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The True Risk To The Financial Markets Is Not High Frequency Trading

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Why HFTs Are Only A Symptom, Not The Cause Of Financial Industry Fragmentation

Since the explosive debut of the Flash Crash back in 2010 and, more recently, Michael Lewis’ book “Flash Boys,” professional financial news and retail financial news websites have been inundated with articles discussing High Frequency Trading, market rigging, market manipulation and the consequences of new regulations.

However, HFTs and the emotional reaction they incite around the financial world are not the true cause of the current average investor mistrust that is facing the financial markets.

HFTs are merely the visible rupture of a far more severe systemic problem.

Main Street mistrust of the financial markets, and in particular the stock market which takes the brunt of average investor anger, is apparent to everyone and a huge concern to the Buy Side Institutions, retail brokers and vendors who sell products and services to the largest market participant group many know as Main Street.

Without the average investor and retail trader, the financial markets would not survive. Worldwide, there is approximately 90 trillion dollars under financial management, nearly all of which comes from Main Street Mutual Fund investors and pension fund holders.(1) An estimated 64+ Trillion dollars were under professional management in 2012, with a projected estimate of $100 trillion by 2020, a mere 6 years from now.(2) This is a staggering amount of money, nearly double the entire global economy of 2012.

The Financial Industry is facing the same systemic malaise as the Communications Industry did after the US government broke up the Bell System after the decade-long antitrust litigation against the company, the largest in the history of the US. AT&T (NYSE: T) survived as the long distance carrier and is still a publicly traded company today. The monopoly of the entire Communications Industry in the US was unprecedented and the breakup lead to a fragmented communications industry that took 2 decades to recover.

Between 1982 and 1994, consumers were frustrated, confused, and overwhelmed by the huge number of little companies and larger firms that rushed to fill the void of Ma Bell. Phone service became a nightmare of choices with rising or unpredictable costs and mayhem for the consumer. Hundreds of smaller firms offered a variety of phone services with no consistency to cost or services. In addition, the then-new industry of Internet services added to the perplexity of finding a good, low-cost phone service. The most maddening aspect of the breakup of Ma Bell was the fact that phone service became more expensive, less reliable, and constantly problematic. Gone were the days of reliable phone service, replaced by a mish-mash of smaller firms with complicated services that failed to live up to customer expectations with hidden costs and fees. Startups grew, stole customers from other firms, and then promptly failed, leaving customers to scramble for another phone service provider. Small Businesses suffered the most with rising phone costs, reduced services, and communications networks they could not depend upon. Most people who lived through that era have long forgotten it.

Out of that era, the cell phone emerged and eventually the smart phone and the dominance of Apple Inc. (NASDAQ: AAPL). This took more than a decade to resolve, however, and emphasizes the length of time it will take for financial services to rid itself of the fragmentation that has consumed the industry.

Other industries have faced similar challenges where too many smaller firms offer similar services or products at varying costs and structure. This is precisely where the Financial Services Industry is today, facing a fragmentation that can destroy even the largest corporation as smaller companies with competitive, or even inferior, products and services appear and seize more customers.

For the Financial Services Industry, Main Street mistrust is merely the beginning of their woes. As regulations continue to fragment the entire industry, more of the smaller venues for trading, new trading instruments and an ever-more complex industry structure are threatening the solvency of even the largest firms and most venerable financial institutions.

The Financial Market is not becoming more efficient.

It has fragmented into so many venues that liquidity is becoming harder to find for the Buy Side Institutions. This is not just for the stock market, but for corporate bond credit markets, derivative swap markets, and other instruments as well. The crisis is not the reluctance of Main Street to trust the financial markets, which, like the controversy around High Frequency Trading, is only a symptom of the disorganization and fracturing of the internal structures that comprise the Financial Markets.

For the average investor, it is the stock market they worry about. For the Buy Side and Sell Side Institutions, it is the fragmentation—too many kinds of venues that are offering order processing to the institutions. Liquidity is spread so widely and thinly that the financial markets are less efficient and costs are soaring.

This will not help salve the unease of the average investor. This market participant group is vast. It ranges from the odd-lot, minimal-capital investor to the seasoned, retail day trader. The most glaring challenge is how to educate millions of new and veteran retail investors and retail traders on the new market structure. Main Street does not fully comprehend the problems that can arise with the fragmentation of a mega-global industry like the Financial Markets. They see HFTs as the threat, yet HFTs would barely be noticeable if the US Public Stock Exchanges were not desperate for liquidity.

The role of HFTs as Maker-Takers via rebates paid by the US stock exchanges became more significant as the exchanges watched their trading volume evaporate suddenly as more alternative venues opened up, competing directly with them. Now there is chatter on the financial websites that the exchanges may be sued for rebate programs for HFTs. Without the liquidity the HFTs provide, the exchanges may be at risk of going out of business.

This is just one of numerous issues that Main Street does not understand or even know about. The magnitude of repercussions if we lost a major exchange to bankruptcy is never discussed, only the blaming of HFTs for everything that appears to be wrong with the stock market at this time.

The fragmented financial markets are at an extreme right now. With some 50+ Dark Pool venues, called ATSs, Alternative Transaction Systems, it is obvious that there are far more Dark Pools than the overall financial industry can support.(3) More than 70% of these venues are likely to go under due to lack of liquidity.

Corporate Bond Credit Markets are facing the same dilemma—too many venues and too little liquidity. It is nearly impossible for Buy Side Institutions to find sufficient liquidity at one venue. Trying to find sufficient liquidity for Corporate Bond fixed-income funds requires going to many different venues, a totally NON-efficient market situation.

Supplying the burgeoning Mutual Fund and Pension Fund institutions with ample, easily located liquidity for ANY trading instrument they wish to buy should be at the top of the list of priorities for the financial market leaders.

Unfortunately, the largest corporations are grappling with new regulations, new competition and declining revenues and/or profits as costs rise.

Basically, after more than two decades of massive expansion, the Financial Industry is facing Market Saturation and Market Decline Phases in the Product/Service Long Term Cycle. Fortunately, this phase seldom persists. As many of the smaller firms start to go under, the larger corporations will need to reinvent or face obsolescence. The giants of the industry will need to assess their future opportunities beyond the scope of what they have done in the past two decades.

Reinvention of an entire Industry, especially one as massive as the Financial Industry, is not easy or painless for the businesses or customers of that industry.

The Communications Industry Decline to Reinvention is an excellent example of the stages that an industry must go through to reinvent. Eventually the Financial Markets will reinvent. Fragmentation will disappear when a few of the strongest companies prevail and seize dominance in their respective market niches of the financial industry, obliterating their weaker competition and most of the smaller firms. Those that succeed will reshape the Financial Industry in ways no one can predict.

The Financial Industry of the second decade of this century will be very different from the one that exists today.

For Main Street, their most critical problem is financial illiteracy. HFTs get all the news media attention, and the commentary on Main Street is totally negative. Sadly, HFTs are not what the retail crowd needs to worry about most. There are far greater concerns, such as which of the big financial companies are strong enough to survive what is coming in the next few years. Without that knowledge, investors who are holding stocks or funds tied to financial services companies are unable to quantify the true risk for their portfolios or their trading activities.

Martha Stokes, CMT

www.TechniTrader.com

1 “Asset Management 2020: A Brave New World.” PWC Asset Management, 2014. http://www.pwc.com/gx/en/asset-management/publications/pdfs/pwc-asset-management-2020-a-brave-new-world-final.pdf. 16 June 2014.

2 “Asset Management 2020: A Brave New World.” PWC Asset Management, 2014. http://www.pwc.com/gx/en/asset-management/publications/pdfs/pwc-asset-management-2020-a-brave-new-world-final.pdf. 16 June 2014.

3 “Dark Liquidity.” Wikipedia. http://en.wikipedia.org/wiki/Dark_liquidity. 16 June 2014.

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Disclosure: All statements are my opinions only and are not to be construed as anything more than opinions. I am not a broker or an investment advisor. I am strictly an educator. There is risk in trading financial assets and derivatives. Due diligence is required for any investment. Examples presented are for educational purposes only.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

 

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