Too big to succeed

First the “flash crash.” Then the Facebook trading debacle. Now, Knight Capital shoots itself, accidentally and critically. What’s going wrong with the basic market function of an orderly match between buyers and sellers?  Let’s look closer look inside the maelstrom that is the cutting edge of modern trading for the answer, and perhaps some hidden good news for long term investors.

High speed is relative

Traders have always sought an information edge through speed.  In 1815, Nathan Rothschild used carrier pigeons to get early knowledge of Napoleon’s defeat at Waterloo, allowing him to trade for weeks on the news in London before others knew. Super fast forward to 2012, where algorithmic high speed trading uses computers to assess vast amounts of data for supposed patterns and inefficiencies, pumping out massive numbers of almost instantaneous buy and sell orders in hundreds of stocks for hundreds of millions of dollars.  We’re talking milliseconds here, far faster than even Olympic timing, leveraged into vast amounts of money. I see it as too much money pressed into too little time, and we now see what happens.

Flash crash, then Faceplant.

The first crack in the high speed trading juggernaut occurred in May 6th, 2010 flash crash in ways that are still not completely clear.  Nonetheless, a massive number of instantaneous sell orders cause the stock market to plummet 1000 points, only to recover minutes later.  Very unnerving, all agree.

Next, Facebook’s IPO is botched by NASDAQ, which is unable to keep track of electronic orders for hours, causing huge losses. UBS gets whacked for $362 million, for example.

It goes on.  The BATS IPO in March of this year is priced at $15.25 and soon begins trading at 4 cents, due to a – you guessed it – flash crash in orders.  The IPO is cancelled completely by the end of the day.

Next up, Knight Capital

Wall Street’s desire and ability to shoehorn even more money into smaller and smaller spaces gets even weirder. Last week, Knight Capital, through which more than 11% of New York Stock Exchange volume is channeled, debuted its in-house proprietary algorithmic program on Wednesday morning. It immediately went amok, ginning up hundreds of millions of share trades.  Before the program was turned off 45 minutes later, Knight lost $440 million. Somebody forgot to write a kill switch into the code, apparently, so the program continued unhindered on its Frankenstein way.  As we speak, existing Knight shareholders are being wiped out as Knight is in the process of being bought and recapitalized by its trading partners and customers.

Moore’s Lament

Meanwhile we get the announcement from Louis Bacon Moore that his fabulously successful hedge fund, Moore Capital, is returning $2 billion to clients, because of a lack of investment opportunities and declining returns.  All credit to him for saying it like it is, and walking his talk.  Moore’s lament is a perfect example of the what is now the flip side of “too big to fail.” Moore, Knight, and others are “too big to succeed.” It’s a classic case of too much money chasing ever smaller returns.  It starts with someone gaining some investment advantage that eventually gets arbitraged away as others discover newer, better, faster methods (runners, pigeons, telegraph, telephone, fax, internet, next?).

Don’t worry

While these developments are startling, they are not new, and they are not necessarily bad. I believe the Knight Capital implosion is simply the death rattle of high speed trading (or perhaps the gasping that comes before the rattle) and that Moore’s refund is the acknowledgement that hedge funds risk chumming themselves into tiny pieces through size and leverage.

Sounds scary, but for individual investors who keep their hands and feet away from the moving parts, the danger is limited. Long term, diversified index based investors can do well while fervid, activity-obsessed investment professionals chase their tails.  After all, the S&P is up 11% this year, while none of the major hedge fund indexes is close to that.

High speed trading may move too fast to keep its balance, and at $2 trillion, the hedge fund behemoth may be too big to succeed.  But investors who know enough to stand clear needn’t lose sleep over the panicky headlines.

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