Monday, August 29, 2011

High Frequency Trading: Tail That Wags The Dog, Part II

A follow up to this previous post.

High Frequency Trading: Tail That Wags The Dog

Hedge fund manager, Leon Cooperman, thinks regulators should go after high-frequency trading. In this CNBC article, he said there's no reason markets should go up and down by such large percentages each day. He also said:

"Credit default swaps are also adding instability to the marketplace, and they should only be permitted to be traded in by those institutions and individuals that own the underlying bonds," Cooperman explained.

Charlie Munger, often bluntly critical of the financial sector, said* the following about derivatives like credit default swaps:

"Unlimited leverage comes automatically with an option exchange. Then, next, derivative trading made the option exchange look like a benign event. So just one after another the very people who should have been preventing these asininities were instead allowing foolish departures from the corrective devices we'd put in the last time we had a big trouble—devices that worked quite well."

"Interest rate swaps have enormous dangers given their size and the accounting that has been allowed. But credit default derivatives took that danger to new levels of excess—from something that was already gross and wrong."

So these changes undermine control of financial leverage in the system. Munger makes the point that these changes essentially take away the Federal Reserve System's longtime control of margin credit.

More on high frequency trading. From this Minyanville article written by Jeffrey Saut:

So who's selling? I think it is the "machines," driven by high-frequency trading (HFT) and Exchange Traded Funds (ETFs)...Exacerbating the situation are ETFs that are leveraged 2:1, or even 3:1, which if bought on margin implies 4 to 6 times leverage. Moreover, when ETFs buy or sell, they do so across the spectrum of stocks within their universe with NO regard for the fundamentals of any individual stock. So yeah, I think it is the "Rise of the Machines" that has compounded the "selling stampede"...

It's likely that some or all of the many market "innovations" that have come about go a long way toward explaining this Bespoke Investment Group chart that I mentioned in the previous post.

Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us -- our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It's like letting rats into a restaurant. - Charlie Munger

Charlie Munger on Accountants & High Speed Traders

If these new sources of liquidity and ways to make side bets via things like credit derivatives have added instability we'd be wise to fix it yesterday. It's just dumb to allow things to function so much like a casino considering the vital purpose that the capital markets serve.

Until that happens, an individual investor with a long horizon has to learn to buy shares with discipline, whenever prices get comfortably below intrinsic value, and have the temperament to hang on for an unnecessarily rough ride.

The good news is the long run value creation of a good business does not fluctuate nearly as much as market price action might otherwise seem to indicate.


* Munger also added the following about derivatives: "In the '20s we had the 'bucket shop.' The term bucket shop was a term of derision, because it described a gambling parlor. The bucket shop didn't buy any securities. It just enabled people to make bets against the house and the house furnished little statements of how the bets came out. It was like the off-track betting system.

Derivatives trading, with no central clearing, brought back the bucket shop, because you could make bets without having any interest in the basic security, and people did make such bets in the billions and billions of dollars. Some of the most admired people in finance — including Alan Greenspan — argued that derivatives trading, substituting for the old bucket shop, was a great contribution to modern economic civilization. There's another word for this: bonkers. It is not a credit to academic economics that Greenspan's view was so common." 
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