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Money Murder Mystery: Who Killed the Stock Market?

Stock-Markets / Stock Markets 2015 May 25, 2015 - 10:12 AM GMT

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MoneyMorning.com Shah Gilani writes: Liquidity, the "life blood" that allows the world's capital markets to function, has been murdered.

Liquidity was choked violently in the bond market by the gloved hands of its erstwhile babysitter – the broker-dealers- but it bled to death in the stock market from a thousand cuts.

We should be afraid. The lurking henchmen who worked as lookouts on "the job" are the very regulators and guardians of the stock and bond markets who should've stopped it.

Worse, they don't understand their own crime.

That's scary enough, but what's more frightening is how the wheels of both the stock and bond markets could seize and come to a screeching halt at any time.

Investors who don't want to be murder victims need to examine the evidence.

Here it is, in black and white with red all over…

Dead on Arrival: One of the Most Important Functions of the Market

Liquidity – the victim in our financial-markets murder mystery – is the ability to buy and, more importantly, sell the stocks, bonds, derivatives, and other financial assets that define the capital markets.

And you want – indeed, you need – to be able to make these transactions without moving prices too much.

If you have to pay up for a stock or bond because there are more buyers than sellers, while the additional cost isn't desirable, it's not the end of the world. At the end of that trade, you actually own the asset.

But if you want to sell that same asset at a time when there are more sellers than buyers – and the price is falling – if the buyers you thought would always be there disappear…

Well, you're dead.

And in the absence of liquidity – meaning the absence of buyers – prices can fall precipitously.

In other words, liquidity is critical for smooth functioning markets. Abundant liquidity has been the hallmark of U.S. capital markets. While there have been corrections and crashes in those markets, most of them were caused by massive selling that overwhelmed normal liquidity.

That's not the case anymore.

There is only normal liquidity on sunny, up-market days.

But on down days – for stocks and for bonds – liquidity dries up quickly. Indeed, it can disappear altogether – literally – in a matter of seconds.

Disappear as in: none. No buyers to be found – at any price.

We saw this exact scenario play out on May 6, 2010, in the infamous "Flash Crash." All stock market indexes plunged that day. The Dow Jones Industrial Average plunged 998 points, about 9%, in 36 minutes. That was the biggest intraday decline in Dow's entire history.

Lots of mini-flash crashes – mostly in single stocks – have happened since.

More are on the way.

The Real Killer Isn't Who You Think

Don't for a New York second believe that some day trader hunkered down in the basement of his parent's suburban London house, whom U.S. regulators want to hang for causing the Flash Crash, is the villain in this capital-markets whodunit.

So what if this trader "manipulated" markets by putting down thousands of sell orders to create the appearance of a virtual Mongol horde coming to burn stocks down?

So what if he then canceled them after profiting when the futures he shorted fell on the market's reaction to his spoofing and layering games?

Truth is, that's done thousands of times every minute of every trading day by the high frequency trading (HFT) desks nestled safely within big banks, investment banks, and hedge funds – and by Virtu Financial Inc. (NASDAQ: VIRT), a company recently listed on the Nasdaq – as well as at trading desks all over the world.

Stock market regulators want you to believe that there are "bad guys" out there who are going to be rounded up for "crimes against the market."

But the regulators are telling us this because they can't ever tell us the truth.

The truth is, the Flash Crash happened because regulators – unwittingly at first, then by aiding and abetting HFT market-gamers – oversaw the gradual, then wholesale, destruction of liquidity in the U.S. stock market. It can and will happen again.

There's only one reason stocks can free-fall: There's no liquidity. If there are no buyers waiting to catch falling assets at even bargain prices, there is no "bottom" to the market.

If there's no liquidity – and no bottom other than zero – investors caught in the next free-fall may not be so lucky, especially if markets don't rebound like they did in May 2010.

Disrupting the Disruptor

That brings us to an important question: Where have all the bidders gone?

Just what has caused this capital Disruptor, this lack of liquidity we're experiencing today?

The answer isn't a secret. And it's not hard to understand.

So-called "modernization" – which unfolded one step at a time – changed how the markets function.

The net result of all those changes is the lack of liquidity that we're seeing today.

Once upon a time, would-be buyers of stocks used to line up to buy shares of the stocks they wanted.

In these ancient times, they sent orders to their brokers, who then sent those orders down to the floor of the New York Stock Exchange (and, later, to other physical exchanges).

Upon arrival, "specialists" wrote, with actual writing implements, the orders down in their leather books. Both buyers and sellers put down orders.

Lots of prospective buyers wanted to have orders down to snap up shares if prices dropped to levels these traders believed to be good purchase points.

On any given day – for years and years, in every well-known stock – there were hundreds of thousands, then millions of shares to be bought on specialists' books on the NYSE, the American Stock Exchange (AMEX) and, later, on the electronic books of market-makers on the National Association of Securities Dealers Automated Quotations (Nasdaq).

The first big hit to liquidity resulted from increased exchange competition. The advent of computers on trading desks, and then personal computers, yielded Instinet (the first private electronic trading network for institutions).

This was followed by a bevy of electronic communications networks (ECNs). ECNs fought and won the right to list, on their trading platforms, the same stocks that once only traded on the NYSE, the AMEX, or the Nasdaq.

With many different venues available to traders and investors, the orders that once stacked up on the books of a handful of specialists got spread around everywhere.

Then came decimalization…

Now, prior to decimalization, stocks mostly traded in eighths of a dollar (which, incidentally, harkens back to the days of Spanish "pieces of eight"), meaning increments of 12.5 cents each.

But the Securities and Exchange Commission (SEC) decided that, from April 9, 2001, on, stocks could trade in increments of one penny – in decimals, because there happen to be 100 pennies in a dollar.

While it was noble to think that smaller increments would tighten bid-ask spreads, lower transaction costs, and increase market liquidity, there were unintended consequences.

And liquidity was one of the victims.

How It All Works

In a nutshell, so-called market "insiders" – meaning specialists and market-makers who get customers' orders to execute and therefore know what prices they are willing to buy and sell at and for how many shares – instantly discovered they had a cheaper way to make money. That's because specialists and market-makers also trade for themselves.

Let's go back, before decimalization, and pretend I was a specialist or market-maker in XYZ stock. Let's say you sent me an order to buy you 100,000 shares of XYZ at $25. I see there are not a lot of buyers below your order who are willing to buy at the next level down, which would have been $24.875. And I see there are a lot of "sell" orders coming in at $25.125. I would sell you the shares you want myself.

That means I'd be short 100,000 shares, because I am a specialist or market-maker and can do that. I do that because I see there are a lot of "sell" orders – and not a lot of "buy" orders – so I believe I'll benefit by being short if the stock goes down.

But if I'm wrong and more buyers come in, or out of the blue a big buyer comes in and buys the stock being offered at $25.125, I'm in trouble. I'm short at $25, and the stock is already higher trading at $25.125. Because I'm at risk for at least 12.5 cents a share if I personally sell you the stock you want, maybe I won't make that trade – or I will trade against you.

But after decimalization, I'm only risking a penny if the next highest offer to sell is $25.01. I'll be far more inclined to hit your bid and sell short stock to you if I know I'm only risking one penny, if I can cover my short at $25 by buying shares back at $25.01.

What happened after decimalization was that specialists, market-makers, and traders of all stripes actually had less risk when they speculated because the minimum increments were cut from 12.5 cents to a penny.

On the other hand, mostly buyers – who wanted to buy stocks for a longer-term investment and who wanted good prices – kept getting picked off by traders trying to then knock down prices.

In the final analysis, fewer and fewer buyers were willing to just put down orders and leave them. Buyers now stay on the sidelines waiting until they see favorable prices to put down orders.

The net effect of all the changes I've described to you: There's no real liquidity anymore, most importantly on the downside, because orders are spread around now and because buyers don't like getting picked off – meaning they stick to the sidelines until they're ready to put down orders.

Then came the high-frequency traders.

The exchanges and regulators let the HFT crowd infiltrate the wires transmitting "buy" and "sell" orders to and from exchanges and trading venues, so they could read "order flow" like specialists and market-makers – but without providing the actual services that are supposed to be part of their duties.

In other words, they are just "pick-off artists" reading our orders and trying to influence those specialists and market-makers to trade on us, around us, and against us.

So what if it's a penny, says the HFT gang and the regulators under their breath?

HFT gangs are not liquidity providers – despite their claims. They turned off their computers during the Flash Crash.

There were no buyers in the Flash Crash because there is no real liquidity in the stock markets anymore.

That's a problem that's going to one day crash the markets. We have the regulators to thank for that.

And the bond market?

It's bleeding liquidity at an alarming rate. In fact, it's the bond market – not the stock market – that's going to crash first. And that bond-market stumble will tank the stock market.

You didn't know that?

That's a story for another day. In fact, it's the next big Disruptor story I'll tell you. You need to hear it…

Source :http://moneymorning.com/2015/05/25/a-money-murder-mystery-who-killed-the-stock-market/

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