From my column last Saturday in the Keys Weekly.
Q. What’s the latest on financial reform?
A. Last week the Senate passed major financial reform legislation that is in now being reconciled with a bill passed by the House last year. Once the differences are ironed out, it will be signed into law.
The legislation, not without controversy, contains a number of provisions intended to try to reign in banks, set up new regulatory agencies and avoid future taxpayer-funded bailouts. Among other things, the legislation would:
- Create a council of risk regulators tasked with preventing the failures of massive companies which could threaten the entire financial system;
- Establish a consumer protection division for financial products;
- Allow the government in extreme scenarios to seize and close down failing financial companies in order to protect taxpayers from future bailouts;
- Call for a one-time audit of the Federal Reserve;
- Force most derivatives to be traded on exchanges, where regulators will have more transparency and power to oversee them.
On Wall Street, most of the angst revolves around one particular aspect of the proposed reform. The Senate version of the bill directs regulators to restrict banks from proprietary trading – currently a huge source of profits for the banks. Whether or not the banks are forced to spin off, or completely separate from, their derivatives trading business remains to be seen. The Street and its lobbyists appear to be trying quite hard to derail this provision.
In general, the changes in the proposed legislation seem to imply that our financial system was sound, but the credit crisis and Great Recession were caused by a lack of regulation and oversight. As a result, the legislation will reduce the size of the industry’s profits, but will not address the size and/or political power of Wall Street. Read into that whatever you may.
One particular part of the reform that I was particularly glad to see dealt with the credit rating agencies. A system where the banks getting rated pay the firms doing the rating is hard to defend. The end of that practice alone is something to be noted.
Q. What’s with all this volatility in the market lately?
A. It’s been a strange, tough few weeks in the stock market. From the crisis in Greece to the Gulf oil spill and the bizarre 1,000 point “flash crash” in the Dow, there are plenty of reasons the market seems uncertain.
Take inflation. Two months ago, inflation was the most predominant concern among many investors. You’ll remember inflation is a general rise in the price level of various goods and services that can be caused by an increase in the supply of money. You may also remember that both the Federal Reserve and the federal government recently pumped huge amounts of money into the economy to recover from the credit crisis and ensuing recession. So with inflation such an obvious risk, why, then, are some investors starting to become concerned about deflation again?
Well, an odd thing happened while we were waiting for inflation to show up. The Euro, the primary currency of Europe, began to fall in value as a result of the recent bailout in Greece. As the Euro falls, the value of the U.S. dollar increases – at least on a relative basis. And because commodities like oil, gold and grains are priced in the dollar in international markets, a stronger dollar means you can buy more of that commodity for the same buck, so commodity prices tend to drop. Except, well, for gold, which usually moves in the opposite direction of the dollar, but has instead recently reached a record high.
Confused yet? So is the market. It can be hard to stay on top of it all. Here’s the thing, though – you don’t need to in order to be a successful investor. In fact, instead of worrying about all this volatility, some investors actually welcome it. Buying high quality, high return companies at prices well below what they’re really worth offers you the best chance to grow your wealth long-term – regardless of the inflation rate. So if you’re tired of the noise, I’d encourage you to think about becoming a value investor. There’s plenty of room.
Q. What is high frequency trading?
A. Five years ago, if you asked me to name two arcane financial subjects that I’d probably never hear discussed in a diner in the Keys, I’d have said ‘credit default swaps’ and ‘trading algorithms.’ During lunch at Mangrove Mike’s in Islamorada a year ago, however, I first overheard someone mention swaps. If that shocking 1,000 point drop in the Dow Jones last Thursday was any indication, you may soon become familiar with the term “high frequency trading,” too.
High frequency trading or HFT is many things – including another example of how Wall Street is more interested in being a casino than a steward of wealth. Simply put, HFT is stock trading done by blazing fast computers at Wall Street firms – some of which are located literally right next to the computers that drive the NYSE and NASDAQ. The powerful algorithms on these HFT machines can create and change orders for stock in milliseconds. It is believed that a handful of HFT firms now account for half of all trading volume on the nation’s stock exchanges.
The problem is that through loopholes in the rules, high-speed traders get an early glance at how others in the market are trading. Seems odd, no? After all, if you learn a big secret about a company, trade on that secret, and then make money a month later, it’s considered insider trading and you’d go to jail. When HFT firms get to peek at the buys and sells of others in the market and then make their own trades split seconds later, however, it’s condoned and encouraged by the major stock exchanges. Not only that, HFT machines routinely take advantage of slower traders…or, in other words, us.
Why the loopholes? The exchanges say to “create liquidity,” or to ensure that large investors can buy or sell positions quickly. As you might have guessed, though, the exchanges also earn fees for allowing sneak peeks.
Did a HFT glitch cause the historic crash of last week? Officially, it remains to be seen. Candidly, though, I’ve got a hunch.
$TNDM This is the comp the mkt worries about? Peerless can't seem to raise VC $, more discounts & use credit lines...? http://bit.ly/bQo0Fd 2 days ago
