CALDEIRÃO DE BOLSA

By Henny Sender

Published: May 21 2010 19:42 | Last updated: May 21 2010 19:42

In the mid-1990s, the New York Fed installed trading terminals on its foreign exchange desk. For years, it then stayed on the sidelines, letting currency markets find their own level. But in June 1998 the NY Fed went into the markets to push the yen up against the dollar. And it did so through the terminals rather than by calling the Wall Street dealers.

By bypassing the dealers, the NY Fed saved on the commissions that Wall Street charges. More important, it reduced the risk that it would be front run – Wall Street trading desks were known to use information from orders to position themselves favourably.

“If the [NY] Fed called a desk and asked the price, the dealers would start buying before they even gave you the price,” recalls a former NY Fed official who was on the foreign exchange desk. “The dealers were up in arms. By using the terminals, we were anonymous and we could get the best price.”

The terminals the Fed used are primitive compared with the technology used in trading today. Indeed, testimony from the wizards of the electronic exchanges on Capitol Hill in the past few days testifies to how dramatically trading has changed.

Despite photos in newspapers of people on exchange floors, with their head in their hands as global equities sank this past week, the vision the testimony evokes is of a world where machines have bypassed humans as computers at hedge funds respond to minute changes in prices to spew instructions to computers at electronic exchanges.

It isn’t only hedge funds that are using the electronic exchanges but increasingly traditional investment firms as well. They too are discovering the joys of anonymous trading. They save on commissions to Wall Street and – more important – avoid having their order flow treated as valuable fodder for proprietary trading desks.

This trend means that, while regulation threatens to dent an increasingly valuable source of profits on Wall Street, the technology is beginning to erode trading profitability in some areas, such as equities.

Powerful investment firms such as BlackRock are already exploring ways to form their own dark pools, setting up mechanisms for their clients – among them the most powerful sovereign wealth funds and pension funds in the world – to trade inexpensively via them rather than through Wall Street.

Indeed, SWFs themselves are experimenting with ways to bypass Wall Street. When Norway’s fund, for example, makes allocations to managers who invest in shares on its behalf, rather than write a cheque and let the manager pass on a wish list of stocks to Wall Street, it sometimes buys the stocks itself, supplying them directly to the fund manager.

Some clients clearly fear that Wall Street does not always act in their best interests. Much of the internal e-mail traffic at Goldman Sachs (relating to its role in a controversial subprime deal) released in the course of the Congressional hearings and regulatory charges of fraudulent misrepresentation, to some eyes appears to confirm such fears: that Wall Street has superior information and uses it (admittedly with varying degrees of success) to take advantage of clients not as sophisticated as the dealers themselves. (Goldman contests the charges.)

Banks are facing further headwinds. The financial reforms that the US Senate passed on Thursday may not resolve all the issues that emerged during and after the financial crisis. But one principal effect will be to curb the banks’ profitability in areas such as proprietary trading and derivatives.

The regulatory bite, the rating agencies downgrades that will inevitably follow, and jitters over the widening investigations are all putting downward pressures on the share prices of the large banks. Even while the European crisis means that the Fed’s zero interest policy remains, banks’ funding costs are creeping up and will creep up further following negative rating actions.

It isn’t clear at what point respect for Wall Street turned to fear and anger, as shown by all these developments. But in any case, the backlash was long overdue.

henny.sender@ft.com