"Dark Pools" is the title of a new book that describes the "flash crash" when the stock market imploded for a day on May 6, 2010. Some may recall that the stock market effectively shut down for the day as stocks like Procter & Gamble dropped from $32 a share to a few cents. For the 100 million of us with 401(k) and IRA accounts, what if the problem had persisted for more than just a day? Who, out there in cyberspace, is messing with our money?
Author Scott Patterson explains it all in his book that chronicles the rise of computerized artificial intelligence and the computerized trading that has come to dominate the stock market. How dominant? Patterson writes, "At the end of World War II, the average holding period for a stock was four years. By 2000, it was eight months. And by 2011, it was twenty-two seconds." One high frequency trading firm's average holding lasted for 11 seconds. High frequency traders now account for more than 70 percent of all stock trading volume.
Money management companies are using high-speed trading facilities coupled with artificial intelligence to capture profits of just fractions of a cent per share, but they do it millions of times on millions of shares -- like the firm whose average holding period is 11 seconds. Many of these firms are trading 24 hours a day throughout the world.
Rapid-trading firms using artificial intelligence to trade massive amounts of stock create two problems for the rest of us. The 100 million of us that have $6 trillion in 401(k)s and IRAs invest through large mutual funds. Artificial intelligence manages to sniff the scent when one of our funds is beginning to buy a position in a company, and they (the AI computers) start buying. This sets in motion a shark feeding frenzy that gets in the way of our mutual fund managers trying to gain a position at a reasonable price.
To their credit, what they are doing is not illegal, and there is an argument that they have created more liquidity in the markets. What they also achieved, to their credit, was doing away with the pricing of stocks in one-eighth of-a-dollar increments. Pricing stocks down to the penny is what enables small differences in buy and sell positions to take place.
The second problem created by the denizens of the "dark pools" is that they so dominate the bulk of market trading today that they are trading largely against each other. There are no longer enough "dumb investors" like individual day traders and people trading individual stocks on a whim. High-speed traders can effectively fake each other out as they did in 2010. The flash crash occurred, we think, because all the algorithms were triggering a sell, and were then waiting for some signal to buy -- which never came.
After all, a company suddenly selling for half price looks like a great buy, except the computer judges that it (the computer) might be "catching a falling knife." The system freezes and voilà -- we have the Flash Crash, and our mutual fund values drop to zero.
It may be reassuring to remember that the underlying companies we effectively own are still worth a lot of money. It's just that their stock can be temporarily worthless. It's the classic "disconnect" between the values of shares and the company values that they normally represent.
The system we depend on is based on so-called "marked to market" pricing. Every stock our mutual funds own is valued based on the relatively small handful selling on an exchange at the moment. So, a very small percentage of any company's shares are determining the value of all the rest. If those share prices are subject to artificial intelligence and computerized rapid trading that nobody fully understands, the volatility jeopardizes our security and our ability to save effectively for retirement.
I don't see any movement on the part of feckless regulators or legislators to correct this insidious cancer growing in the heart of our financial system. What would allow all of us to benefit from it, however, would be a very high income tax on short term capital gains -- like 75 percent. Who of us would care? The tax would not cost a cent to those of us with retirement money or who are buy-and-hold investors. Instead, it would pay back the American public for some of what we may be currently losing, and it would do an end run around government bureaucrats who stand to be gamed by people much smarter than they are.