Bill King on high frequency trading and Goldman Sachs crime

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Bill King on high frequency trading and Goldman Sachs crime

posted on Jul 25, 2009 11:49AM

Bill King: Automated front-running on an unfathomable scale

Posted By GreenLightAdvisor On July 10, 2009 @ 7:23 am In Markets | No Comments

This post is a guest contribution by Bill King*, well-respected and straight-talking author of The King Report. GreenLightAdvisor has added supplemental notes on supporting material.

For the past several years Street operators have assumed that the computer jockeys who were being employed by proprietary trading departments on The Street were developing algorithms that would find other algorithms that represented buyside orders so prop desks could trade against those orders.

Another trading prop that has been occurring for years is certain firms feed their electronic trading systems into prop desks so traders can see in real time money flows into and out of stocks and groups.

However recent revelations are forcing the Street to consider the possibility of automated front-running on an unfathomable scale. The two “front-running” issues are: 1) “queuing” [of orders] - finding orders loaded into a system, particularly limit orders, and trading against them; and 2) “latency” - discovering and then front-running electronic orders by a penny or more by exploiting the latency or lag in execution.

HFT (high frequency trading) is being done on every electronically traded item on a global basis. Ergo, firms could be making pennies a few billion times per day … It was imperative for the NYSE and other exchanges to price securities in pennies to disguise “HFT” and to provide ample trading opportunities.

[GLA]

Bloomberg and others write about “HFT” as a result of a corporate espionage case involving Goldman Sachs and the alleged theft of its proprietary trading software by Sergey Aleynikov, a story that has broken wide open during the last two weeks:

Bloomberg : Aleynikov, 39, is the former Goldman computer programmer who was arrested on theft charges July 3 as he stepped off a flight at Liberty International Airport in Newark, New Jersey. That was two days after Goldman told the government he had stolen its secret, rapid-fire, stock- and commodities-trading software in early June during his last week as a Goldman employee. Prosecutors say Aleynikov uploaded the program code to an unidentified Web site server in Germany.

It wasn’t just Goldman that faced imminent harm if Aleynikov were to be released, Assistant U.S. Attorney Joseph Facciponti told a federal magistrate judge at his July 4 bail hearing in New York. The 34-year-old prosecutor also dropped this bombshell: “The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways.”

Former Goldman Programmer Sergey Aleynikov Arrested for Theft Charges on July 3rd - Click play to watch:

How could somebody do this? The precise answer isn’t obvious — we’re talking about a black-box trading system here. And Facciponti didn’t elaborate. You don’t need a Goldman Sachs doomsday machine to manipulate markets, of course. A false rumor expertly planted using an ordinary telephone often will do just fine. In any event, the judge rejected Facciponti’s argument that Aleynikov posed a danger to the community, and ruled he could go free on $750,000 bail. He was released July 6.

Reuters: Federal authorities contend the computer codes and related-trading files that Aleynikov uploaded to a German-based website help this major financial institution generate millions of dollars in profits each year.

The platform is one of the things that gives Goldman an advantage over the competition when it comes to the rapid-fire trading of stocks and commodities. Federal authorities say the platform quickly processes rapid developments in the markets and using secret mathematical formulas, allows the firm to make highly-profitable automated trades.

[GLA]

While the Street is percolating with anger and curiosity about “High Frequency Trading” there is also frustration and astonishment that the media, regulators and our duly elected are not addressing what could be the biggest financial abuse story of our times, if not history.

[GLA]

Bloomberg: Meantime, it would be nice to see someone at Goldman go on the record to explain what’s stopping the world’s most powerful investment bank from using its trading program in unfair ways, too. Oh yes, and could the bank be a bit more careful about safeguarding its trading programs from now on? Hopefully the government is asking the same questions already.

[GLA]

Though the blogoshpere is all over the ‘HFT’ trading story an important piece of the puzzle has not been publicized enough. Few people realize that exchanges actually pay firms to trade against order flow when they act as a SLP - “Supplementary Liquidity Provider”.

[GLA]

Read more about SLP here, here, and here.

[GLA]

Exchanges will pay firms ¼ of a penny if they “provide liquidity” when an order appears in their system. This is extra incentive to front run order flow … Theoretically a firm could “scratch” all day and profit.

Over the past decade the move to electronic trading and pricing in pennies was heralded by Street insiders as a means to improve liquidity for clients. This appears to be a deception. Virtually every facility benefitted proprietary trading at a select few firms. Who’s the patsy?

Anyone with a modicum of industry experience understands that “providing liquidity” is at best a euphemism for front-running order flow.

Source: Bill King, The King Report, July 10, 2009.

* Bill King is market strategist with Chicago-based broker-dealer M. Ramsey King Securities. He has over 30 years’ equity trading and management experience with major Wall Street firms including Nikko Securities International, E F Hutton, Nomura Securities International, Dean Witter, and Jeffries and Co. To subscribe to The King Report, e-mail Bill at billking@ramkingsec.com.