4/1/14 – High-Frequency Trading and Market Trust

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 1, 2014 1:00:00 PM

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The New York Times has an excerpt from Michael Lewis’s new book, Flash Boys, which is essentially about how the stock markets have become rigged. There will be a tremendous amount of debate on whether his charges are fair, what actions should be taken, and so forth—the FBI has apparently already launched an investigation—but to my mind, this somewhat misses the point.

Right now, we have banks that have paid billions in penalties for not following the rules on mortgage lending. We have repeated systemic breakdowns of the markets. Many banks are being investigated, and sued, for market fixing in interest rates, gold prices, and other areas.

The financial system exists to serve society and to allocate capital efficiently for the benefit of all. For it to work, it has to have the trust of the larger society. Who wants to invest in a rigged game? All of these scandals point to a massive failure on the part of regulators and institutions that is eroding the real value Wall Street brings. Lewis’s book is about one instance of this systemic failure.

I don’t blame the people doing the high-frequency trading, as long as they were playing by the rules. I do blame the exchanges that created the rules those traders were gaming. I blame the SEC for allowing this. The failure has been on the part of those setting the rules of the game.

This is not the first and won’t be the last financial scandal. In my own world, that of financial advisors who work with individuals and institutions, there are occasional tragedies when someone steals from his or her clients. As sad as that is, it doesn’t invalidate the work of the many great advisors out there, like the ones we have at Commonwealth.

I was looking back yesterday at some books I’ve discussed here on the blog, and found my review of the Fourth Turning. That book, which has had a very good prediction success rate, forecasted a sea change in American society by around 2025. Looking at how the country has changed in my lifetime (roughly the past 50 years), one of the major trends has been an increased focus on making money to the exclusion of other activities. Along with this has come the increasing financialization of the economy. A reversal of this trend could be one of the changes on the horizon.

As always, there are two sides to the story. High-frequency trading does have benefits, but they do not justify some of the abuses. The financialization of the economy has helped millions, but it has also done damage. It’s not being a Luddite to say that those costs need to be limited, even as we preserve the positive aspects.

I wrote last year and before that the LIBOR interest rate-fixing scandal would have legs. That is happening, although it’s not getting much publicity, but what I didn’t appreciate at the time was how widespread this kind of behavior might be, and what the systemic effects were. This is what we’re starting to see, in Lewis’s book and other reports.

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