Conditions for a failed stock market

Technology and financial whiz kids have made stock trading not what it was before. High speed computers and how they are being applied to the stock trading system are a recent development that is more a curse rather than light at the end of the tunnel. Then there is high speed communication and the ability to move huge funds across borders to effect trading makes stock trading very precarious.

The war chests of big funds today are so huge that many could dominate the trading activities of small stock markets. And when operating in concert, several funds could execute transactions many times the size of the normal daily trading volumes of a small market. The implication is that they could corner not only several stocks but virtually take control of all the trading activities in a market. They could churn stocks up and down to their advantage.

Such a situation is made worst by small stock markets with fewer stocks and smaller capitalisation, and lesser number of investors. The small traders become easy preys to the big funds. And with the permission and connivance of stock market regulators, the funds could muscle their way into the system with their computers plugged in and extracting whatever information on buy and sell in their favour.

The rationale that the same thing is being done in New York is invalid. In a big market, with many similar big funds, there is a possibility of them cancelling each other’s action. In a small market, it is like a big fish in a small pond, it can cause big waves and rule the pond.

To make matters worst, some small exchanges are in a hurry to grow, to show results, and are tempted by the big funds’ presence. The big funds took advantage of the greed and impatience of small exchanges by dangling the carrot of bringing in their war chests to increase trading volumes to a small market. In return they dictated to the small exchanges how the trading system should operate, reducing bid sizes, reducing trading fees, and applying a lighter touch through deregulations, and of course allow their computers to plug into the system. The big funds thus were able to manipulate the trading systems and rules and regulations for easy profits.

Rules could be bent to accommodate the needs of the big funds, for instance, while short selling is not allowed in many exchanges, the big funds could circumvent this through scrip borrowings. The exchanges could be easily convinced, and being a willing partner that is dependent on the patronage of big funds, they would create a scrip lending systems for the big funds to cover their short positions. The convenient excuse is that it is another business for long term investors to enjoy some income, and for the exchange too.

The truth is that these innocent and ignorant long term investors would earn a pittance in scrip lending but end up facilitating the big funds to drive down the value of their long term investments.

Under normal circumstances, most exchange regulators would not condone to such violations to the integrity of the trading system. But exchanges are hungry for income and business. The higher the trading volume the more clearing fees they will collect to boost their bottom line. And they could justify to their stakeholders with the good returns, and keep a close eye while the big funds clean up the small investors in the market. And they can claim that it is caveat emptor, that the investors came in with their eyes open. No one is forcing the investors to trade.

A more convenient situation will be an exchange that is self regulating. It can then do anything it wants, provides whatever flimsy excuses, to run a flawed system, a system that allows the big funds to take advantage of the small traders. The outcome is quite clear when only the big funds are making profits and the general investors are all losing their pants. This can only happen when the authority ignores the risk of conflict of interests, when an exchange is profit seeking and allowed to regulate itself.

The govt or authority is the ultimate arbiter of the conduct of an exchange. It is the authority of last resort to ensure that stock exchanges are properly run and not run solely for its own benefits at the expense of other stake holders. But the ultimate authority can also fall asleep, thinking that if they have the best men in charge, an exchange will be properly and fairly managed.

There are many other reasons for a govt to give an exchange a free hand to do as it likes. It can be a matter of convenience, or a matter of incompetence, that they are dumber than the exchange management and are afraid to question what the exchange is doing.

There could also be a higher objective, to want to build up a big exchange at all cost, at the quickest time. Such wild ambition, and without full knowledge of how the exchange is being run, how destructive the big funds and their high speed computers can be to an exchange, things can go very wrong. As long as the exchange management can claim that what they are doing is to achieve the objective of a big and vibrant stock market, they could be easily left off the hook.

Another condition is that there is no whistle blower. No one wants to assume the leadership to point out the flaws in the system. Everyone is watching, knowing that things are going wrong, but not willing to rock the boat. All the institutions that claimed to look after the interests of the investors just looked the other way. Maybe they could not see anything wrong. Maybe they are waiting for things to happen to play safe. Doing nothing is the safest thing to do. And the govt or authority continues in their ignorant bliss. No complains, so everything is fine.

In reality, exchanges are normally managed wisely by competent managers. There could be some misses now and then, and some of the above conditions may exist at one time or another. But it is unlikely that all the conditions will exist at the same time. When there is a confluence of all these conditions existing, the failure of the stock exchange is imminent.

All govts and regulators must be alert and watch how their exchanges are being operated, and to look out for such warning signs and to take preventive actions early. Failing to do so is being negligent and irresponsible.