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From Facebook Fiasco To Flash Crash, Small Investors Get Hosed By Wall Street

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That Facebook IPO, the attempted BATS IPO, Knight Capital’s close call with obliteration: these and other recent incidents have brought a good deal of deserved and overdue  attention to problems with the mechanics of trading, especially in the United States.

“There has been a lot of value generated by the development of algorithmic trading and some [high frequency] strategies," says Kevin Cronin, global head of equity and FX Trading for Invesco, "but it does not require much of a logical leap to see in these developments cause for concern.”

Why the worry? Let’s begin with an obvious glitch. BATS Global Market Companies, the parent of the BZX Exchange and the BYX Exchange, went public on March 23, 2012. As a result of the malfunctioning of the company’s own trading systems, what BATS called a “systems issue affecting trades in securities in symbol range A through BF,” its own shares quickly dropped from the $16 offering price to just pennies. Its history as a public company didn’t last until the end of that business day.

Forbes’ Steve Schaefer was writing by the following Monday of what such blowups do to “the public’s fragile confidence that markets are fair to all participants.”

Facebook

The much-hyped social media concern Facebook went public just two months later. The result was not quite as thorough a debacle as that of BATS, but it wasn’t pretty. Part of the problem was that the underwriter, Morgan Stanley, was overly aggressive in the pricing. But this was compounded by the computer malfunctions at the exchange concerned, NASDAQ. Millions of dollars of trades were mishandled. As the smoke cleared, many of the early investors had the feeling they had been … well, the word “defriended” doesn’t quite cover it.

If this was a one-time foul-up, (or two one-time foul-ups) affecting only the shareholders immediately involved, it wouldn’t be worth a lot of discussion for the rest of us. The usual clichés: “markets involve risk,” “stuff happens,” would suffice. But this isn’t isolated, and the trends are worrisome.

What is worrisome isn’t simply that the systems sometimes fail. It is that usually they work as designed, and this has unfortunate results for the folks who were once the backbone of the market. A lot of actual or potential retail investors find themselves in the position of supermarket shoppers who keep getting line-jumped.

Suppose that as soon as you, out shopping in a certain grocery store, chose a check-out lane, several other ‘shoppers’ regularly appeared in that lane ahead of you. Heck, they ‘beamed in’ as Trekkies would say. Would you continue shopping in that particular store? Especially if your choice of a particular line turned out to be the signal that caused these voyagers to beam into position ahead of you? You would be in good company if you answered “no.” What may be happening in markets today is the loss of real liquidity, covered up somewhat by the creation of a lot of virtual liquidity. The real shoppers are leaving, the techno-churners are staying.

Knight Capital

“Those of us participating in the markets,” Cronin told me, “have to ask ourselves: what are we trying to solve for here? Capital formation? That is a critically important function and one that the equity markets have long served, both the primary and the secondary markets. But we surely aren’t trying to solve for the ability to trade in a microsecond for its own sake, or just because as a matter of engineering it’s possible.”

It may well be, as he suggests, engineering for its own sake that has gotten out of hand. A little more than two months after Facebook’s inauspicious debut, the glitch-gremlins hit Knight Capital (August 1).This seemed like karma. Knight had earlier in the year bragged that its new “Sumo algorithm” would allow it to “use real-time and historical liquidity measures to complete an order as quickly as possible.” By the end of August 1, though, Knight’s executives no doubt felt as if a sumo wrestler were sitting on their respective chests.

It still isn’t clear just what happened, but it appears that faulty coding snafued the trading in 140 stocks. One of those stocks was Molycorp Inc., a Colorado based mining concern, which usually has a volume of 2.6 to 2.7 million shares daily but which sat more than 5.7 million shares change hands within a period of 45 minutes August 1.

Decimalization

Behind all the glitches is a trend, the rise of algorithmic and high-frequency trading to a level of prominence that would have been unimaginable as recently as the 1990s. What is behind this rise to prominence? Some analysts look to the SEC’s decimalization of the U.S. markets in 2000.

Two senior advisors at Grant Thornton, David Weild and Edward Kim, have argued for years now, that the late 1990s stock market bubble “and the legislative and regulatory aftermath created … a Perfect Storm,” conditions ideal for undermining infrastructure and driving long-term investors out of equity.

One of the factors that perfected this storm, in their view, was the decimalization of the U.S. exchanges in 2000.  Badly mixing Hollywood metaphors from one movie to another, they call decimalization a “Death Star.”

The ability of small and medium sized firms to access the public equity markets is the especial concern of Weild and Kim. Those wider pre-decimalization minimum ticks had allowed for wider spreads, and those wider spreads had paid for a professional network, which in turn did the critical work behind a successful IPO. Those spreads, those large ticks, had paid for middle-market institutional sales groups, after-market support, and research analysts.  All of those have shriveled since and an IPO has become an obstacle course, where slip-ups become ever easier.

IPOs are not in principle severable from the working or failings of the secondary market. If computerized traders jump in front of the other shoppers (or, to be more technical, jump in front of a best bid and offer, a BBO), and there is an eighth or even a sixteenth of a dollar until the next price point, the jumpers run some risks. They run much less risk if they can get just one penny in front of a BBO. Thus, the HFT games-playing is encouraged.

Invesco, Cronin said, is “especially concerned that if we were to move to sub-penny quotes the risk would virtually disappear and the real goals of the system would be severely undermined.”

Cronin sees merit in the Weild/Kim argument. "We've tried to create a one-size-fits-all system, and it now appears that was a mistake. Pennies are perfectly reasonable for some issuers, especially large market cap stocks, but not so reasonable for others."