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Market Structure & The Near Miss

Posted By Barry Ritholtz On August 6, 2012 @ 7:22 am In Markets,Really, really bad calls | Comments Disabled

“It is the paradox of the close call. Probability wise, near misses are not successes. They are indicators of near failure. And if the flaw is systemic, it requires only a small twist of fate for the next incident to result in disaster. Rather than celebrating then ignoring close calls, we should be learning from them and doing our very best to prevent their recurrence. But we often don’t. People don’t learn from a near miss, they just say, “It worked, so let’s do it again.” Other studies have shown that the more often someone gets away with risky behavior, the more likely they are to repeat it. Modern disaster prevention can and should be about stopping trouble before it strikes, not cleaning up afterward.”

-Ben Paynter, Wired Magazine

 

 

The near miss is a misnomer. As George Carlin once said, what we really mean is a “near hit.” Carlin, whose wonderful use of language made his comedy that much sharper, used to say “A collision is a near miss . . . Boom, they nearly missed — but not quite.”

The markets have had a series of “near misses” over the past few months — assorted single stock flash crashes, trading glitches, even the Facebook IPO were all market structure collisions. The snafu with Knight Trading as they were testing new algo trading execution software was reputed to cost them $10 million per minute — about $167,667 per second.

It is becoming readily apparent that The replacement of specialist and market makers with algo bots and HFTs is the underlying cause of this crumbling capital markets infrastructure. Do not think that the equity markets are any better than the US electrical grid or roads and bridges and tunnels — the virtual market is crumbling even faster than our bridges can rust.

The lawyers at the SEC have not quite wrapped their heads around this. They too suffer from a structural defect — they are organized as a law firm. As we have suggested previously, they should be organized more like a large investment bank — with different divisions set up parallel to the divisions and actions of different major Wall Street Actors.

Regardless, it is increasingly clear that we are playing long odds, and assuming that snake eyes will never be rolled. The probability is that will eventually be a losing bet. Anytime we have a nonzero possibility of something occurring, the proper question is not WILL something happen but WHEN.

The sooner the market regulators figure this out, the better off investors will be. Until then, we have a Central Bank driven market (if not quite CB run economy, as Congress has abdicated their role). The hated phrase Risk Off/Risk On actually translates into “What will bankers do next? Here is my guess and here is my bet.”

As noted above, “if the flaw is systemic, it requires only a small twist of fate for the next incident to result in disaster.” That is what we have today. The combination of HFT/Algos and Central Bank intervention has turned the concept of fundamental investing into a quaint anachronism.

“Modern disaster prevention can and should be about stopping trouble before it strikes, not cleaning up afterward.” I suspect that one day, things like macroeconomic trends and earnings will matter much more than they do today. It is likely going to take a significant dislocation to get there. . .

 

 


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