Frank Thoughts: Price Distortion Subsiding
Frank Boland
October 13, 2022

Price distortion in the stock market started in 2005 with the impact of high-frequency-trading. Three years later the Fed responded to the debt crisis with 0% interest rates. Both events would lay the groundwork for price distortion. Zero percent would obliterate active stock managers and give rise to trillions in index funds. The zero-interest rate policy set up what was to become a negative feedback loop. Over half the stock market became indexed which effectively removed it from the process of individual price discovery. Now, as the Fed increasingly moves rates higher, it favors active managers.

High- Frequency-Trading’s introduction to the N.Y.S.E. was driven by modernization. But speed of execution has nothing to do with the purpose of an exchange, which is … price discovery. Instead, it became a computer “game.” A game not well known by people in the financial business but very well known by technology professionals. The fastest computer, intercepting a transaction, would “win.” Machines replaced specialists. An HFT firm – Citadel - now pays Robin Hood to show them what their order book looks like. Before computers, if a human did that, it would be considered unethical.

 Many years ago, I had a client who was a partner in the second largest specialist firm. When he had a good day, he would send me some of the “new” money. “Under no circumstance” was I ever to give it back to him if he asked. He did this because specialists could -and often did- go broke. If he made a mistake, he and his partners had unlimited liability and could go into bankruptcy. That made my client not only risk adverse but cynical. One day, a specialist friend of his was given the assignment by the exchange of being the market maker in a new IPO called Resorts International.

Resorts was opening a gambling casino offshore in the Bahamas. The IPO was hotter than hot. The specialist shorted the stock from the opening trade, strongly believing it was overpriced. And his job, as a market maker, was to take the other side of a trade when there was an order imbalance. He went bankrupt doing it. I called my client and said, “I’m sorry that happened.” His response was, “Nah, he forgot he was in the moving business, not the storage business.” That could never happen when you pay someone to tell you what’s coming your way in an order flow. That creates price distortion.

When you take individual risk away - which arguably the Fed has done since 2008 – there is little responsibility or accountability. Unlike the Resorts’ specialist, there is no individual cost. In fact, during the past pandemic crisis, people were paid while they stayed home. This caused distortion not only in the stock market but in the economy with Inflation. The Fed created this price distortion with Quantitative Easing. QE is when the central bank artificially becomes the dominating big buyer in the fixed income market. It is in effect creating money ... and more money creates more inflation.

When excess money is in circulation, asset bubbles build. It developed in bonds, stocks (unicorns), housing, bitcoin etc. These assets became locked in parity. Zero interest rates eliminated dispersion in the stock market, which is vital to active managers. The stock market thus became one asset class as if it were simply another commodity. However, beginning this year with interest rates rising, we are experiencing some early differentiation in stocks. Besides the Fed’s assertion that they will continue to raise interest rates to 4.6%, the HFT firms are now maxed out at close to the speed of light. With both macro forces essentially done, we will be back to our own responsibility and accountability.

Francis Patrick Boland

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