How Wall Street Stole $1 Trillion From You

It appears that technology has outsmarted the regulators -- again.

The Thursday intraday crash in the U.S. stock market was not so much dramatic by its magnitude, although it was big, but by its speed. With the flip of a switch, 500 extra Dow points vanished. The total intraday market value loss was northwards of $1 trillion.

The losses in our favorite BRIC markets were also notable, largely because many investors still follow the erroneous perception that emerging markets are riskier -- they aren't, especially considering recent events. However, since huge swings on Wall Street clearly affect BRIC investors, I'd like to examine the Wall Street crash in more detail.

How to Lose 500 Points at the Flip of a Switch

What caused the losses? Well -- a switch flip. High frequency trading (HFT) is sounds like a great deal on the surface, but it actually transfers billions of dollars from investors and puts them into the pockets of Wall Street firms that employ the practice. How it works: A firm rents space inside the NYSE -- next to the NYSE servers. This is necessary since the trading is done in milliseconds. If the server of the HFT firm is located a mile away, or even in the building next to the exchange, it won't work as the distance slows the orders by milliseconds and gives the advantage to those that are right next to the NYSE server.

There is no problem during ordinary trading conditions when there is no selling pressure on the market. But when there is selling pressure, the HFT firm may choose to simply stop operations temporarily -- flip the switch on those powerful computers -- and all that illusion of market liquidity that it had created instantly disappears.

So in non-volatile times the HFT firms add liquidity to the market, but when the market really needs that volume -- like last Thursday -- they can chose to simply stop operations and remove that necessary volume that would help to stem the decline. This is why there were stocks that declined from $40 to one cent last Thursday!

Yes, the exchanges will cancel orders that were 60% away from the 2:40 pm price, but that is a band-aid solution. What about those erroneously-executed orders that were 50% away from the 2:40 pm price?

The Root of the Problem

It is fair to say that by facilitating HFT, NYSE Euronext (NYSE: NYX) is looking out for its corporate interests and not after the interests of institutional and individual investors. The NYSE used to be a non-profit organization, but when it turned into a public corporation it now looks after the interests of its shareholders and not the investors that use the exchange.

But I don't want to single out the NYSE. Most big Wall Street firms that run HFT outfits -- such as Morgan Stanley (NYSE: MS), JP Morgan (NYSE: JPM) and the rest, truly carry responsibility for Thursday's crash. The NYSE is largely a facilitator.

HFT computers raise exchange volumes by basically churning the market -- trading aimlessly for the sake of creating volume and acquiring liquidity rebates from the exchange. These are not buy-and-sell decisions made by an individual and based of that individual's view of the prospects of a particular company. These are computers shooting orders and sometimes buying and selling at the same price because the HFT firm receives a "liquidity rebate" -- it gets paid from the NYSE just for generating extra volume.

In The Big Short, Michael Lewis concluded that the seeds of the crash in the real estate and credit markets were sown by the turning of Solomon Brothers from a partnership into the first Wall Street public corporation. The partners no longer had "skin in the game" by risking their own money. The focus changed from long-term stability and firm profitability to making a quick buck for the biggest bonus and biggest earnings beat in the next quarter. This is how AAA-rated subprime CDOs were born and this is how Credit Default Swaps were born, which attributed to the collapse of many financial institutions.

Similarly, the seeds of last Thursday's crash were sown on the day the NYSE became a public corporation. By allowing the NYSE to turn into a for-profit organization, regulators also contributed to last week's crash. The NYSE is bound to look after the interests of its shareholders first, which do not necessarily coincide with the best interests of investors using the exchange. High frequency trading for the NYSE is similar to what the AAA subprime CDOs and CDSs are to the rest of the Wall Street's corporations -- a self-destructive maneuver borne by the desire to generate short-term profits to the detriment of public interests.