Tuesday, May 11, 2010

Crony Capitalism -- Statistical Evidence that the Government and the Investment Banks Have Rigged the Stock Market

Earlier this week, financial news junkies heard that investment banking giants Goldman Sachs and J.P. Morgan achieved improbable proprietary trading performances this past quarter. Each had a record number of profitable, prop-trading days: all of them.

Proprietary trading refers to the trades that are executed on behalf of the investment bank itself. In other words, not for clients.

In fact, for all of 2009, the majority of GS' prop-trading days resulted in profits of over $100 million each.

What are the odds of this sort of thing occurring in a natural market, in which all participants are on a level playing field? According to Karl Denninger, about 1 in 1,000,000,000,000,000,000 -- or roughly the odds that Juliette Lewis will be named the next Pope.

I will leave it to you, and those who investigate frauds, to determine whether the application of skill, without any sort of cheating such as front-running client orders, insider information or other forms of rigging the markets, can turn the random chance odds of 8.67 x 10-19 into an event that has, in fact, actually occurred.

To see the Goldman trading platforms in action, one need only examine the 90-degree "ramps" in equity prices that seem to occur when normal investors have dropped out of the market. Like most of us since 2008. And today after the whip-saw insanity last week.

"The market is melting straight up without interruption, and without any volume. Retail is now completely out of the market, and our advice to everyone is to stay out and let the computer blow themselves up again. In the meantime, please don't ask how and why Goldman and JPM can both have a perfect quarter. The chart below says it all."

This is a four-day trading chart. Notice the rightmost quadrant, representing today (Tuesday), in which volume went to nil while the Goldman and Morgan trading computers ratcheted the market up as they have for months on end.

How do they do it? And, more importantly, how do they get away with it?

Earlier today, Themis Trading published a white paper (PDF) that describes these trading operations as pure "theft on Wall Street".

Most institutional and retail investors have no idea that the private trade information they are entrusting to the market centers is being made public by the exchanges. The exchanges are not making this clear to their clients, but instead are actively broadcasting the information to the HFT's in order to court their order flow. The exchanges are likely to counter that when a subscriber signs up to their exchange they then allow the exchange to use this data as they see fit.

However, how many investors would have signed that agreement knowing that their hidden orders were being exposed? This practice has been going on for years but not many investors have read the market data specifications. Every day high frequency traders are using the information that some exchanges are supplying to disadvantage unsuspecting investors.

Every time a trader places an order in certain market centers, whether at the market centers directly, or through a third-party DMA, those market centers are collecting data regarding the trader’s order flow. They are supplying the information to HFT's that allows them to track when an investor changes price and how much stock has been accumulated. This information is helping HFT's predict short term price movements.

Institutional as well as retail footprints are being detected, and 'modus operandi' and trading profiles are being created. Traders believe that their trading strategies are protected, when actually their strategies (personal data) -- including variables such as displayed quantity, time stamp, side, revisions, reserve orders, linked executions, order id numbers, accumulations, number of shares -- are being misappropriated for sale by the market centers.

The exchanges seem to think that they own the data and have the right to sell it. Why are the exchanges allowed to do this? We think this is an outrage and demands immediate action by the SEC. How can the public trust the very organizations that are supposed to be protecting them, when these organizations are turning around and selling their personal data. The only difference between personal data theft, and the data-feed issue we highlight in this paper, is the degree of public awareness.

HFT stands for "High Frequency Trading" and, in general, refers to the proprietary trading arms of Goldman, Morgan and certain hedge funds. They use massively scalable computing platforms and custom software to -- in the words of Themis -- disadvantage normal traders.

This sort of activity is outrageous. It's apparently tolerated by the SEC and Congress, despite insiders' knowledge of precisely what's going on. That goes for Tim Geithner, Ben Bernanke and others whose livelihoods depend upon a Dow Jones average that gives normal folks a warm-fuzzy feeling despite the real and ongoing economic debacle.

Investment bankers have been collecting billions in bonuses using sordid tactics that could legitimately be called criminal. And the SEC and Congress are simply looking the other way. Meanwhile, the public is backstopping all of the risk and eating the trading losses.

Now that's change you can believe in.


robot said...

Linked at the Robot.
Your 401k Are Belong To Us

student aid said...

Great posting thanks

Phil said...

I shared this post with a conservative friend who's also an options trader. He replied as follows:

... I have been reading extensively about this since the computer-driven melt-down and melt-up last Thurs ... The way I understand it, what Goldman and Morgan are doing is not technically considered "insider" trading since insider trading is defined as having inside knowledge of what something like an earnings report are going to be prior to public release. These firms might also be doing this, but no one has been able to prove that. The charges are rather about HFT, high-frequency-trading. The exchanges the blog are attacking will say they are making order knowledge public in order to promote customers getting the best price. That is, after all, the purpose of an exchange. Market makers of stocks may hold public orders back until they find a price where they can make money on price arbitrage but the exchanges are supposedly not allowed to do this.

If, as the article says, the orders are being made public before others have a chance, that's one thing. The controversy as I understand it about HFT is that the orders are NOT always made public but the super computers the large firms are using can discover price and volume of orders faster than others. Here is how it works:

I put in an order to buy 100,000 shares of Google at up to $508.50/share but let's assume that this order is not revealed to the market. Still, the order is sitting there on my server.

Goldman's supercomputer puts out an order to sell 100 shares at $508.25 (current market price as of this writing) and my server eats it.
Goldman's computer says, "Gee, that was easy" and puts in another order to sell another 100 shares at $508.26 and my server again takes it.
Then Goldman's computer tries $508.27 and is successful again.
Goldman's computer keeps firing out orders to sell 100 shares incrementally higher until it tries $508.51 and my server does not accept it. So now, Goldman knows my order is at $508.50 and starts firing off sell orders continually until the remainder of my 100,000 share order is filled. Goldman knows that it can buy these shares at the current market of $508.25 and make the spread of $0.25 per share which might not seem like a lot, but x 100,000, that's $25,000 and their computers are doing this for hundreds or thousands of stocks all day. And remember this all occurs in a fraction of a second, which makes it nice work if you can get it :) The only thing Goldman has to worry about is if Morgan's computers which are trying to do the same thing are able to do the trade faster. This is why these companies are spending so much money on progamming whizzes and the fastest IT resources they can get.

This is a technology cold war on whose computers are fastest. One millisecond can make all the difference. This is why companies like Goldman must locate their computing power right AT the exchange in NY and the exchange leases server space for this purpose. They also pay $3,500/mo. for data which is a lot for us, but nothing for them. The reason is that to locate a trading server even 100 miles from Wall St. means 1-2 milliseconds of delay due to simply the speed of light and data transfer, resistance of wires, etc. That can mean the difference between them scooping trades or someone else scooping them. Congress is reluctant to try to stop this because, technically, there is nothing illegal about what they are doing, but they do have a clear advantage over retail customers.

We can never compete with HFT, but we can still make money in longer-term (in this case, >1 second) trading.

I look forward to reading any feedback to this.

fboness said...

Every long term is made up of a series of short terms. If the HFT computers win every short term then they win the aggregate long term as well.

portable media player said...

Goldman team is still taking orders to sell 100 shares higher and higher until he is $ 508.51 and my server does not accept. So far, Goldman knows my order is $ 508.50 and begins to withdraw from sales orders constantly until the rest of my part in 100,000 is met. Goldman know you can buy these shares on the market today for $ 508.25 and make the
portable media player