Is This The Next Area of Concern?

By Justin Urquhart Stewart 09:28 9- Nov -2009

So where is the next problem going to come from? Even though we haven’t anywhere nearly sorted out the mess from the last crisis, people are still desperately looking for the next one. Sadly the gift of foresight has not been given to me but at least some common sense might provide some help.

So where is the next problem going to come from? Even though we haven’t anywhere nearly sorted out the mess from the last crisis, people are still desperately looking for the next one. Sadly the gift of foresight has not been given to me but at least some common sense might provide some help.

The murky worlds of ‘High Frequency Trading’ (HFT) and ‘Dark Pools’ are beginning to attract some attention and certainly some light into this gloom could be revealing. Essentially, as the name implies, HFT is automated computer trading at high speed and high volumes. These are systems which are often run and owned by investment banks and trade according to their proprietary programmes and seek out any pricing differences or anomalies they can find, and consequently trade on them. The idea being that even with fractional differences, a huge volume of trades can be potentially very profitable.

The term ‘Dark Pools’ refers to trading that takes place away from the major exchanges and are traded at prices which are not disclosed until after the transactions have been completed. These are normally for institutions wishing to trade quite substantial blocks of shares without drawing attention to themselves. These structures are called ‘crossing networks’ and are run by independent operators, exchanges and investment banks. To a great extent these came about because of the monopolistic behaviour of certain stock markets and their uncompetitive charges.

Now all of this innovation should be welcomed, after all faster trading at lower costs should be good for clients and users, and also improving proper price formation and, of course, ironing out price aberrations as they occur. Surely this is a great use and application of technology?

However, I would consider that there are some considerable issues that should be addressed here.  First of all, can we really regard HFT as investing? Isn’t it rather an automated computerised gambling and trading programme, feeding off other market trades? It is certainly light years away from the concept of what a stock exchange is for, whose primary role is to raise money for business in the most cost effective and efficient manner. The secondary role for stock markets was thus the trading in the stock listed upon those exchanges – HFT has taken this to a whole new level. So in reality, this has no connection with share ownership or investment in companies which goes against the main premise of a joint stock limited company. Research and evaluation of companies is thus irrelevant, corporate ethics and social responsibility of no interest and the actual business of the company of no consequence whatever. This is not investment – this is programmed gambling.

Also, to those who serve their clients in the markets, these trading programmes will be automatically reacting to individual and even small private client trades and effectively getting better prices than the stockbroker can and, one can argue, distorting the market. After all what then is ‘best price?’ In fact you could find the situation whereby the investment house you may be trading with could be making a ‘turn’ out of giving wider prices just to enable them to make more - especially if they are able to see trades entered before they are actually executed – and yes, that is possible.

Does this then make it a fair and open market? Is there thus a case for banning such behaviour as it is anti-competitive and monopolistic towards other providers and traders, and distorts the market?

These are valid concerns, but of course it is always easy to apply the dogma of the ‘Spinning Jenny’ and ban such innovation. However, I don’t think there is any reason for such Luddite behaviour – standing in the highway of progress normally results in messy road kill.

I don’t have an easy answer or solution, but I can see a problem not just in distortion, but rather in trading that is hidden. This is a charter for potentially illegal, corrupt or more probably potentially destabilising markets and just where another financial explosion could occur, if there was lack of capital support, security and effective regulation.

The answer I suspect will lie with the need for greater transparency and intelligent automated and live trading regulation to sit alongside these functions. Additionally those that operate in such worlds, should have to bear the necessary capital requirements to cover the risks themselves and not to fall back on governments and tax payers.

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After the GM/Magna fiasco, I suspect the Russian investor in the rejected consortium must be indeed annoyed at not being able to acquire such assets at a knock down price. For others though, this period of weaker industrial valuations has provided both a boon and boom for emerging market investors with reserves to spend.

China especially has taken the opportunity to buy into such technology at prices akin to a fire sale. The preferred bidder for Ford’s Volvo car brand, Geely, is offering to pay about a third of what Ford paid a decade ago. Also the Beijing Automotive Industry Corp is taking a stake in Koenigsegg, the Swedish supercar company that has bought Saab, and another Chinese car maker, Sichuan Tengzhong  has bought that most American icon - GM’s Hummer brand.

The good news is that this shows that the Chinese are reinvesting their reserves of capital and not sitting on it like the greedy dragon often portrayed. The bad news for western nations is that their hard won and expensive investment in technology is being sold off cheaply – but if you want the capital investment you are going to have to give up something and something valuable.

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And finally.........odd news from Rio de Janeiro.  A Brazilian bricklayer was reportedly killed in a car crash. As is customary in Brazil, the funeral was held the following day, which happened to be the holiday of Finados, when Brazilians visit cemeteries to honour the dead.

What the family members didn't know was that the bricklayer had in fact spent the night at a truck stop talking with friends over drinks of sugarcane liquor known as ‘Cachaca’. He did not get word about his own funeral until it was already happening on Monday morning.

A police spokesman in the town of Santo Antonio da Platina said “the driver Goncalves rushed to the funeral to let family members know he was not dead. The corpse was badly disfigured, but dressed in similar clothing. People are afraid to look for very long when they identify bodies, and I think that is what happened in this case."

His niece Sampaio said that some family members were not sure if the body was Goncalves. "My two uncles and I had doubts about the identification," she told the newspapers "but an aunt and four of his friends identified the body, so what were we to do? We went ahead with the funeral."

The police spokesman confirmed there were doubts: "His mom looked at the body in the casket and thought something was strange. She looked and looked and couldn't believe it was her son," Sampaio said. Before long, the walking dead appeared at the funeral. It was a relief.

“The body was correctly identified later on Monday”, the police spokesman said, “and has already been buried in another state.”

Have a good week.

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited