30 years of Financial Markets Manipulation

Students in my course Applied Investment and Trading in TCD would be familiar with the market impact of the differential bid-ask spreads in intraday trading. For those who might have forgotten, and those who did not take my course, here is the reminder: early in the day (at and around market opening times), spreads are wide and depths of the market are thin (liquidity is low); late in the trading day (closer to market close), spreads are narrow and depths are thick (liquidity is higher). Hence, a trading order placed near market open times tends to have stronger impact by moving the securities prices more; in contrast, an equally-sized order placed near market close will have lower impact.

Now, you will also remember that, in general, investment returns arise from two sources:

1. Round-trip trading gains that arise from buying a security at P(1) and selling it one period later at P(2), net of costs of buy and sell orders execution; and
2. Mark-to-market capital gains that arise from changes in the market-quoted price for security between times P(1) and P(2+).

Here is the illustration of the ‘Strategy’ via Bruce Knuteson paper “Celebrating Three Decades of Worldwide Stock Market Manipulation”, available here: https://arxiv.org/pdf/1912.01708.pdf.

• Step 1: Accumulate a large long portfolio of assets;
• Step 2: At the start of the day, buy some more assets dominating your portfolio at P(1) – generating larger impact of your buy orders, even if you are carrying a larger cost adverse to your trade;
• Step 3: At the end of the day, sell at P(2) – generating lower impact from your sell orders, again carrying the cost.

Knuteson shows that, over the last 30 years, overnight returns in the markets vastly outstrip intraday returns.

Per author, “The obvious, mechanical explanation of the highly suspicious return patterns shown in Figures 2 and 3 is someone trading in a way that pushes prices up before or at market open, thus causing the blue curve, and then trading in a way that pushes prices down between market open (not including market open) and market close (including market close), thus causing the green curve. The consistency with which this is done points to the actions of a few quantitative trading firms rather than

Sounds bad? It is. Again, per Knuteson: “The tens of trillions of dollars your use of the Strategy has created out of thin air have mostly gone to the already-wealthy:

• Company executives and existing shareholders benefitting directly from rising stock prices;
• Owners of private companies and other assets, including real estate, whose values tend to rise and fall with the stock market; and
• Those in the financial industry and elsewhere with opportunities to privatize the gains and socialize the losses.”

These gains to capital over the last three decades have contributed directly and significantly to the current level of wealth inequality in the United States and elsewhere. As a general matter, widespread mispricing leads to misallocation of capital and human effort, and widespread inequality negatively a effects our social structure and the perceived social contract.”