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.

Read more from the author/contributor here.

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