Knight Capital, Latest Debacle That Calls For Massive Reform

Posted by Jeff Carter
on August 9th, 2012

Knight Capital blew up. It is only the latest in a series of blow ups and black eyes that have plagued the financial services industry since 2007. Thankfully, Knight wasn’t too big too fail and they were bailed out by other private firms, not the government. Next time we might not be so lucky.

There are a lot of ideas floating around as to what to do. Some want to bring back Glass-Steagall. That’s not a terrible idea, but it there is no way to bring it back in the same form that it was. Besides, there were some compelling reasons to end Glass-Steagall. One of the unfortunate consequences was concentrating too much risk into too few hands, but in a remake of the act one could remedy that.

The way the markets trade today is unlike anything any pro trader has seen in their entire career. It’s not that the underlying cash or hard assets are that volatile, it’s the structure of the marketplace that allows computerized trading to create volatility.

A good friend of mine Dan Dicker penned an article and advocated for a transaction tax. I agree wholeheartedly with just about everything Dan says, but disagree totally with the idea that a transaction tax will correct the misnomers in the marketplace.

A tax should only be used as a last resort. The only reason for a tax like this would be to correct an externality in the market that can’t be solved any other way. I think that our regulatory systems are messed up, and the structure of the market so messed up that we need to correct that before we entertain any idea of taxing anyone in the marketplace.

On Twitter, Dan and I talked about the “encyclopedia of regulation”. Dan is absolutely correct on that. We don’t need more regulation. Dodd-Frank was more regulation and is one of the poorest legislative pieces our country has ever passed. It’s the equivalent of Alfred E. Neumann pulling the levers of global finance.

We ought to be starting to have a serious discussion about these issues but frankly, there is so much money at stake that it is practically impossible to have a discussion without a lot of sacred cows being protected. We need to be goring them. Just think about the discussion on the Volker Rule and you have a mere taste of what it would take to flatten the marketplace and create a level playing field for both the retail and pro investor. The only winners in that debate would be lobbyists and the lawyers at Sullivan and Cromwell that would reap huge fees.

It comes down to making markets competitive and flat, with great information flow. Exchanges don’t have economic incentives to do that, they cater to the HFT trader because their revenue is based on volume. HFT traders can create a lot of volume in a hurry. But the affect it’s having on the market is a lot like a three year old that’s had way too much candy. Sugar highs lead to sugar crashes.

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