Meyer Lansky, a key architect of modern organized crime, often referred to as “The Chairman of the Board,” built a gambling empire that stretched from New York to Las Vegas to Cuba and back again.
His casinos were luxurious, crowded affairs, a far cry from the “clip-joints” he must have known growing up on the mean streets of the Lower East Side.
“Clip-Joint” was a pejorative given to describe the crooked gambling halls of the day. The dice were loaded, the deck was stacked, the roulette wheel was fixed and every gambler that went in got clipped.
Between the flash crash, the stunning increase in the VIX and the vesuvian eruptions of trading volume seemingly detached from any underlying economic news; it is beginning to feel like Wall Street has become a clip-joint, at least for the average retail investor.
Rise of the Trading Machines
High Frequency Trading, involves complex, rapid, computerized, algorithmic trading of various financial instruments. Firms that engage in high frequency trading, “HFTs”, usually end the trading day with no net holdings (i.e. they have liquidated every position they entered).
By all accounts HFTs played a major role in the Flash Crash of May 2010when the Dow went from being down 300 points to being down 1,000 points within 5 minutes. The SEC/HFTC issued a joint report regarding the Flash Crash which reads in part: “The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just four minutes…HFTs began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.”
HFTs currently constitute a majority of trading volume for US Equities. Consequently, there has been a significant increase in the VIX (the index gauging the volatility of the S&P 500). According to Gary Wedbush, EVP and head of capital markets at Wedbush Securities, “You can look at a VIX chart and that’s almost perfectly correlated to high-frequency trading volumes.”
There is nothing inherently wrong with computerized trading. However, the enormous impact the HFTs have on the market, makes it extremely difficult for individual investors to determine if a 200 point increase in the Dow is based upon fantastic economic news or just robo traders playing footsie with their equations.
In discussing the impact of HFTs on retail investors, Jim Cramer wrote: “(HFTs) have a speed edge and weapons that are like machine guns in World War I and individual investors are foot soldiers, mowed down by a new technology they can't understand. The individual investor is fodder in the face of these fields of fire.”
However, not everyone dislikes the HFTs. The exchanges love them. Considering the volume of trades and the resulting revenue the HFTs generate for the exchanges, I understand their position. It squares nicely with their short term financial interests. The exchanges argue that HFTs create additional market liquidity. That is true, but the type of liquidity that can make the Dow drop 600 points in 5 minutes is the type of liquidity that can drown a retail investor.
From “Clip-Joints” to “Carpet-Joints”
Back to our pal, Meyer Lansky.
He made a fortune, because he realized that in the long run the casino makes more money when the dice are not loaded, the deck is not stacked and the roulette wheel is on the up and up. In his swanky establishments, lovingly dubbed “Carpet-Joints,” the customers knew, win or lose, the game was fair and square. Wall Street would be well served to follow Lansky’s lead on this point.
The house always has its mathematical advantage and market makers always have their spread. Gamblers and investors expect that. But they also expect a fair shot, honest dice, a market that effectively values assets.
Unfettered, high volume computerized trading may be good for short-term profits at the exchanges. But, for the long term good of the financial community and the country, retail investors need to trust that the market accurately reflects underlying economic conditions and are not merely algorithmic tornadoes conjured up by the HFTs.
If retail investors lose faith in the integrity of the market, the trip from carpet-joint to clip-joint is a short one indeed.