The Liquidity Trap aka Defending The Indefensible (by Mark St.Cyr)

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This week the markets were abuzz with commentators railing back and forth about volume levels or what some refer to as participation levels. One of the highly touted reasons given was Europe is on vacation. I would argue most “participants” are not only on vacation, but quite possibly more are taking a “Permanent Vacation.” And the industry itself is not only to blame for the dwindling numbers, but is acting as the travel agent selling only one way tickets.

People are leaving these markets and they aren’t coming back anytime soon. You no longer need to be a market maven to understand because anyone with a morsel of simplistic rationale now understands the game is rigged. And what was at first an assumption or oppressive nagging feeling was validated for all to see in the debacle of Knight Capital Group.

Everywhere one turned the argument was being made that this abomination known as HFT (High Frequency Trading) is giving liquidity to the markets. It allows for tighter spreads of the Bid and Ask, and on and on. Although there might be a legitimate case for that argument at some level, the levels that current HFT’s are playing does not. Nor is the game they’re playing meant to “help” liquefy the markets for smoother operations. It’s meant to drain as much liquidity (aka unsuspecting or naive participants money) and enrich its masters in a zero sum game.

But this beast has shown it can and will turn on its creators. For those that want to argue it’s not a zero sum game. Then why did Knight implode to near insolvency overnight? Easy. Because instead of winning (or extracting) the money this program was designed to garner, it lost it. Period. Knight found itself  where you, me, and anyone else not capable of guarding against it were supposed to be. All I have to say in sympathy to that is “Welcome to our world. Hope you enjoy your visit!”

I’m not a professional trader or financial analyst like the so-called “experts” touted across the financial channels. However I am a businessman and I grew up knowing and understanding right from wrong. I’m also quite experienced within the arguments of legal and illegal. And I think too many have forgotten a very simple truth: “Just because something is legal doesn’t make it right.”

Let me pose this hypothetical; How would you react if you were on some wonderful resort beach with your family. Waters were calm, weather was perfect, scenery was incredible to behold. Then out of nowhere you witnessed a swimmer get attacked and devoured by a great white shark on the periphery of the beach. The incident goes unnoticed by anyone else. Everyone is oblivious. But you know what you saw. When reporting you are struck by the lack of responsiveness. The authorities seemingly don’t care. When you push on the issue it’s explained liked this:

“Well this resort is right in the middle of where the sharks live. But there’s no other place like it. So as long as the sharks don’t feed in the middle of the lagoon, and only take a swimmer or two from the edges where no one notices business continues. It’s a win, win. People get to enjoy the resort, and the sharks are content. And besides people getting eaten by sharks is a part of nature. Not like we didn’t put up a warning sign 50 miles from the beach stating “Beware there might be big fish with teeth swimming in the ocean.” The term shark scares people, so we like our description better. It’s not like we tried to hide or mask the dangers. So please, go enjoy this wonderful property with your family and friends. Remember there’s an open bar between 7 and 9. Enjoy your time here… Next!”

If my hypothetical sound outrageous, or gets under the skin for those whom want to defend HFT in its current form I ask this question. If the incident that happened at Knight Capital Group resulted in the exact opposite. Meaning, instead of losing nearly $500 Million dollars but instead profited by that same amount. Would we have heard about it? Trick question, yes we would…

Champagne glasses would have been overflowing at the cheers and celebratory back slaps that would have taken place at the next quarterly earnings report. You would hear pundits, and so-called “expert” analysis on how this operation took in record profits. Oh how they would have celebrated their wisdom for creating some new black box trading algorithm that will revolutionize the trading world. Bonuses would be paid to the creators. Management would eye new digs for their trophies of market brilliance. Yet, all of it would come from where?

Unsuspecting naive swimmers who are told pay no attention to those fins they see near the beach. But even the naive understand instinctively somethings wrong. And they’re not going to come back until the sharks are gone regardless how many times they get a brochure stating, “Newly renovated! Come enjoy, the waters fine!”

© 2012 Mark St.Cyr