Michael Lewis’s new book “Flash Boys” is an expose on high speed trading of stocks that allows traders to rip off the unsuspecting public by inserting itself in all stock trades between buyers and sellers. The high frequency trading (HFT) boys buy fast and sell fast, picking the pockets of the average investor.
The problem with this story is not the scandal itself. Most investors are not sympathetic with the likes of the typical HFT scammer. Billions of dollars earned essentially by the Wall Street version of a parasite is not going to generate much public support. The problem is that the scheme Lewis focused on generally nets a few pennies a trade — a number so low that most small investors wouldn’t even notice. Of course a few pennies a trade adds up when you operate at speeds up to 1,000 trades a second. But paying $31 a share for a given stock instead of $30.90 might not draw much attention in the short run.
A much bigger scandal that Lewis completely missed is in the commodities market. Here high frequency trading can do a lot more damage for prices paid by the average person on such things as gas or food than speed trading of stocks.
For starters, the commodities markets don’t trade in actual commodities. The markets trade in futures contracts. You don’t buy or sell a bar of silver or a bushel of wheat. You buy into a contract to buy or sell these commodities. This may look good on paper, but the reality is that few contracts are ever executed where the commodity in question actually changes hands, meaning that commodities trade in an imaginary world. So a high frequency trader can trade back and forth with these paper contracts setting imaginary prices based on imaginary commodities that exist only on paper.
Worse of all, the price of the contract is a small fraction of the price of the actual price of the commodity. It’s essentially “buying on margin,” and a rather substantial one at that.
The purpose of the futures market was originally to allow producers or a user of a commodity to lock in prices. That’s gone out with 78 rpm records. As 60 Minutes once pointed out, the biggest trader in oil was not an oil company but a Wall Street bank. This isn’t about trading commodities. It’s all about gambling for quick returns.
Futures contracts are no different than gambling chips, and HFC allows the commodities gambler to high speed trade in the middle of the night when there is little trading going on. Bring in another trader and trade back and forth, setting artificial prices and forcing other traders in and out of their positions, making millions in the process.
Worst of all, some of the commodities prices resulting from this flim-flam have no relationship to reality whatever. Silver, a market I follow closely, has a price of about one fourth of what it would have been in an otherwise “free” market. How do we know this? Because silver exists in nature at a ratio of 16 to 1 to gold. That gives us a price of 1300/16 or roughly $80 an ounce, not the present $19 an ounce. In addition, there are substantially more gold bars in inventory than there are silver bars (which is what’s required for commercial use and what has to be delivered for a silver futures contract). This would cause a crisis if most of the traders on the short side had to deliver silver to meet their obligations. There would be a default, and a possible domino effect on other related derivative contracts.
A lot of this nonsense could be reduced if the regulators would do their jobs, placing substantial limits on trading and identifying who actually is a legitimate trader in the commodity in question. As one critic noted during the Bernie Madoff hearings, the Wall Street regulators couldn’t find third base if they were sitting on the third base line in Fenway Park. Wall Street regulators are either corrupt or incompetent, and it’s anyone’s guess which is worse.
It should come as no surprise that one common nickname for the COMEX (COMmodities Exchange, inc) is “the CRIMEX.”
The best bet would be to stop high frequency trading altogether by placing a small charge on each trade. While most legitimate traders wouldn’t notice the charge, those trying to trade in milliseconds would be put out of business. At the same time we could just close the COMEX and the other futures exchanges and get rid of the most obvious gambling casino on Wall Street. It couldn’t be any worse than it is now, where only a handful of paper traders set prices with nothing to do with reality.
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