Senatorial Subcommittee Begins Investigation of High Frequency Trading

Tuesday began the first day of Senator Carl Levin’s Permanent Subcommittee on Investigations hearing on “Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets,” covering potential market ‘rigging’ that was brought to the public’s attention via the release of Michael Lewis’ book “Flash Boys”, and further highlighted in a 60 Minutes interview on CBS this past March. Michael Lewis was not the first person to highlight this matter, but the first best-selling author to bring it to the public’s attention. The matter of high frequency trading and its potentially adverse affects is also discussed in great detail by Les Leopold who wrote the book “How to make a Million Dollars an Hour: Why Hedge Funds Get Away with Siphoning off America’s Wealth”.

High frequency trades are enacted by machine and not by people and are literally enacted on in fractions of time on the span of a millionth of a second. Typically the high speed frequency trades are enacted upon by a class of hedge funds. They set up their ultra high speed computers right next to the stock exchanges so that the high frequency trader get the feed a few nanoseconds before the rest of the world, and for this they pay a fee to the exchange. Then with the help of expert programmers, that information is effectively used to automatically jump in ahead of normal investors. When these high frequency traders buy stocks that others want, they effectively jack up the price a little bit and then sell them back to these normal speed buyers. This means that when the rest of us hit the buy button on E-Trade, a high frequency algorithm has probably jumped in there before us, bought the stock we want, and is selling it back to us for a few pennies of profit. They do this millions of times a minute, racking up from $5 to $20 billion a year. It's like a hidden private sales tax that goes into the pockets of high frequency traders. Our pension funds and 401(k) s are fleeced as well. So basically, the major concern is that high frequency traders are front running ahead of the rest of non-high frequency traders and adding a layer of cost onto the system.

Typically those that argue on behalf of high frequency trading insist that they add liquidity to the market. Before accepting such arguments, it is good to recall what liquidity really means in the stock market. Liquidity simply means that when you buy a stock, you should be able to just as easily sell that stock. Now you may not be able to sell the stock at the price you want, but at least there is a market available that has some price at least you can sell the stock at. In other words, there is someone out there who is willing to take the risks of buying and owning the stock at some price. So potentially any additional trader that wants to transact at a specific price is adding liquidity. So effectively, the argument should not be whether or not high frequency trading adds liquidity, but does it distort the market, and add additional hidden costs to trades that eat away at returns while simultaneously not adding anything of economic value.

Another common argument is that anything done now by computer was formerly done by ordinary people. Well, people do not work in the nanosecond time scale.

The bulk of today’s discussion was focused on the current pricing model of ‘make or take pricing’. Essentially, exchanges arrange trades by allowing traders to post standing limit orders that indicate the prices the traders are willing to buy and sell as well as the associated quantities. A standing limit order will ‘stand’ or stay in place until there is another trader willing to buy or sell at that price, and may go completely unfilled. Other traders see the prices, and place appropriate market orders which are just buy or sell at the current price, or marketable limit orders, where a buy limit order is a trade at or above the lowest offer in the market.

In ‘make or take pricing’, those traders that place the standing limit offers are said to be the makers of the market, in the sense of ‘making market liquidity.’ Those traders that place a market or marketable limit order are said to be the takers in the sense of ‘taking away market liquidity. The exchanges charge those that are labeled the takers an access fee. A portion of the access fees are rebated to those traders that are considered the makers in what is called liquidity rebated.

Here is the concern. You have ‘makers’ that trade in fractions of a second based on algorithms that deliberately seek out liquidity rebates. The trades occur so fast that they are not reflected in the standard bid/ask spread that average investors look at. For that matter, staring at second level NASDAQ quotes which shows all the orders will not reflect this type of trading either because they occur at fractions of a second. To participate in this market requires high level software and extra computing power. So the big question is, does ‘make or take pricing’ model even make sense in today’s electronic market place?

These are not easy questions and it’s unlikely that Senator Carl Levin’s committee will come up with any straightforward answers, mainly because the industry insiders that the senatorial committee is questioning do not really know the answers themselves.

Can the Crisis in Iraq threaten Stock Portfolios?

According to the majority of oil analysts, any forecasts on oil pricing that suggest long term the cost of crude will fall to $90 per barrel or even stay in the low $100 per barrel range is based on the notion that Iraq oil production will be continuously increasing from 2.3 million barrels per day now to about 6 million barrels per day by 2012. The International Energy Agency this past October predicted that Iraq would begin to top past 8 million barrels per day by 2035 and surpass Russia as the world’s second largest oil producer. Now that Iraq appears to be undergoing what can be described for all practical purposes as the beginnings of a civil war, all of this may become unlikely.

If Iraqi production were to shut down, the impact on oil prices would be profound and the oil needs would have to be met by usage of oil elsewhere. Saudi Arabia would certainly be able to make up for the potential shortfall. Although now for the first time in decades, the United States is exporting more oil than it uses, only a scant 3% is actually exported, in part due to government controls, but lifting those controls will not make a significant impact either. The biggest fear is Iraq repeating what occurred to Libya in March of 2011. After the fall of Muammar Gaddafi, oil production in Libya went from 1.6 million barrels per day to 200,000 barrels per day. Only now is Libya back to pre-war levels of oil production with 70% dedicated to exports, and the remainder refined for local use. Libya’s own court system has held back on granting increases in production as Libya is still under a struggle to determine who runs their government.

Currently, Brent for August settlement gained 47 cents, or 0.4%, to $112.93 a barrel for June 13. The July contract ended at $113.41 on June 13, the highest since Sept. 9. The volume of all futures was 1% above the 100-day average for the time of day.

As long as oil prices do not soar, the crisis in Iraq should have little impact on the broad U.S. stock market. If oil prices do start to significantly increase, the increased societal cost can be viewed as potentially causing an economic downturn followed by a recession, and this would crater the stock markets short term.

Right now the oil markets appear complacent about geopolitical risks in Iraq. However there is certainly quite a bit of uncertainly into just how much of a civil war might evolve out of Iraq, and whether there is the potential for U.S. involvement.

Many of the causes of the current conflict in Iraq can be traced back to appointment of Paul Bremer President Bush as Presidential Envoy to Iraq on May 9, 2003. His appointment declared him subject to the "authority, direction and control" of Secretary of Defense Donald Rumsfeld. Paul Bremer proceeded to establish de-Baathification laws in which Paul decreed that no member of the ex-ruling Baath party’s top four ranks could hold any position in the public service or state bureaucracy. That included even simple positions as school teacher and members of the Baath party were primarily Sunni Arabs. The administration then proceeded to aid with the election and placement of Shiite Arabs in positions of power, mainly by support of the now Prime Minister of Iraq, Nouri al-Malaki. This practice encouraged and inflated sectarian conflict since 2003 and now seems to have gained momentum with the aggressive actions of militants from the Islamic State in Iraq and Syria (ISIS), which is affiliated with terrorist organization, Al Qaeda.

The country’s 2.58 million barrels a day of exports in May were all shipped from the south while northern shipments via the Kirkuk-Ceyhan pipeline have been halted since March 2, Asim Jihad, an oil ministry spokesman, said June 1, 2014. ISIS, which seized Iraq’s second-largest city of Mosul last week, has control of the pipeline to the 310,000 barrel-a-day Baiji refinery, the country’s biggest. Hopefully the oil flow doesn’t become threatened any further.

Average Americans Are Not Experiencing an Economic Recovery

Unfortunately, the average American still earns less now per hour after inflation than he did five years ago when the U.S. exited its worst recession in decades. Consumer spending drives most of the United States’ economic activity, and it has been weak enough for economist to conclude that the country is experiencing its weakest recovery since the Great Depression.

The problem is not only incomes not rising, on average they appear to be in a state of decline. In May, the real average hourly wage fell 0.2% to an inflation-adjusted $10.38, the government said Tuesday. Real wages have fallen thee straight months amid a sudden surge in consumer products inflation over the same period of time. The surge in inflation wasn’t so much do to the core rate CPI which did move up 0.3%, but the more volatile food and energy prices. Multi-year droughts have played a big factor is rising food costs, and the current crisis in Iraq is unlikely to allow energy cost to go down significantly any time soon.

As it is for the average American, about 40% of the base income goes to housing or shelter, 11% goes to FICA tax, income and sales taxes shave off another 10 to 15%, and about 15% goes to another non-housing related debt which is typically either credit card debt, student debt, or an auto loan. Only about a third of the average wage is left for spending on food, transportation expense such as gasoline, healthcare, and clothing. For the most part, luxury spending is sharply down except for elite classes. As consumer spending is needed to drive economic growth and hence job growth, the average consumer can not increase spending without going further into debt or dipping into savings, none of which they are likely to do.

Over the past decade, rising home prices allowed for home equity lines of credit and home equity loans to be accessed for continued growth which is no longer available since the bursting of the real estate bubble.

The average weekly paycheck has risen an inflation-adjusted 1.8% from June 2009 to May 2014. This may seem like a contradiction as average hourly pay actually went down, but the average work week for the majority of Americans has actually increased. This means that more people are working harder and longer hours for less pay. While this is not a positive for workers and is not boosting consumer spending, it has allowed S&P 500 companies to keep down labor costs, and has been a strong plus for their profits.