According to The Free Dictionary, the term “cornering the market” means “purchasing a security or commodity in such volume as to achieve control over its price”. The cornering entity can manipulate prices to its advantage and can trigger a sell off if it dumps those assets on the market. The dictionary further states that this is “an illegal practice”, which is a useful reminder for regulators.
Since high frequency algorithmic (HFA) traders at investment banks and hedge funds generate 70% of the volume on our equity exchanges, they effectively have a corner on the market. HFA traders may actually own shares for only a few seconds or milliseconds at a time, but the computerized control and manipulation of those shares allows them to drive prices in the direction they desire at the expense of unsuspecting investors. HFA traders are the barracuda; investors are the gold fish. When the two swim in the same tank, guess who loses. If the barracuda sense trouble, they exit the tank through a safety valve to a safe harbor. The water level inside the tank quickly drops because much of the volume has been displaced. The gold fish find themselves swimming alone in shallow waters gasping for oxygen.
The analogy applies to HFA traders who are allowed to prey on investors in our capital markets. Investors are ill equipped to compete with HFA traders who mercilessly exploit them with computers and algorithms. When HFA traders detect a significant market dislocation, they immediately close their positions and pull their bids, as they did on May 6th. Whenever buyers become a scarce commodity, prices fall precipitously. The rapid disappearance of liquidity effectively takes the oxygen out of the market. It can happen at anytime. It is galling enough to have HFA traders front-run and pump-and-dump share prices to make obscene profits at the expense of investors. It is unconscionable to have them place investors in peril when they take the off-ramp at the first sign of trouble.
The SEC and CFTC issued a joint report on September 30th regarding the flash crash. There is little mention of market manipulation other than to say the SEC would explore the conduct of traders for potential abuses. Wasn’t that what the SEC was supposed to be doing all along? Weren’t they supposed to be the watchdog that ensured a level playing field? Apparently, the parabolic growth in HFA trading and the equally parabolic growth of profits were not suspect enough to prompt the SEC to look into the reason why the twin growth trajectories had uncannily similar paths skyward. See an interesting segment from ‘60 Minutes’ on this subject: www.youtube.com/watch?v=WstJM_aNSj8. One would have thought that the string of statistically impossible, consecutive profitable trading days at major investment banks and hedge funds would have raised a red flag for even most somnambulant regulator. Don’t hold your breath thinking that anything meaningful will result from the SEC’s investigation into this matter. These guys are not the most capable gumshoes on the planet.
The most notable observation one takes away from the report is how seemingly oblivious the regulators are to the near and present danger posed by high frequency algorithmic trading. It is almost as if they refuse to see the elephant in the room. To illustrate the point, let us examine a couple of the statements in the ‘lessons learned’ section of the report:
“As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”
“Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations.”
Based on the above statements, which are typical of those strewn throughout the report, it seems the regulators had an epiphany when they learned that HFA traders would actually have the reflexive sense of self-preservation to abandon the market when they sensed that their self-interests were threatened. How dare they leave the market illiquid? The report makes it appear as if a perfect storm occurred because of an imbalance introduced into the market by a single mutual fund seeking to hedge its positions. Unfortunately, it was anything but a perfect storm. It was an accident waiting to happen. The flash crash gave us a quick peek behind the curtain in the Land of Oz. There is too much control of the market in the hands of a relative small cadre of HFA traders, who will skip town in a heartbeat. They serve no useful purpose other than to enrich themselves at the expense of honest investors. They provide the perception of liquidity when in reality they simply churn the market. They produce high volume with no staying power. This was clearly demonstrated during the flash crash. Next time, the crash might not be a flash.
The regulators apparently believe the situation is manageable. Their proposed solutions are an attempt to treat the symptoms rather than the root of the problem. On a pilot basis, the SEC has implemented the installation of circuit breakers across a wide range of securities. The breakers pause trading across the U.S. markets in a security for five minutes if that security has experienced a 10% price change over the preceding five minutes. The regulators contend that a temporary halt in trading should allow the market to reorder itself and regain its equilibrium. This may or may not be the case depending on the nature of the event that causes the sell-off. Circuit breakers could be as ineffective and futile as rearranging the deck chairs on the Titanic. Who is to say HFA traders will return to the market after they are spooked? Who wants to catch a falling knife? What is to prevent investors from piling up behind the narrow door, ready to flee the market after the breakers are reset?
Perhaps, regulators are not as clueless are they appear. Maybe, they understand the danger, but do not want to upset the markets by doing anything rash. At this point, it is difficult to put the toothpaste back in the tube. If they suddenly ban HFA trading there will likely be a major disruption. On the other hand, maintaining the status quo leaves the market vulnerable to a major disruption at any time. Regulators are in Catch-22 situation whether they realize or not.
What should responsible regulators and government officials do in reaction to the events of May 6th? The first thing they should do is recognize that our markets are cornered. They should learn from history that attempts to corner markets usually end badly. For example, witness the Hunt brothers attempt to corner the silver market in the late 1970s and early 1980s or Sumitomo’s attempt to corner the copper market in the 1990s. Both schemes ultimately failed when the silver and copper markets collapsed. Next, regulators should attempt something novel. They should enforce the law. Market manipulation is illegal. It should be relatively easy to monitor and flag patterns of HFA trading that are blatant manipulation. Indict the perpetrators and put them out of business and into orange jump suits. In other words, try to put the toothpaste back into the tube and try to do it as quickly as possible before the market crashes around our ears.
Unfortunately, we cannot depend on the SEC and CFTC to address the problem in any meaningful way because their ranks are riddled with bureaucrats who used to work on Wall Street. The foxes are guarding the proverbial hen house and they are doing an excellent job. As a result, the cartels of HFA traders have free rein to rape and pillage investors. As usual, the wise guys always win.