Why Small Investors Are Avoiding Wall Street

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Wall Street, banking, economics, and finance…not exactly “rocket science,” but, often, more obtuse, and decidedly, more obnoxious. Let’s start with Wall Street. A few years ago, I viewed a documentary about the hundreds of millions of dollars which were being spent on super/high-speed computer networks by certain factions of the Wall Street crowd. At the time, I wondered why shaving fractions of a millisecond (a millisecond is one-thousandth of a second) from computerized stock transaction-times could justify such huge expenditures. Last Sunday, the CBS program, 60 Minutes, showed how fractions of a thousandth of a second can be utilized to accumulate billions of dollars on Wall Street.

The 60 Minutes program focused on a new book by Michael Lewis titled Flash Boys. In the book, Lewis details the methodology whereby state-of-the-art, high-speed networks are used by certain factions of the money-grubbers on Wall Street to make billions of dollars by beating their competition “to the punch” on equity trades. According to Lewis, the market is therefore “rigged” against other traders, and certainly against mom and pop investors. Here is how it works.

Speed Is Very Expensive, Yet Disturbingly Profitable
The Rich Get Richer…at Whose Expense?

 The Money

When an equity (say, stocks) buyer in Manhattan sees a price on a particular stock that is favorable and initiates a routine purchase, he or she hits the “buy button” on their computer. That sends a computerized “buy” signal speeding through computer networks to an equities exchange on the New Jersey side of the Hudson River. Some portion of the buy-order shares may be executed there, often with the remainder of the shares to be supplied by other exchanges somewhat farther away geographically. In essence, the buy-order is executed and completed, daisy-chain style, down a network of exchanges, each progressively farther away from the buyer in Manhattan.

The boys with the super-fast toys (high-speed computer networks) “see” the buy-order on the trading networks as it arrives at the very first exchange, the closest one – just across the Hudson River. They proceed, in much less time than it takes to blink, to buy shares in that same equity – which serves to very slightly raise the market price of that equity. Then, virtually simultaneously, they sell those shares back, at the higher price, to the original buyer whose buy order is still loping along its daisy-chain path toward completion. The original buyer ends up with his equities, but not at the original price which prompted him to buy. In order to complete the purchase, he must now pay a slightly higher price for the balance of shares which were not available at the first exchange …and you can guess who reaps the profit!

The arrival of the original buy-order at the first equities exchange across the Hudson River ostensibly provides the first opportunity for the HFT boys, the so-called “high-frequency traders” to observe and instantaneously “intercept” the buy order; at that point, their computers spring into action before the original buy-order goes any further down the line.

Although each individual transaction may only net the high-speed, high-frequency traders a penny or two, multiply that by thousands of such trade transactions per second, and it adds up to a handsome profit in a six and one-half hour trading day. A penny of profit per transaction at 10,000 profitable transactions per second during six and one-half hours of trading nets a daily profit of $2,340,000! This structured example and its huge profitability is likely far more conservative than the reality happening on Wall Street.

Not bad at all for the high-speed, high-frequency traders who can afford this capability, but not so good for the average buyer whose “intentions to buy” are anticipated by what might be termed “virtual mind-reading” using high-speed networks. What chance does the little guy have who sits at home in front of his desktop computer trying to make money in the stock market? Can a minnow swallow a shark?

The practice described is termed “front-running” by virtue of the fact that the high-speed nets allow the speed-guys to get in front of the buy-transaction and alter the playing field before all the shares are actually purchased. The practice has not been deemed illegal by government regulators up to this point, but the FBI is now investigating as are other regulatory agencies now that the public is beginning to see and understand a quintessential example of how “it takes money to make money.” Many of us knew this all along – that politics and financial markets are rigged in favor of the rich. I believe the popular phrase is “income/wealth disparity.”

For non-techies: The speed of data along computer networks, even the slower ones, is still blazingly fast – close to 186,000 miles per second which is the speed of light in vacuum and represents the fastest speed possible in the universe; Einstein’s physics says so.

At the speed of light, it takes 5.4 microseconds (millionths of a second) to travel one mile. The difference between a standard, cabled data network and a high-speed fiber-optic cable network in terms of the time it takes to transport data one mile is very tiny, a fraction of a microsecond, and yet that seemingly innocuous margin of improvement is enough to make certain folks on Wall Street billions of dollars.

If the Hardware Chapter of this Story Seems Unbelievable,
Consider the Following Chapter: “Software on Wall Street”

 Data 1's and 0's

Yes, it is true: Computers are dumb slaves! They only do what they are instructed to do via software/firmware programming. Those “marching orders” in the form of data 1’s and 0’s, those computer “algorithms” as they are called in the tech world, are what direct and empower computers to do complex evaluations and calculations in much less than the blink of an eye. The computer programming which implements high-frequency trading on Wall Street and the complex calculations used in banking is among the most sophisticated, anywhere.

Do you recall hearing about financial “derivatives?” These are the shadowy and extremely complex financial transactions that ran amuck and, along with sub-prime mortgages, almost sank our economy back in 2008. Very few people completely understand derivatives – even high-flyers on Wall Street who profit from them. Very few bankers understand them, even at the highest echelons of financial responsibility in the banking world.

If not these folks, who does understand derivatives? In a real sense, only the people who have written the computer code, the programs which execute derivative transactions. Who are these guys? Very often, they hold Phd degrees in mathematics or physics, but they initially had little or no background in finance. Many were educated elsewhere, including Russia and the Ukraine. Among the ranks are folks who could accurately be described as “colorful characters,” non-conformists with different viewpoints and interesting motivations. After the 2008 financial collapse, many of these Phd types were called upon to help the financial world unravel the tangle caused by derivatives and their complex nature.

It is all just a bit scary, don’t you think? What kind of a world has man created for himself? The fact that we have all of this incredible technology gives fitting and glorious testimony to man’s tremendous resourcefulness and accrued knowledge. I am in awe when such technology is used to good purpose, as exemplified by further scientific research about man and his universe. I am grateful for the improved life we all lead thanks to technology’s role in advancing medicine.

Frankly, I am saddened that so much money and technology supports the non-productive, selfish money-grubbing that occurs on Wall Street and in our financial system. Please note that I carefully separate from my criticism the key role computers play in keeping accurate records within our financial system.

My Assessment of Today’s Stock Market

Lately, the market has been rather stuck for some time at the same optimistically high level, but with significant and frequent ups and downs. Although mom and pop investors made good money riding the coat-tails of the big boys during the recent, extended bull market (the only way for the little guy to prosper, these days), anyone’s small investment in today’s market is currently going nowhere but up and down. In contrast to mom and pop, you can bet that the big boys make money every time the market goes through one of its short-term cycles. The current, frequent ups and downs of the market are giving mom and pop investors a headache. The fat-cats are getting richer with every cycle.

As proven by history, it is only a matter of time until the financial system has another significant crash, once again, most likely self-inflicted by excessive greed and over-leveraging on the part of the people in its ranks. In today’s world, any number of events could suddenly knock Wall Street for a loop. At that point, much will be lost, but the big losers are usually the little guys who do not have the visibility to see it coming and can’t sell on a dime in time to get out. The next major crisis will likely not be followed by another extended bull market in which the losers can fairly quickly recover their lost capital.

It is no wonder that so many small investors have given Wall Street the cold shoulder in recent years. Small investor participation in the market is way down, while high-frequency trading is way up…surprise! The man on the street is getting smarter and wiser. If one still likes to gamble, the odds and the entertainment are better in Vegas.

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I have always maintained that technology is a two-edged sword which cuts both ways. Use it wisely and it will germinate flowers in the garden of life. Use it unwisely, and it will grow a weed-patch and become the root of much evil.

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