Computerized Front Running and Financial Fraud

How a Computer Program Designed to Save the Free Market Turned Into a Monster

Linked on our blogs with The Web of Dept, and with The Model Economy Community.- Published on Global Research.ca, by Ellen Brown, April 23, 2010.

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.  Note that 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 considered an acceptable (if morally dubious) price to pay for continuously “liquid” markets.  But front running by computer, using complex trading programs, is an entirely different species of fraud.  A minor flaw in the system 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: … //

… Flash Trades: How the Game Is Rigged:

An integral component of computerized front running is a dubious practice called “flash trades.”  The Story of the Financial Debacle: Goldman Plays, We Pay, on Global Research.ca, by Robert Scheer, April 23, 2010.

The Goldman Sachs Indictment,on Global Research.ca, by Patrick O’Connor and Barry Grey, April 23, 2010. 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 U.K. 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: … (Full text).

(Ellen Brown developed her research skills as an attorney practicing civil litigation in Los Angeles. In Web of Debt, (find it on amazon.co.uk, see also all her books), 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 web of debt.com, ellen brown.com, and public-banking.com.
Ellen Brown is a frequent contributor to Global Research. Global Research Articles by Ellen Brown
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