Economic Warfare - the next US bust?

[dieseltaylor]

I was aware that large US trading houses do some naughtiness with front-running other peoples purchases - and by generating and cancelling thousands of rders to sense, rather like ASDIC/Sonar what is going on.

Here is a little piece on the potential damaging effects it may have :

http://www.nanex.net/20100506/FlashCrashAnalysis_Part4-1.html

Who needs enemies when profit mad corporations engage in their own electronic warfare. Benefit to the general public nil, dangerous yes.

Analysis of the "Flash Crash"

Date of Event: 20100506

Complete Text

There are 9 exchanges that route orders to NYSE listed stocks: NYSE, Nasdaq, ISE, BATS, Boston, Cincinnati (National Stock Exchange), CBOE, ARCA and Chicago. Each exchange submits a bid and/or offer price for each stock they wish to make a market in. The highest bid price becomes the National Best Bid and the lowest offer price becomes the National Best Ask. Exchanges compete, fiercely at times, to become the best bid or offer because that is where orders will be sent for execution. Exchanges also go to great lengths to ensure they avoid crossing other exchanges (bidding higher than others are offering, or offering lower than others are bidding), because if they do, many High Frequency Trading (HFT) systems will immediately execute a buy/offer and capture an immediate profit equal to the difference. Today, it is very rare to see markets crossed in stocks for longer than a few milliseconds.

Beginning at 14:42:46, bids from the NYSE started crossing above the National Best Ask prices in about 100 NYSE listed stocks, expanding to over 250 stocks within 2 minutes (See Part 1, Chart 1-b). Detailed inspection indicates NYSE quote prices started lagging quotes from other markets; their bid prices were not dropping fast enough to keep below the other exchange's falling offer prices. The time stamp on NYSE quotes matched that of other exchange quotes, indicating they were valid and fresh.

With NYSE's bid above the offer price at other exchanges, HFT systems would attempt to profit from this difference by sending buy orders to other exchanges and sell orders to the NYSE. Hence the NYSE would bear the brunt of the selling pressure for those stocks that were crossed.

Minutes later, trade executions from the NYSE started coming through in many stocks at prices slightly below the National Best Bid, setting new lows for the day. (See Part 1, Chart 2). This is unexpected, the execution prices from the NYSE should have been higher -- matching NYSE's higher bid price, unless the time stamps are not reflecting when quotes and trades actually occurred.

If the quotes sent from the NYSE were stuck in a queue for transmission and time stamped ONLY when exiting the queue, then all data inconsistencies disappear and things make sense. In fact, this very situation occurred on 2 separate occasions at October 30, 2009, and again on January 28, 2010. (See Part 2, Previous Occurrences).

Charting the bid/ask cross counts for those two days reveals the same pattern as 5/6! Looking at the details of the trade and quote data on those days shows the same time stamp/price inconsistencies. The NYSE stated that during the same intervals, they were experiencing delays in disseminating their quotes!

In summary, quotes from NYSE began to queue, but because they were time stamped after exiting the queue, the delay was undetectable to systems processing those quotes. On 05/06/2010 the delay was enough to cause the NYSE bid to be just slightly higher than the lowest offer price from competing exchanges, but small enough that is was difficult to detect (See Part 3, The Evidence). This caused sell order flow to route to NYSE -- thus removing any buying power that existed on other exchanges. When these sell orders arrived at NYSE, the actual bid price was lower because new lower quotes were still waiting to exit a queue for dissemination.

This situation led to orders executing against whatever buy orders existed in the NYSE designated market maker (DMM) order book. When an order is executed, the trade is reported to a different system (CTS) than quotes (CQS). Since trade report traffic is much smaller than quote traffic, there is rarely any queueing or delay.

Because many of the stocks involved were high capitalization bellwether stocks and represented a wide range of industries, and because quotes and trades from the NYSE are given higher credibility in many HFT systems, when the results of these trades were published, the HFT systems detected the sudden price drop and automatically went short, betting on capturing the developing downward momentum. This caused a short term feed-back loop to develop and panic ensued.

Some trading firms have stated that they detected a problem with the accuracy of the data feed and decided to shut down which further reduced liquidity. We think the delay in NYSE quotes was at the root of this detection.

On the subject of HFT systems, we were shocked to find cases where one exchange was sending an extremely high number of quotes for one stock in a single second -- as high as 5,000 quotes in 1 second! During May 6, there were hundreds of times that a single stock had over 1,000 quotes from one exchange in a single second. Even more disturbing, there doesn't seem to be any economic justification for this. In many of the cases, the bid/offer is well outside the National Best Bid/Offer (NBBO). We decided to analyze a handful of these cases in detail and graphed the sequential bid/offers to better understand them. What we discovered was even more bizarre and can only be evidence of either faulty programming, a virus or a manipulative device aimed at overloading the quotation system. You can see our results in Part 4, Quote Stuffing.

Recommendations:

1. Quote and trade data must be time stamped by the exchanges at the time it is generated. This will ensure delays can be detected by everyone.
   
   Reasoning: Changing the procedure to time stamp at the time a quote or trade is generated is a near trivial exercise. It probably comes as a surprise to many that time stamping isn't done that way now.
   
2. Quote-stuffing should be banned.
   
   Reasoning: It is a manipulative device designed to overload the quotation system. Quote and trade dissemination (data feed) is a finite resource, and should be treated as such.
   
3. Add a simple 50 millisecond quote expiration rule: a quote must remain active until it is executed or 50ms elapses. If the quote is part of the NBBO, it may be improved (higher bid or lower offer price) at any time without waiting for the expiration period.
   
   Reasoning: The exchanges must protect the integrity of the National Best Bid/Offer system. What is the point of having a National Best Bid/Offer, if not everyone in your nation (apologies to Alaska/Hawaii) can reasonably execute a trade against it? 50ms is approximately the time it takes light and electronic communication to travel from New York to California and back. It is impossible to transmit information any faster. This rule would not limit quote/trade rates. So long as trades are executing, quotes can update thousands of times a second. Only a small percentage of quotes today would be affected and the potential for catastrophically high rates would be eliminated.

[costard]

Nice find Diesel. Thanks.

[ASL Veteran]

I was aware that large US trading houses do some naughtiness with front-running other peoples purchases - and by generating and cancelling thousands of rders to sense, rather like ASDIC/Sonar what is going on.

Who needs enemies when profit mad corporations engage in their own electronic warfare. Benefit to the general public nil, dangerous yes.

Here, maybe this will help ease your mind

http://content.lawyerlinks.com/default.htm#http://content.lawyerlinks.com/library/sec/nasd/NASD_Section_2100.htm

If you check NASD rule IM-2110-3 which I have helpfully linked to above you will find that Front Running is already illegal in the US. You have to scroll down about halfway and the page is designed so that you can't copy text from it so I can't give you a sample of what it says. Apparently they are also discussing expanding the rule as discussed here

http://www.willkie.com/files/tbl_s29Publications%5CFileUpload5686%5C2856%5CFINRA_Proposes_Expanding_Prohibitions.pdf

Judging from the time of that report the new rules may already be in effect, although very few licensed brokers or broker dealers would have played it close to the edge under the old rules since the penalties can be pretty severe.

[JonS]

the page is designed so that you can't copy text from it so I can't give you a sample of what it says.

Your web-fu is weak, old man.

IM-2110-3. Front Running Policy

It shall be considered conduct inconsistent with just and equitable principles of trade for a member or person associated with a member, for an account in which such member or person associated with a member has an interest, for an account with respect to which such member or person associated with a member exercises investment discretion, or for certain customer accounts, to cause to be executed:

(a) an order to buy or sell an option or a security future when such member or person associated with a member causing such order to be executed has material, non-public market information concerning an imminent block transaction in the underlying security, or when a customer has been provided such material, non-public market information by the member or any person associated with a member; or

( an order to buy or sell an underlying security when such member or person associated with a member causing such order to be executed has material, non-public market information concerning an imminent block transaction in an option or a security future overlying that security, or when a customer has been provided such material, non-public market information by the member or any person associated with a member prior to the time information concerning the block transaction has been made publicly available.

The violative practice noted above may include transactions which are executed based upon knowledge of less than all of the terms of the block transaction, so long as there is knowledge that all of the material terms of the transaction have been or will be agreed upon imminently.

The general prohibitions stated above shall not apply to transactions executed by member participants in automatic execution systems in those instances where participants must accept automatic executions.

These prohibitions also do not include situations in which a member or person associated with a member receives a customer's order of block size relating to both an option and the underlying security or both a security future and the underlying security. In such cases, the member and person associated with a member may position the other side of one or both components of the order. However, in these instances, the member and person associated with a member would not be able to cover any resulting proprietary position(s) by entering an offsetting order until information concerning the block transaction involved has been made publicly available.

The application of this front running policy is limited to transactions that are required to be reported on the last sale reporting systems administered by Nasdaq, Consolidated Tape Association (CTA), or Option Price Reporting Authority (OPRA). The front running policy also applies to security futures transactions regardless of whether such products are reported pursuant to such systems. Information as to a block transaction shall be considered to be publicly available when it has been disseminated via the tape or high speed communications line of one of those systems, a similar system of a national securities exchange under Section 6 of the Act, an alternative trading system under Regulation ATS, or by a third-party news wire service.

A transaction involving 10,000 shares or more of an underlying security, or options or security futures covering such number of shares is generally deemed to be a block transaction, although a transaction of less than 10,000 shares could be considered a block transaction in appropriate cases. A block transaction that has been agreed upon does not lose its identity as such by arranging for partial executions of the full transaction in portions which themselves are not of block size if the execution of the full transaction may have a material impact on the market. In this situation, the requirement that information concerning the block transaction be made publicly available will not be satisfied until the entire block transaction has been completed and publicly reported.

[Adopted by SR-NASD-87-45 eff. Dec. 30, 1987; amended by SR-NASD-2002-40 eff. Oct. 15, 2002.]

Selected Notices to Members: 96-66.

Hint: ctrl+c, ctrl+v

[dieseltaylor]

ASL Veteran:

Sorry perhaps I should have made it clearerin my post. What is in the rule books is essentially having inside knowledge, as one would expect professionals aware of a trade should not be screwing their customers. Sad in a way that it actually needs to be written.

What I wa referring too was generating lots of trades and cancelling them within seconds to sense deals. Now the effect is that of front-running but without having ANY knowledge of whose transaction it is. Therefore apparently "legal". The bum note is that certainly NASDAQ was allowing certain firms a second or so knowledge ahead of the general market.

"

Flash trading is a practice in which some equity exchanges hold orders to buy and sell shares for a split second before making that information public (available to other exchanges).[1] The exchanges' customers can view these prices ahead of other traders for a fee. High-speed computer software can take advantage of that brief period between when an order is placed and when it's executed to allow those members to potentially get better prices and profits by slipping in and making the trade themselves.[2]

Offered by Nasdaq OMX Group, BATS, Direct Edge and CBOE Stock Exchange, flash trades are designed to enable those market centers to execute orders within their markets when another market is quoting the industry's best price. In flash orders offered by Nasdaq and BATS, information about the marketable order is displayed in the exchanges' proprietary data feeds to generate orders that will meet or beat the industry's best price. Direct Edge sends order information to a group of "enhanced liquidity providers" to generate order responses.[3]

Flash trading was put under scrutiny in July of 2009, when U.S. Senator Charles Schumer proposed to the Securities and Exchange Commission to ban flash orders because of the unfair advantage they allegedly create for hedge funds and Wall Street firms who use computer-driven trading strategies. [4] Schumer said that if the SEC did not institute a ban, he would introduce legislation to do so.

Shortly after that, on August 6, 2009, Nasdaq OMX and BATS said they would voluntarily end flash orders on their marketplaces.[5]

Direct Edge’s Enhanced Liquidity Program (ELP), Nasdaq’s flash order program, and BATS Exchange’s Bolt Option Liquidity program, allow certain members to receive information about orders before the public. According to Senator Schumer, they allow those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity.[6]

http://www.marketswiki.com/mwiki/Flash_trades

So you have to ask yourself does that sound like it was a fair deal? And do you really think that the problem of flash trading has gone away or has one element of it, the most obviously unfair, has bit the dust.

Anyway we do know that High Frequency Trading still exists - witness my first post. However lets see what Goldman Sachs thinks is dangerous:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aFeyqdzYcizc

July 9 2009 (Bloomberg) -- Never let it be said that the Justice Department can’t move quickly when it gets a hot tip about an alleged crime at a Wall Street bank. It does help, though, if the party doing the complaining is the bank itself, and not merely an aggrieved customer.

Another plus is if the bank tells the feds the security of the U.S. financial markets is at stake. This brings us to the strange tale of Goldman Sachs Group Inc. and Sergey Aleynikov

And finally an article which highlights how flash trading works at working out the market.

http://www.onlineforextrading.com/blog/flashing-high-frequency-trading/

[ASL Veteran]

ASL Veteran:

Sorry perhaps I should have made it clearerin my post. What is in the rule books is essentially having inside knowledge, as one would expect professionals aware of a trade should not be screwing their customers. Sad in a way that it actually needs to be written.

What I wa referring too was generating lots of trades and cancelling them within seconds to sense deals. Now the effect is that of front-running but without having ANY knowledge of whose transaction it is. Therefore apparently "legal". The bum note is that certainly NASDAQ was allowing certain firms a second or so knowledge ahead of the general market.

Oh, I agree that sounds like front running. I don't think it's because of order cancellations though. Order cancellations, while annoying, are understandable when trading a thinly traded security. According to your links though it sounds like the order is being held for a split second so that would squarely fall within the rules for front running because that's what front running is. The trades being held are the material non public information. The problem is that if your reread the rule it states that automatic executions are exempt - that's probably the loophole that makes it legal (although I'm not in the compliance department so I can't be sure ). I think one of your links said that the exchanges have stopped doing it already so I would guess that the problem has largely been addressed.

[ASL Veteran]

The thought occurred to me that my explanation may not make sense to some readers, so I figured I would expand on it a bit. First a classic case of Front Running:

Let's say that Costard is a licensed broker and one of his clients is Wall Street high roller Diesel Taylor. Diesel decides that CM:N is going to be a huge hit so he decides he's going to place an order for 100,000 shares of BFC at the market (ie, he wants his order filled at whatever price he gets from the market). He calls up Costard and tells him what he wants to do. Costard figures that Diesel Taylor's order is large enough that it will drive the price up so he decides that he might as well make a little money on the side. Costard has Diesel Taylor's order in hand but before he works the order he puts out a buy order for 500 shares of BFC in his own personal brokerage account. Costard then places Diesel Taylor's trade for 100,000 shares and sure enough the price goes up. When Costard has finished with Diesel Taylor's order he then goes out and sells his 500 shares at the new higher price and pockets a nice profit. That is Front Running.

Okay, so what was apparently happening in the articles Diesel Taylor provided? Let's say that Costard is a computer genius who works at the NASDAQ exchange. He tells his boss "hey, there is a loophole in the Front Running law that exempts automatic executions, so why don't we just hold orders for a half second and start up a service whereby our special customers can see the held orders before we execute them?" His boss loves the idea and so Flash Trading is born.

Now you have two wall street high rollers - Jon S and Diesel Taylor. Jon S signed up for NASDAQ's special feed and Diesel Taylor did not. Jon S is sitting at his desk with six monitors stacked up and has his cup of coffee sitting nearby. One of those monitors has the special NASDAQ feed for upcoming orders on BFC. Diesel Taylor is sitting at his computer with four monitors stacked up with no coffee and decides to place an order for 100,000 BFC at the market. The order goes to the NASDAQ, but rather than executing the order immediately the NASDAQ holds the order for a half second and retransmits that information to Jon S's computer. Jon S then sees the order Diesel Taylor placed and Jon S decides that placing his order before Diesel Taylor's order executes would be beneficial so that's what he does. Since Jon S is on the special NASDAQ feed his order is not held but gets filled immediately. Diesel Taylor's order was held by NASDAQ and so his order gets filled after Jon S's order gets filled. So yeah, Jon S is front running, but he is doing so because the information is being given to him by NASDAQ. I suspect that the reason the NASDAQ could do that is because of the automatic order exemption in the Front Running rule. There may have been some political favors involved too since I have no doubt that the big shots running the exchanges would know the big shots at the SEC, NASD, or the other regulatory bodies.

Having said all that, it's possible that I misunderstood the articles and that I'm way out in left field on it. I have to admit that I didn't give the articles a very thorough read.

[dieseltaylor]

Yout right on the money there, But the new flash trading and how it works is here:

COMPUTERIZED FRONT RUNNING:

ANOTHER GOLDMAN-DOMINATED FRAUD

Ellen Brown, April 21st, 2010

http://www.webofdebt.com/articles/computerized_front_running.php

While the SEC is busy investigating Goldman Sachs, it might want to look into another Goldman-dominated fraud: computerized front running using high-frequency trading programs.

Market commentators are fond of talking about “free market capitalism,” but according to Wall Street commentator Max Keiser, it is no more. It has morphed into what his TV co-host Stacy Herbert calls “rigged market capitalism”: all markets today are subject to manipulation for private gain.

(Image: Jared Rodriguez / t r u t h o u t; Adapted: annablume, CloCkWeRX)

Keiser isn’t just speculating about this. He claims to have invented one of the most widely used programs for doing the rigging. Not that that’s what he meant to invent. His patented program was designed to take the manipulation out of markets. It would do this by matching buyers with sellers automatically, eliminating “front running” – brokers buying or selling ahead of large orders coming in from their clients. The computer program was intended to remove the conflict of interest that exists when brokers who match buyers with sellers are also selling from their own accounts. But the program fell into the wrong hands and became the prototype for automated trading programs that actually facilitate front running.

Also called High Frequency Trading (HFT) or “black box trading,” automated program trading uses high-speed computers governed by complex algorithms (instructions to the computer) to analyze data and transact orders in massive quantities at very high speeds. Like the poker player peeking in a mirror to see his opponent’s cards, HFT allows the program trader to peek at major incoming orders and jump in front of them to skim profits off the top. And these large institutional orders are our money -- our pension funds, mutual funds, and 401Ks.

When “market making” (matching buyers with sellers) was done strictly by human brokers on the floor of the stock exchange, manipulations and front running were possible but were against the rules, which were strictly enforced. Front running by computer, using complex trading programs, is an entirely different species of fraud. A minor potential for cheating has morphed into a monster. Keiser maintains that computerized front running with HFT has become the principal business of Wall Street and the primary force driving most of the volume on exchanges, contributing not only to a large portion of trading profits but to the manipulation of markets for economic and political ends.

The “Virtual Specialist”: the Prototype for High Frequency Trading

Until recently, most market making was done by brokers called “specialists,” those people you see on the floor of the New York Stock Exchange haggling over the price of stocks. The job of the specialist originated over a century ago, when the need was recognized for a system for continuous trading. That meant trading even when there was no “real” buyer or seller waiting to take the other side of the trade.

The specialist is a broker who deals in a specific stock and remains at one location on the floor holding an inventory of it. He posts the “bid” and “ask” prices, manages “limit” orders, executes trades, and is responsible for managing the uninterrupted flow of orders. If there is a large shift in demand on the “buy” side or the “sell” side, the specialist steps in and sells or buys out of his own inventory to meet the demand, until the gap has narrowed.

This gives him an opportunity to trade for himself, using his inside knowledge to book a profit. That practice is frowned on by the Securities Exchange Commission (SEC), but it has never been seriously regulated, because it has been considered necessary to keep markets “liquid.”

Keiser’s “Virtual Specialist Technology” (VST) was developed for the Hollywood Stock Exchange (HSX), a web-based, multiplayer simulation in which players use virtual money to buy and sell “shares” of actors, directors, upcoming films, and film-related options. The program determines the true market price automatically, by comparing “bids” with “asks” and weighting the proportion of each. Keiser and HSX co-founder Michael Burns applied for a patent for a “computer-implemented securities trading system with a virtual specialist function” in 1996, and U.S. patent no. 5960176 was awarded in 1999.

But things went awry after the dot.com crash, when Keiser’s company HSX Holdings sold the VST patent to investment firm Cantor Fitzgerald, over his objection. Cantor Fitzgerald then put the part of the program that would have eliminated front-running on ice, just as drug companies buy up competing patents in order to take them off the market. Instead of preventing front-running, the program was altered so that it actually enhanced that fraudulent practice. Keiser (who is now based in Europe) notes that this sort of patent abuse is illegal under European Intellectual Property law.

Meanwhile, the design of the VST program remained on display at the patent office, giving other inventors ideas. To get a patent, applicants must list “prior art” and then prove that their patent is an improvement in some way. The listing for Keiser’s patent shows that it has been referenced by 132 others involving automated program trading or HFT.

Since then, HFT has quickly come to dominate the exchanges. High frequency trading firms now account for 73% of all U.S. equity trades, although they represent only 2% of the approximately 20,000 firms in operation.

In 1998, the SEC allowed online electronic communication networks, or alternative trading systems, to become full-fledged stock exchanges. Alternative trading systems (ATS) are computer-automated order-matching systems that offer exchange-like trading opportunities at lower costs but are often subject to lower disclosure requirements and different trading rules. Computer systems automatically match buy and sell orders that were themselves submitted through computers. Market making that was once done with a “specialist’s book” -- something that could be examined and audited -- is now done by an unseen, unaudited “black box.”

For over a century, the stock market was a real market, with live traders hotly bidding against each other on the floor of the exchange. In only a decade, floor trading has been eliminated in all but the largest exchanges, such as the New York Stock Exchange (NYSE); and even in those markets, it now co-exists with electronic trading.

Alternative trading systems allow just about any sizable trader to place orders directly in the market, rather than routing them through investment dealers on the NYSE. They also allow any sizable trader with a sophisticated HFT program to front run trades.

Flash Trades: How the Game Is Rigged

An integral component of computerized front running is a dubious practice called “flash trades.” Flash orders are permitted by a regulatory loophole that allows exchanges to show orders to some traders ahead of others for a fee. At one time, the NYSE allowed specialists to benefit from an advance look at incoming orders; but it has now replaced that practice with a “level playing field” policy that gives all investors equal access to all price quotes. Some ATSs, however, which are hotly competing with the established exchanges for business, have adopted the use of flash trades to pull trading business away from the exchanges. An incoming order is revealed (or flashed) to a trader for a fraction of a second before being sent to the national market system. If the trader can match the best bid or offer in the system, he can then pick up that order before the rest of the market sees it.

The flash peek reveals the trade coming in but not the limit price – the maximum price at which the buyer or seller is willing to trade. This is what the HFT program figures out, and it is what gives the high-frequency trader the same sort of inside information available to the traditional market maker: he now gets to peek at the other player’s cards. That means high-frequency traders can do more than just skim hefty profits from other investors. They can actually manipulate markets.

How this is done was explained by Karl Denninger in an insightful post on Seeking Alpha in July 2009:

“Let’s say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40. But the market at this particular moment in time is at $26.10, or thirty cents lower.

“So the computers, having detected via their ‘flash orders’ (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) ‘immediate or cancel’ orders - IOCs - to sell at $26.20. If that order is ‘eaten’ the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.

“Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become ‘more efficient.’

“Nonsense; there was no ‘real seller’ at any of these prices! This pattern of offering was intended to do one and only one thing -- manipulate the market by discovering what is supposed to be a hidden piece of information -- the other side’s limit price!

“With normal order queues and flows the person with the limit order would see the offer at $26.20 and might drop his limit. But the computers are so fast that unless you own one of the same speed you have no chance to do this -- your order is immediately ‘raped’ at the full limit price! . . . [Y]ou got screwed for 29 cents per share which was quite literally stolen by the HFT firms that probed your book before you could detect the activity, determined your maximum price, and then sold to you as close to your maximum price as was possible.”

The ostensible justification for high-frequency programs is that they “improve liquidity,” but Denninger says, “Hogwash. They have turned the market into a rigged game where institutional orders (that’s you, Mr. and Mrs. Joe Public, when you buy or sell mutual funds!) are routinely screwed for the benefit of a few major international banks.”

In fact, high-frequency traders may be removing liquidity from the market. So argues John Daly in the Canadian Globe and Mail, citing Thomas Caldwell, CEO of Caldwell Securities Ltd.:

“Large institutional investors know that if they start trying to push through a large block of shares at a certain price – even if the block is broken into many small trades on several ATSs and markets -- they can trigger a flood of high-frequency orders that immediately move market prices to the institution’s disadvantage. . . . That’s why institutions have flocked to so-called dark poolsoperated by ATSs such as Instinet, and individual dealers like Goldman Sachs. The pools allow traders to offer prices without publicly revealing their identities and tipping their hand.”

Because these large, dark pools are opaque to other investors and to regulators, they inhibit the free and fair trade that depends on open and transparent auction markets to work.

The Notorious Market-Rigging Ringleader, Goldman Sachs

Tyler Durden, writing on Zero Hedge, notes that the HFT game is dominated by Goldman Sachs, which he calls “a hedge fund in all but FDIC backing.” Goldman was an investment bank until the fall of 2008, when it became a commercial bank overnight in order to capitalize on federal bailout benefits, including virtually interest-free money from the Fed that it can use to speculate on the opaque ATS exchanges where markets are manipulated and controlled.

Unlike the NYSE, which is open only from 10 am to 4 pm EST daily, ATSs trade around the clock; and they are particularly busy when the NYSE is closed, when stocks are thinly traded and easily manipulated. Tyler Durden writes:

“[A]s the market keeps going up day in and day out, regardless of the deteriorating economic conditions, it is just these HFT’s that determine the overall market direction, usually without fundamental or technical reason. And based on a few lines of code, retail investors get suckered into a rising market that has nothing to do with green shoots or some Chinese firms buying a few hundred extra Intel servers: HFTs are merely perpetuating the same ponzi market mythology last seen in the Madoff case, but on a massively larger scale.”

HFT rigging helps explain how Goldman Sachs earned at least $100 million per day from its trading division, day after day, on 116 out of 194 trading days through the end of September 2009. It’s like taking candy from a baby, when you can see the other players’ cards.

Reviving the Free Market

So what can be done to restore free and fair markets? A step in the right direction would be to prohibit flash trades. The SEC is proposing such rules, but they haven’t been effected yet.

Another proposed check on HFT is a Tobin tax – a very small tax on every financial trade. Proposals for the tax range from .005% to 1%, so small that it would hardly be felt by legitimate “buy and hold” investors, but high enough to kill HFT, which skims a very tiny profit from a huge number of trades.

That could work, but it might take a tax larger than .005% or even .1%. Consider Denninger’s example, in which the high-frequency trader was making not just a few pennies but a full 29 cents per trade and had an opportunity to make this sum on 99,500 shares (100,000 shares less 5 100-lot trades at lesser sums). That’s a $28,855 profit on a $2.63 million trade, not bad for a few milliseconds of work. Imposing a .1% Tobin tax on the $2.63 million would reduce the profit to $26,225, but that’s still a nice return for a trade that takes less time than blinking. A full 1%, on the other hand, would pretty well wipe out the profit and kill the trade.

Better yet, however, would be to fix the problem at its source -- the price-setting mechanism itself. Keiser says this could be done by banning HFT and installing his VST computer program in its original design in all the exchanges. The true market price would then be established automatically, foreclosing both human and electronic manipulation. He notes that the shareholders of his former firm have a good claim for voiding out the sale to Cantor Fitzgerald and retrieving the program, since the deal was never consummated and the investors in HSX Holdings have never received a penny for the sale.

There is just one problem with their legal claim: the paperwork proving it was shipped to Cantor Fitzgerald’s offices in the World Trade Center several months before September 2001. Like free market capitalism itself, it seems, the evidence has gone up in smoke.

Ellen Brown developed her research skills as an attorney practicing civil litigation in Los Angeles. In Web of Debt, her latest of eleven books, she turns those skills to an analysis of the Federal Reserve and “the money trust.” She shows how this private cartel has usurped the power to create money from the people themselves, and how we the people can get it back. Her websites are www.webofdebt.com, www.ellenbrown.com, and www.public-banking.com.

http://www.webofdebt.com/articles/computerized_front_running.php

[costard]

The thought occurred to me that my explanation may not make sense to some readers, so I figured I would expand on it a bit. First a classic case of Front Running:

Let's say that Costard is a licensed broker and one of his clients is Wall Street high roller Diesel Taylor. Diesel decides that CM:N is going to be a huge hit so he decides he's going to place an order for 100,000 shares of BFC at the market (ie, he wants his order filled at whatever price he gets from the market). He calls up Costard and tells him what he wants to do. Costard figures that Diesel Taylor's order is large enough that it will drive the price up so he decides that he might as well make a little money on the side. Costard has Diesel Taylor's order in hand but before he works the order he puts out a buy order for 500 shares of BFC in his own personal brokerage account. Costard then places Diesel Taylor's trade for 100,000 shares and sure enough the price goes up. When Costard has finished with Diesel Taylor's order he then goes out and sells his 500 shares at the new higher price and pockets a nice profit. That is Front Running.

Okay, so what was apparently happening in the articles Diesel Taylor provided? Let's say that Costard is a computer genius who works at the NASDAQ exchange. He tells his boss "hey, there is a loophole in the Front Running law that exempts automatic executions, so why don't we just hold orders for a half second and start up a service whereby our special customers can see the held orders before we execute them?" His boss loves the idea and so Flash Trading is born.

Now you have two wall street high rollers - Jon S and Diesel Taylor. Jon S signed up for NASDAQ's special feed and Diesel Taylor did not. Jon S is sitting at his desk with six monitors stacked up and has his cup of coffee sitting nearby. One of those monitors has the special NASDAQ feed for upcoming orders on BFC. Diesel Taylor is sitting at his computer with four monitors stacked up with no coffee and decides to place an order for 100,000 BFC at the market. The order goes to the NASDAQ, but rather than executing the order immediately the NASDAQ holds the order for a half second and retransmits that information to Jon S's computer. Jon S then sees the order Diesel Taylor placed and Jon S decides that placing his order before Diesel Taylor's order executes would be beneficial so that's what he does. Since Jon S is on the special NASDAQ feed his order is not held but gets filled immediately. Diesel Taylor's order was held by NASDAQ and so his order gets filled after Jon S's order gets filled. So yeah, Jon S is front running, but he is doing so because the information is being given to him by NASDAQ. I suspect that the reason the NASDAQ could do that is because of the automatic order exemption in the Front Running rule. There may have been some political favors involved too since I have no doubt that the big shots running the exchanges would know the big shots at the SEC, NASD, or the other regulatory bodies.

Having said all that, it's possible that I misunderstood the articles and that I'm way out in left field on it. I have to admit that I didn't give the articles a very thorough read.

Thanks for that ASLVet. I read the commentary as the exchanges fighting it out for the right to sell the shares - the parcel going to the exchange with the highest demand (or the best software, something like that).

The bit I find puzzling is that the banks (or traders, anyway) are skimming the profits from their customers. In an industry where trust is the only measure of relative worth of the participants, it would seem to me that they are quite willing to forgo clients in the race for short term profits. So, do they know something we don't (There is no long term future for the market?) or are they just trading on their willingness to screw their clients just a little less than their opposition in order to maintain market share? Either way, I can't see them being around much longer so long as they continue in this fashion. Given their track record (they've proven themselves about as trustworthy as the Pakis and Afghanis), maybe better just to nationalise the businesses and let the rest of the market take heed of the lesson.

[ASL Veteran]

Thanks for that ASLVet. I read the commentary as the exchanges fighting it out for the right to sell the shares - the parcel going to the exchange with the highest demand (or the best software, something like that).

The bit I find puzzling is that the banks (or traders, anyway) are skimming the profits from their customers. In an industry where trust is the only measure of relative worth of the participants, it would seem to me that they are quite willing to forgo clients in the race for short term profits. So, do they know something we don't (There is no long term future for the market?) or are they just trading on their willingness to screw their clients just a little less than their opposition in order to maintain market share? Either way, I can't see them being around much longer so long as they continue in this fashion. Given their track record (they've proven themselves about as trustworthy as the Pakis and Afghanis), maybe better just to nationalise the businesses and let the rest of the market take heed of the lesson.

No, not skimming profits. A trader can't skim profits from a customer. The customer is going to get an execution price based upon the skill of the trader and the trader is using various devices to get better prices for their customer (and thus enhancing their reputation and their own profits). The trader is "screwing" other trader's or other trader's customers by giving themselves an advantage over them. This really doesn't affect 'the little guy' too much. If you are trading 100 shares or 500 shares of something then you aren't moving the market so it's got no effect on you. It's really high rollers 'screwing' other high rollers.

Outside of the realm of the actual people doing the trades though, the people affected by this would be the holders of mutual funds or retirement funds, stuff like that. If you are a mutual fund and you are trying to get your order filled and the 'other guy' has access to the flash trading and you don't then you are operating at a disadvantage. The ones who might suffer or benefit from that are all the customers who are holding that mutual fund etc. This is why a firm like Goldman Sachs would be crying foul. I'm not sure what you would nationalize here or what positive effect you think that would have. I have to admit that remark has me scratching my head.

[dieseltaylor]

Certainly GoldmanSachs need looking at. Being given Bank status has only aggravated a problem, this should be wound down and transitioned back to where they were - at least.

I am reminded of the Knights Templar, another trans-national organisation which became too big for its boots. Bearing in mind all the positions filled by ex-GS staff in the US government etc, and the influence they exercise, it definitely would be salutory for people to see no company is TOO big.

It does strike me as bizarre that in most countries there are organisations that are proscribed in certain ways. Freemasons and the British police being one example. I am sure Quakers were proscribed against, the Communist party in the US!, just because an organisation is a "company" does not mean it is harmless to the State.

[costard]

No, not skimming profits. A trader can't skim profits from a customer. The customer is going to get an execution price based upon the skill of the trader and the trader is using various devices to get better prices for their customer (and thus enhancing their reputation and their own profits). The trader is "screwing" other trader's or other trader's customers by giving themselves an advantage over them. This really doesn't affect 'the little guy' too much. If you are trading 100 shares or 500 shares of something then you aren't moving the market so it's got no effect on you. It's really high rollers 'screwing' other high rollers.

Outside of the realm of the actual people doing the trades though, the people affected by this would be the holders of mutual funds or retirement funds, stuff like that. If you are a mutual fund and you are trying to get your order filled and the 'other guy' has access to the flash trading and you don't then you are operating at a disadvantage. The ones who might suffer or benefit from that are all the customers who are holding that mutual fund etc. This is why a firm like Goldman Sachs would be crying foul. I'm not sure what you would nationalize here or what positive effect you think that would have. I have to admit that remark has me scratching my head.

Given that the unit holders of mutual funds are almost entirely little guys trying to get the benefits of scale and risk spread from participation in the fund, this argument would have to be disingenuous, at best. The trader gets his reward for skill in the comission he receives for the trade - taking another bite of the cherry for his company is at least unethical: he's acting on inside information about the movement of shares. At worst, it's theft based around the idea that what the punter doesn't know won't hurt them, and none of them are smart enough to figure out what's going on anyway. The racist comparison was regrettable and I apologise for any distress caused. The last remark concerning a possible course of action open to a sovereign government in the face of such entrenched behaviour in the corporate realm is merely the cutting of the Gordian knot: put the buggers out of work and let the rest know that the behaviour is poorly regarded and will not continue. It shouldn't take too much time for the legal arguments to make their way through the court system in the US, provided there is the recognition on the part of the participants that the fabric of their society is under threat from the continuance of these practices.