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Todd Harrison: The War on Capitalism Targets High-Frequency Trading


Why HFT regulation could derail the market.

Editor's Note: Todd posts his vibes in real time each day on our Buzz & Banter where subscribers can follow over 30 professional traders as they share their ideas in real time. Want access to the Buzz plus unlimited market commentary? Click here to learn more about MVPRO.

A strange game; the only winning move is not to play.
-- WOPR, War Games

You remember May 2010. The S&P 500 Index (INDEXSP:.INX) had just rallied 83% in 14 months and was about to fall 16% the following two months. Greece dominated the headlines as it struggled with its debt, and there were concerns that a contagion could spread across Europe.

And there was the Flash Crash, an event that in the most literal definition, was the world's fastest stock market crash. 

Following the 1,000-point plunge, German Chancellor Angela Merkel lashed out, saying that "speculators are our adversaries," and that she was "resolved to win the battle against markets." 

Senator Chris Dodd wasn't far behind, offering that high-frequency trading (HFT) created a "casino environment" where "finance is getting detached from the real economy."

The War on Capitalism, it would seem, was just getting started. 

The morning after the flash crash, we asked, "What if high-frequency trading actually provides liquidity in the marketplace? It's conceivable that the 1,000-point market swoon was triggered by computerized models 'pulling bids' at precisely the same time. . . and if that's the case, banning the robots would lead to more, not less, market volatility."

I table that thought for discussion as HFT makes the media rounds. Michael Lewis has a book about it; 60 Minutes did an exposé on it, and the FBI, SEC, CFTC, and the New York State Attorney General have all launched investigations into whether the activity is legal.

Anyone who has paid attention to the stock market in the last five years will tell you that it hasn't traded naturally -- some of us asserted that even earlier -- but now, it seems to be coming to a head.

Of course, we've seen this movie before -- or a movie like it.  In 2000/2001, there was corporate malfeasance and disconnects between research and trading, which led to Regulation FD. 

In 2007/2008, there was FASB 187, Level III assets, accounting irregularities, and collateralized securities that most regulators couldn't fathom. 
And now, on top of the extremely complex machinations of global central banks, we have HFT.

It is difficult, if not impossible, to regulate what you don't understand, which is why over-the-counter derivatives (and the risks they pose) remain opaque despite the first phase of the financial crisis five years ago. 

It's also important to realize that the inability to regulate evolutions in the financial sphere make many of these situations unscrupulous but not illegal, at least by the letter of the law prior to the actions in question. People have crawled through loopholes and exploited the system for their own benefit for a long time; they were front-running regulation, as HFT has seemingly done now.

That is subject to change, of course; given the current state of our socionomic spectrum, nothing garners votes like a good old-fashioned witch hunt on Wall Street. And there is clearly an unfair advantage to "seeing" an order prior to it reaching an exchange and buying it up to see to the original buyer. That will change, either through law or innovation, but that's not the risk as I see it.

While HFT has existed since 1999, it only recently exploded in popularity.  It is now estimated that 50-70% of all US equity trading volume is driven by HFT, a staggering number, which is all the more amazing when you consider that the much of the growth was in a market that has gone straight up since the March 2009 nadir. 

In short, unwinding this architecture, if that becomes the mandated plan, will be extremely tricky -- like unwinding DNA from a genetic pattern.

Random Thoughts:

  • With Q1 in the rear view and fresh risk appetites as a matter of course, we've seen a reversal of recent trends: N's over S's (NDX (INDEXNASDAQ:NDX) outperformance of S&P) led by high-beta and biotech.
  • In terms of our field position, the S&P and financials are above their respective breakout levels (S&P 1850 and BKX (INDEXSP:BKX) 71.50) while the Russell (INDEXRUSSELL:RUT), NDX, and Dow Transports (INDEXDJX:DJT) have yet to confirm the move to the upside (above RUT 1182, NDX 3640, and TRAN 7600).  A full list of the levels to watch can be found here.
  • While the technical signals suggest S&P 1960, the tertiary tells would go a long way to support that price target.
  • Gold, which was also sold into quarter-end, isn't bouncing in kind. Gold $1,300 was double-secret support that is now double-secret resistance. I don't know how much Russia matters to this complex; the more pressing question is whether gold is something we need or something we want as there is inflation in the former and deflation in the latter.
  • We highlighted the VXO (INDEXCBOE:VXO) yesterday, and it continues to hug 12-half.  This isn't a timing mechanism, but it does provide context for our field position. 
  • David Rowan is atop the leaderboard in Minyan March Madness with three games to go. Pretty impressive as these things go, or at least from where I'm sitting down at 51.

Twitter: @todd_harrison

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