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COMPUTERIZED FRONT RUNNING: ANOTHER GOLDMAN-DOMINATED FRAUD

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Headlined to H2 4/26/10

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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 abuse 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.

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Ellen Brown is an attorney, founder of the Public Banking Institute, and author of twelve books including the best-selling WEB OF DEBT. In THE PUBLIC BANK SOLUTION, her latest book, she explores successful public banking models historically and (more...)
 

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