Tuesday, December 21, 2010

Dumb Money

Jonathan Spicer of ABC News came up with this piece on Friday regarding something referred to as "dumb money" that for decades has been a consistent moneymaker for a handful of Wall Street firms.

What is dumb money? Most trades that you make. The proper term is 'payment for order flow', and it works like this:

1. You make a transaction via an online broker.
2. The online broker doesn't put your transaction to the stock exchange directly. Instead, they put it through a middleman known as a market maker.
3. The market maker undercuts the stock exchange's price by a minute amount, a tenth of a penny per share, and that's the price you're charged. They then give the online broker a little bit of money for their trouble.

The big profit made by the market makers isn't really in the trades themselves. The real profit is the knowledge they gain from being able to see all of these trades before anyone else. They know where the money's flowing, making them better able to execute trades at more advantageous prices. They are, to put it another way, the smart money.

Why is this bad? A lot of these trades end up skittering over the stock exchange entirely, and when a trade skips over the exchange, that trade does not effect the price of the stock. The SEC currently estimates that a third of all stock trades do not have any effect on stock prices. That's a modern-era record.

Essentially, the more trading that skips over the exchange, the less stock prices have anything to do with what's actually going on in the world, and the more it resembles playing a slot machine that's been tampered with. Miscommunication among market makers, it was found, was a major factor of the 'flash crash' that occurred in May. Trades that a market maker does not deem profitable are routed to the exchange, and somewhere along the way, one automated trade somewhere kicked off a whole slew of sell orders. Not knowing what was going on, the market makers choked, pretty much stopped buying stocks entirely, dumped a whole mess of stocks on the exchange, and just about all that was getting through were the sell orders.

The SEC does not want this happening again, obviously. Something they'd like to do to curb it is called a 'trade-at' rule, in which a market maker could not execute a trade unless it could beat the market price by a full penny, not just a tenth. If it couldn't do that, the trade would have to go to the exchange. It would pretty much kill dumb money and the market makers hate it.

On your end, you personally just need one thing: for the exchange to know your trade happened. No sense having the exchange itself being dumb money.

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