Is investing a level playing field?

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.


More on Mindful Money:

The sins of high frequency trading

Knight Capital: The Rise and fall of the Machines

HFT: The Sorcerer’s New Apprentice

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The Financialist

14 thoughts on “Is investing a level playing field?”

  1. Anonymous says:

    You have a lot in common with John Redwood – spot on analysis but nobody listens.

    1. Anonymous says:

      Hi yarnesfromhorsham and welcome to my part of the blogosphere.

      Actually I have noticed that some of the messages and themes are hitting home but I am afraid that progress can be slow because our political class are resistant to new ideas.

  2. Andy Zarse says:

    Hi Shaun, whilst I too have grown weary of tedious homilies about democracy from the Higher-ups, I am completely fed up to the back teeth with central banks repeated attempts at market manipulation. Seriously, if anyone else tried such a course of action they’d be locked up, in theory at least.

    As you say, the results are a kind of avant guard white noise chaos characterised by wild and random fluctuations in asset prices. How is this fair on savers and investors, and how can their advisers make a assessment of markets when Govts keep sticking their flippin’ oars in? I can’t help thinking of the tale of The Sourcerer’s Apprentice, and the law of unintended consequences is going to play its mischievious role at some point very soon. Frankly, the sooner the brooms run out of control the better…

    1. Anonymous says:

      So the broom runs out of control, does this result in currency collapse, social chaos and hunger ?

  3. Drf says:

    I left a comment but it seems there are problems with the comment system again.

    1. Anonymous says:

      Hi Drf

      Just to let you know I had raised the problems with the editor here and have forwarded this onto him so that he knows that the issue has not been fixed.

      Also apologies….

    2. Anonymous says:

      i had that problem yesterday – took several attempts!

  4. ernie says:

    Central banks only really exist to support their “client” banks and their governments. They have proved over and over again that they are unable to forecast economic trends/events and cannot actually change macro economic trends. They can, however, seriously distort short-term market price signals. In this crisis so far, they started by acting on interest rates, then moved on to becoming the receptacle for large volumes of bad assets via the various mechanisms employed such as QE. They have now moved to the final stage – outright buying of stocks in order to try and create some fantasy where higher stock prices will magically restore economic growth. The resulting distortions are obvious to everyone. The result is that the markets go up purely on central bank words/deeds and cannot sustain themselves on real-world data. The final outcome to all this is not in doubt. Perhaps if any of us is left standing after the tornado hits, we might consider abolishing central banks?

    1. Anonymous says:

      Hi Ernie

      Central banking in its current form certainly needs modifying in fact the entire banking system needs reform and change.

  5. max says:

    very good post Shaun. I fear you are absolutely right, and since the central bankers have absolutely no idea what they are doing, it seems likely that QE to infinity will overshoot considerably.

    1. Mike from Enfield says:

      An overshoot could, conceivably, be a price worth paying were it not for the fact that there appear to have been no measurable (positive) effects on the wider economy. As far as I know, unlike in the USA, the UK has no explicitly stated target at which QE is aimed – they just turn the tap on/off when it kind of ‘feels right’ (does the BoE employ astrologers…?).

      It seems most unlikely we’d ever hear an announcement that the policy is to be discontinued due to any negative effects so it will be interesting to find out which particular ‘beneficial’ effects they cite as having been achieved when (if?) it is ever withdrawn.

      1. Anonymous says:

        Hi Max

        The only target the Bank of England has explicitly is the 2% inflation one. Maybe their failure there has put them off other ones! They are also supposed to “subject to that (inflation target), to support the Government’s economic objectives including those for growth and employment. ” But that is unquantifiable.

        More and more their argument for QE has involved the word counterfactual, or everything would have been worse otherwise which is weak at best.

  6. Noo 2 Economics says:

    Hi Shaun,

    I have to disagree with you and the markets on this. Bernanke was clear – “Unfortunately, withdrawing policy accommodation AT THIS JUNCTURE would be highly unlikely to produce such conditions” and then “IF we see continued improvement and we have confidence that that is
    going to be sustained, then we could in the next few meetings … take a
    step down in our pace of purchases.”

    The capitals are of course mine, so he says at the moment no way are we going to desist from ongoing QE but maybe, following continuous sustained improvement we COULD (not WILL) in the NEXT FEW MEETINGS i.e. at least 3 months away and maybe a lot further away than that reduce the purchase pace.

    What is there to misunderstand? It really isn’t his fault that markets have over – reacted to his comments even if there has been marginally disa[ppointing news from China which, at the end of the day is only 1 month’s numbers.

    I think the authorities (Governments, CB’s and IMF) are getting twitchy about how they are going to pull out of all this market interefrence, sorry, QE, without crashing every market in the World and it it was that fear that probably prompted the question that Bernanke answered in terms of demonstrating that he did have some kind of slow withdrawal plan

    Now, should CB’s be interfering with market pricing mechanisms whether that be equities or bond markets? Absoloutely not!

    1. Anonymous says:

      Hi Noo2

      The game goes on except as time passes there is more interference which will be harder to unwind. I always thought that “exit strategies” from QE type actions would be a problem and I think that more likely problems are appearing rather than less.

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