Wednesday, March 9, 2011

The Recession Is Over For Some People (Part 4)...

      ...but it is going to last a long time for the rest of us. There is one more activity which is going to further increase the flow of assets from the not-so-rich to the very rich. It is called high-frequency trading (HFT) or “black box trading.” In comparison to the outflow of jobs, government incentives and pension liabilities, it has received relatively little publicity, but it is a one-way conduit for the average small investor's assets.
     HFT uses high-speed computers to analyze incoming data and to process a huge volume of transactions at very high speeds. In 2009 only 2% of the 20,000 equity trading firms used HFT, but they accounted for 73% of the volume of transactions.
     HFT users are usually hedge funds, and compete primarily with each other. Generally they hold short-term positions in equities, options, futures and other items that pass through the markets in huge lots; thus they do not compete directly with the small long-term investor. They are looking for small, rapid and consistent returns, and earn their profits through the extremely high volume of transactions.
     Their advantage lies in their ability to analyze and act on opportunities that may last anywhere from fractions of a second to several hours; thus their object is to respond to a deal more quickly than their competitors can. For example, if a fund can respond to an offer in 1/20 of a second while the competition requires 1/10 of a second, it has a huge advantage. Assuming that the profit on a given transaction is, say, two cents per share, and the transaction is for 100,000 shares, the fund has just made $2,000 in 1/20 of a second. HFT users operate around the clock, so they can potentially make billions of dollars per day! Do the arithmetic.
     Of course, such opportunities do not come along 20 times every second, so HFT users have some other tricks up their sleeves. Many have arranged with some exchanges to get a look at incoming orders a fraction of a second before the orders are released to the national market system (a so-called “flash trade”), a legal but ethically questionable tactic.
    The advance peek reveals the quantity the buyer wants, but does not tell how much he is willing to pay. If the HFT user can determine the buyer's maximum price, he has a real advantage over the normal seller, who may make an offer well below the buyer's limit.
     Suppose a flash trade comes in offering to buy X number of shares of corporation C. If it can be determined that the buyer is willing to pay, say, $10.50 per share, and corporation C shares are available on the open market for $10.30, the HFT user wants to price out anyone who is willing to sell for the lower price. So he offers to sell a small lot, say 100 shares, at $10.30 with the condition that the buyer accept immediately or the transaction is subject to cancellation, (an IOC order).
     If the transaction is accepted, he makes another small offer at $10.35 on an IOC basis. He continues this until he gets over $10.50, at which point the buyer cancels. Now the HFT user knows how high the buyer is willing to go, so he offers the remaining number of shares at $10.49. The buyer has had to pay his maximum price before the rest of the market even knows his offer exists! Other schemes are also in use.
     So cannot the small investor just invest in a hedge fund, the same as a normal mutual fund? Well yes, provided he can meet the minimum investment requirement, typically $100,000 or more. Small investors are not welcome.
     If you doubt the value of the HFT system, consider this: Last year the USAs top 13 hedge fund managers earned an average of $1B each; in fact, one of them earned $5B.
     A recent nerws item mentioned that the New York Stock Exchange has been purchased by a German company. Put that together with the 73% I mentioned earlier to see how the small investor is being edged out of the market.
     As one Letter to the Editor recently put it, “What's next? The Statue of Liberty?”
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     But creative interference can also lead to healthy competition, as when athletes compete in sports and games. In some cases it can lead to peaceful coexistence between nations or religions; in others it can lead to war. "Good" and "bad" results such as these are obvious.
     An In-depth Look at the Spirit's Activity – The Spirit Runs Through It.


The Spirit Runs Through It is available in paperback or on Kindle.

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