Photo: Baer Tierkel via Flickr
It is interesting to note that each night on the news, reporters report stock exchage volume. The number they report sounds large. But, the reality is most of the volume on the NYSE and NASDAQ is not done on the exchange.People have this glamorized image of sweaty guys in colourful jackets running around and screaming to fill orders. That’s just not how it happens anymore. Only about 20-30% of the volume is done at the actual exchanges. The rest is done in places the general public has zero access to. The general public is the personal pigeon of the backroom dealers on Wall Street.
Who is trading all this volume? Dark pools of liquidity, private networks, investment bank back offices. That’s where the real edge on Wall Street is.
Let’s take a stock like Citibank. Citibank was broke, and taxpayers bailed it out. It wasn’t traded, then it was relisted. Recently, the government sold most of its stake in Citibank. Reporters stated that “half of all NYSE volume was in Citi.”
Was this volume from investors excited to own the stock? No. It was from high frequency traders, hedge funds and investment banks flipping the stock back and forth.
They used the NYSE as a place to arbitrage the edges that they received from buying order flow from a discount broker. If you use a high cost broker, like Merrill Lynch, Goldman, JP Morgan or Morgan Stanley, the odds are really good that your order never saw a marketplace at all. It was simply internalized on a trading desk and flipped for profit. Big banks will make a market for a big pension fund, and then risklessly arbitrage the trade away. There are no glamorous guys in colourful jackets driving the market anymore.
This is the type of fragmentation that the SEC regulated marketplace has today. This fragmentation is the factor that lead to the flash crash last May. Fragmented markets also lead to less investor confidence. It becomes an insiders game that is rigged against everyone not in the club.
It is important to point out that futures markets are not this way. They are regulated differently and all the underhanded practices that persist on the SEC regulated marketplaces are illegal. Futures markets are more volatile, but that has to do with margin vs. cash markets, not the players themselves.
Because of this fragmentation, it makes it less likely that the average investor can beat the market. They always get dealt a bad hand. This gnaws at investor confidence. The only out for the investor is to put your money in a passive mutual fund that replicates the market. Professor Eugene Fama of the University of Chicago has proven that for the average guy, it’s more advantageous for the little guy to follow his Efficient Market Hypothesis. It’s the only way to beat the underhandedness that is taking place in the back rooms and dark pools of Wall Street.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.