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In the presence of the fat finger

The “fat finger” is at large, and this is no minor character. We feel as though we have already seen the movie, and we know the plot points and the fundamental themes: a distressed asset class that ripples into a variety of markets, excessive leverage and poorly structured capitalization exposed in the process, banks losing faith in each other, investors losing faith in the market, governments turning into public relation firms, opinions and regulations running rampant. Seth Klarman about sums it up, and it’s no joke. But the fat finger stirs up this volatile solution, and the result could be unsettling.

Maybe this thing was already at large when we first saw the movie, and we either missed it or it was more subtle then. I would have noticed a 1,000 point drop reversed in minutes, it would have been remembered. But now that I am conscious of the fat finger, I see it all the time… like just the other morning. Early with the financial talking heads, I was watching the ticker from the corner of my eye while reading email and scanning the headlines on the Bloomberg page. Nothing out of the ordinary in light of the week we’d just had. The index futures were down about half of a percent, see-sawing a little. It felt safe to take a sip of coffee and look away for a moment… next thing I see, futures are up and rising fast. Attention now undivided. What gives, some news must have broken… and sure enough, up “breaking news” flashes: the German lower house has approved participation in the EU rescue package. That’s it? Was that an unexpected outcome? Surely the event was discounted by the market already. And while these thoughts and others formulate, taking a few minutes as it was early in the morning like I said, the stock futures descend again to their original level. It was almost funny, I almost laughed, it was as if I and the “market” were both scratching our heads together, with our normal fingers. Which experience, trivial as it was, makes me wonder if this was a cameo by the fat one, of which there may be others.

I used to think that, maybe, financial consolidation has concentrated capital to a degree that market efficiency has suffered. But as I now take note of high-frequency trading and the machine systems that make such a thing possible, I begin to question if it isn’t rather capital dissolution that we are witnessing. More precisely, if capital concentration is suggestive of few but highly influential decision makers, machine trading is suggestive of no decision makers at all. Only algorithm.

Studies show that some 70% of trading volume now occurs through such high-frequency trading systems. A friend with whom I was chatting about this phenomenon, who has some experience with the subject, made a convincing case that these machines are the new market makers. I see his point, except that now these market makers proactively transact with one another, executing millisecond trades for fractions of a penny. Sometimes they get carried away, the Dow drops 1,000 and bounces back. Germany does the expected, but the dumb machine doesn’t know from nuance.

As financial reform seems now well on its way to passage, I have not heard anything about high-frequency trading being monitored. I find this odd, considering that the fat finger seems to have added to market volatility, and considering that finance theory – including valuation analysis and risk assessment – has not yet caught up with chaos. I also find it odd, considering that few other stones have been left unturned. Is this not a stone worth turning? If not, why? 

Disclosure: No positions.