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Liquidity Hypochondriacs Are Promoting a Myth


Equity doesn't require liquidity by definition. Debt, on the other hand, does.

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Michael Lewis writes good books. His most recent, Flash Boys, is creating a stir with its well-crafted marketing campaign and a touchy subject. Unlike The Big Short, which no one in the real world wanted to admit they were on the wrong side of (spoiler alert: we all were), Flash Boys has an antagonist that everyone can openly hate: high-frequency trading (HFT). This post isn't about that.

The hype over a fact well known to any professional is unimportant. The real story lies with the Liquidity Hypochondriacs, who defend their actions with the heavily promulgated myth that HFT provides necessary liquidity for the markets. Here's the thing: There is no liquidity in the securities that matter when the eventual problem comes around. Equity, the low man on the capital-structure totem pole, doesn't require liquidity by definition. Debt, on the other hand, does.

A large chunk of what is perceived to be some of the deepest, widest, and most resilient of that debt now resides in a Yucca Mountain of carry at the Fed. Futures and options products linked to those obligations now transact massive pre-arranged trades away from the mirage that is the prevailing presented price. (If the market was liquid, why would they need to "block" away?) HFT will always have the Eric Stratton defense from Animal House on its side. Investors and traders need to come to terms with monetized capital markets -- stock prices that actually represent the underlying supply and demand. Only then can investors and traders get into the minutia of speed. The business of Wall Street, and to a degree, the US, is the creation and churning of financial products.

There's a host of scummy things going on in the electronic-trading world, and for-profit exchanges complicate that. But there was no shortage of shenanigans going on in the ol' pit days, either. Let's just drop the liquidity myth as the reason this is supposed to be okay.
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