Computerized Front Running: Another Goldman-Dominated Fraud
Written by Ellen Hodgson Brown
Tuesday, 27 April 2010 06:22
http://www.atlanticfreepress.com/news/1/13124-computerized-front-running-another-goldman-dominated-fraud-.html
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.
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 pools operated 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.
+44 (0)7786 952037
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http://www.thisweek.org.uk/
http://www.911forum.org.uk/
"Capitalism is institutionalised bribery."
_________________
www.abolishwar.org.uk
<http://www.elementary.org.uk>www.elementary.org.uk
www.public-interest.co.uk
www.radio4all.net/index.php/series/Bristol+Broadband+Co-operative
<http://utangente.free.fr/2003/media2003.pdf>http://utangente.free.fr/2003/media2003.pdf
"The maintenance of secrets acts like a psychic
poison which alienates the possessor from the community" Carl Jung
<https://217.72.179.7/members/www.bilderberg.org/phpBB2/>https://217.72.179.7/members/www.bilderberg.org/phpBB2/
--
Please consider seriously the reason why these elite institutions are not discussed in the mainstream press despite the immense financial and political power they wield?
There are sick and evil occultists running the Western World. They are power mad lunatics like something from a kids cartoon with their fingers on the nuclear button! Armageddon is closer than you thought. Only God can save our souls from their clutches, at least that's my considered opinion - Tony
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