anything but the bare minimum.
On Mindful Money, we have highlighted the problem of analysts tipping off favoured hedge funds about equity and bond analysis. At the time, we asked the question: "Where does trust erosion stop? Investors have had to deal with the continuing Libor scandal, allegations that the gold market is rigged, and a G20 report suggesting oil prices are manipulated by traders."
It should be said that the majority of market manipulation is short-term and investors – as opposed to traders – should always have a longer time horizon. Algorhythmic trading can cause short-term dislocation in markets, but it is unlikely permanently to skew market response to economic events. However, the market is supposed to be a level playing field, in which all participants can make an informed decision. It is clear that this is not happening.
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