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Wall Street’s (Fractured) Fairy Tales -- #3: It’s a Kinder, Gentler, Chastened Wall Street (Part I)

In his interview with the Wall Street Journal today, Treasury Secretary Timothy Geithner said the Obama administration “wouldn't allow Wall Street to return to such old habits as taking on excessive risk,” or that Wall Street could be “returning to business as usual.”  
"I don't think the financial system is reverting to past practice, and we won't let that happen," Mr. Geithner said.

Secretary Geithner said it and I believe him. He’s right, they aren’t ‘reverting to past practice.’ They never stopped their business as usual practice! OK, maybe long enough for Hank Paulson, as Treasury Secretary, to dispatch his personal nemesis, Dick Fuld of Lehman Brothers (and coincidentally, 24,0000 other employees in the process.)  

And maybe long enough to slurp at the taxpayer trough when taxpayer-funded loans were offered. The scent of free money will attract Wall Street like corn brings in the pigs. So they cried poor and talked about how dreadful their exposure was to risk that could bring the whole economic system of the United States crashing down if they didn’t get a few tens of billions of that free money themselves. It was only when they discovered that the free money came with a cap on salaries and bonuses that – miraculously – they all managed to unwind all those apocalyptic positions and were suddenly solvent enough to return our money – after ensuring their bonuses were covered, of course.  

What planet is Secretary Geithner living on?

Using Goldman Sachs (NYSE:GS) as but one example, The Firm went from “we’re drowning out here! Send us a taxpayer lifeline!” to (less than six months after “nearly going under”) a quarter in which 97% of all trading days reflected massive profits. That is a statistically impossible feat – unless somebody was lying one of those times. Which is it, Goldman? Did you really not need that lifeline from us? Or did you not resort to front-running and other chicanery – you know, Wall Street business as usual – in your most recent reporting period?

Mr. Geithner further notes, "The consequence of achieving stability is that people can raise money, can raise equity, can borrow more easily at lower rates, that these markets have liquidity again.”

How’s that working for you, Mr. and Mrs. American? Can you raise money? Borrow more easily at lower rates? And with nearly a third of all American homes carrying mortgages in “negative-equity” (there is more owed on the mortgage than the property is worth) are you feeling like you have ‘liquidity’ again?  

Mr. Geithner and the rest of the Administration aren’t so much worried about the cause of the problem – Wall Street continuing to cheat the rest of America via shady trading practices – as they are about the effect.  As the article notes, “the administration is concerned about the potential for populist anger, particularly as banks resume paying high salaries and bonuses to executives.”  

Populist anger?  How very condescending of them!  Rather than worry about the effect, “populist anger” – which shifts the responsibility to those of us poor unwashed out here unable to control our frustration instead of discussing this over a 40-year-old scotch at The Club, the way gentlemen do – let’s place the onus back where it should be: on the cause.

It’s business as usual on Wall Street. Program trading, dark pools, algorithmic trading and high-frequency trading are but a few of the terms you may have heard that evince ways in which Wall Street ensures the playing field is uneven versus individual investors.

These terms are tossed around all to freely, so let’s take a moment to try to define them. They mean very different things to different people so I’ll stick with the best plain vanilla definitions I can.

For instance “program trading” means, in common usage, massive “black box” computer-generated trading in which computers are programmed to execute hundreds of millions of shares in toto based upon some event like a close above x or CPI coming in below y or the price of oil going to z, all without the pesky time-wasting hand of man getting in the way. If the order can’t be executed within 25 milliseconds – less time than your brain can comprehend that the period at the end of this sentence means the end of a thought, then some other computer on Wall Street beat you to the trade. (And I do mean “on” Wall Street. If you’re more than a couple blocks from Wall and Broad, the delay in transmission of an extra 10 milliseconds will lock you out of every trade.)

Actually, that definition refers more to algorithmic trading. The NYSE defines program trading rather more benignly as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more." Of course the NYSE is an organization that defines one of those delightfully Orwellian terms Wall Street lawyers are so fond of: it is an SRO, or a Self-Regulatory Organization. The definition of a Self-Regulatory Organization? “Foxes guarding the henhouse.”

The other three terms are the step-children of this basic idea of program trading. Algorithmic trading (also called automated trading, algo trading, black-box trading, or robo trading) refines the NYSE definition to take in computer trading based on a pre-ordained algorithm like those I described above.

Algo trading is widely used by pension funds – you know, that ultra-safe money your defined benefit plan is supposed to be doing fundamental analysis of the best industries and companies to secure your future with -- mutual funds, and, of course, hedge funds.  (Hedge funds were leading-edge inventors of most of this garbage.)  In algo trading, million share orders are also typically broken down into 300 or 500 share lots so “they don’t disrupt the markets” – and, coincidentally, let anyone but the institutions know who’s buying what or who’s dumping what.

High-frequency trading refers to the highest-speed trading where computers once used only for sophisticated national defense are programmed to initiate orders based on information before human traders can even process the information. (Rather than talk about front-running your measly 5,000 share order in milliseconds, the Gentleman’s Club way of referring to this is " extremely low latency" trading.) In the U.S., high-frequency trading now accounts for 73% of all equity trading volume. And your pension fund and mutual fund managers, who drone on about “buy and hold is the best investment strategy” and “investing for the long term” are the biggest players in this game of millisecond trading.  

Finally, dark pools (also called dark liquidity) are the mechanisms by which much of this trading is hidden. Trades are placed via crossing networks (a type of ATS -- Alternative Trading System) that matches buy and sell orders electronically without routing the order to a publicly-displayed marketplace. Via crossing networks, the order is either placed into a black box (a true dark pool) or shown to other participants who can afford to be members of the crossing network. (All dark pools are dark but some are slightly less opaque than others.) The advantage of the crossing network is the ability to execute a large block order without impacting the public quote.

Wall Streeters will tell you this secrecy is necessary because it creates better executions. After all, if an institution places an order for a million shares and it crosses the tape, why, tens of thousands of the Little People out there would panic and we’d have a disorderly market, they say. (Whereas when they buy a million of this and sell a million of that all in less than a second, it’s OK?)

Every time reform is suggested for Dark Pools, the industry's lobbyists go into hyperdrive, claiming transparency would be bad for liquidity, that they would then be giving Col Sander's recipe to Popeye's, they wouldn't be able to fulfill their endowment charter, blah, blah, blah.  

Question here. Isn’t the public entitled to know when 20 mutual funds are dumping the same security their manager touted as great on CNBC just two weeks ago? Not according to Wall Street. These woolly mammoths don’t want a bunch of little rodents around they might have to avoid stepping on or suffer bad PR. They will tell you this is all done to maintain liquidity in the marketplace.

Bullfeathers. Volume is not the same thing as liquidity.  Regulators aren’t the guys lured away from Wall Street by the promise of 7-figure annual bonuses, houses in the Hamptons, and transport by corporate jet, so they are always playing catch-up to those other guys. Wall Street has them snookered right now into believing that more volume means more liquidity. It does not. The markets were far more liquid back when individual investors’ actions could actually affect the market. All volume means is that the wave of institutional buying or selling has become a tsunami. Individuals can surf a wave; we can only be dashed by a tsunami.

So… What can we do about it? We can all throw open our windows and scream, “I’m mad as hell and I’m not going to take it any more!” But that’s already been done to no effect. The revolving door between Wall Street and Washington DC only guarantees no change other than a management of “populist anger.” What a derisive and dismissive term. What a derisive and dismissive approach.

In Part II, I will provide, for the cynics, ways to profit from the current reality. If you think none of this will change, there are some publicly-traded firms that benefit hugely from the status quo.

For those filled with "populist anger,"  I’ll suggest a couple very straightforward actions this nation could take to restore equity, parity, balance, liquidity and honesty to the financial markets.

Finally, for the optimists, I’ll provide a few ways to invest in spite of the current uneven playing field, but which will provide even better opportunity if the overweight brontosauruses and bad-tempered tyrannosaurus rexes are brought under control.

Full Disclosure: We own no Wall Street brokerages (oops, “banks.”) We own only one mutual fund position. (For more on why we eschew open-end mutual funds, see the current article here.)

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