On Goldman Sachs’ illegitimate high frequency program trading
Update: Goldman Sachs finally responds, claiming that HFT accounts for less than 1% of its Q1 & Q2 revenue.
Update 2: Paul Krugman wrote an op-ed on this here.
The NYT reported yesterday that Goldman Sachs’ high frequency program trading may have given the bank an unfair competitive leg up over its rivals:
Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer.
And when a former Goldman Sachs programmer was accused this month of stealing secret computer codes — software that a federal prosecutor said could “manipulate markets in unfair ways” — it only added to the mystery. Goldman acknowledges that it profits from high-frequency trading, but disputes that it has an unfair advantage.
Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.
Yes, that story of the former Goldman employee stealing his employer’s secret sauce is still pending investigation. But as you may wonder, why should high-frequency trading give an unfair advantage to those who employ it? The NYT goes on to give an example of how slower traders lost out to quicker moving ones:
It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.
The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.
In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.
Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.
The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.
In other words, fast-moving investment banks like Goldman Sachs were able to front-run the rest of the market by determining investors’ sentiments by virtue of being able to (arguably illegitimately) examine incoming orders and estimate the upper limit of how much the market traders were willing to pay for shares. That’s clearly an unfair advantage which has virtually nothing to do with investment strategy.
The next question one should ask is, how much of Goldman’s profits are due to high-frequency trading? We don’t know for sure, but a glance at the first chart of this post would yield a reasonable ‘guestimate’ of “quite a hell lot”. Goldman Sachs consistently ranks at the top for program trading activity on the NYSE.
On a side note, the NYSE filed to halt publication of statistics on daily program trading activity on Wall Street, of which Goldman Sachs is king:
The Exchange has filed with the SEC to implement the decommissioning of the [Daily Program Trading Report] DPTR requirement following the July 10, 2009 trade date. Accordingly, the last required submission of the DPTR will be on July 14, 2009, which is the second business day after the last trade date for which the DPTR is required.
Curiously the NYSE page on program trading activity states that there are “no entries listed for this page”. I presume this means there must be some other ways to obtain the data, because Zero Hedge somehow managed to obtain theirs recently. Searching the Web, I found this page which appears to be updated regularly:
Unsurprisingly, Goldman Sachs is still tops. It’s closest competitor, Credit Suisse is barely half as active as it is, judging by the statistics.
Congress appears to be finally taking note of this possibly illegal activity. Democratic New York Senator Schumer has requested the SEC to ban flash trading, or the variant of program trading which allows fast-moving traders to look at pending orders held by the exchange for milliseconds before processing them:
July 24 (Bloomberg) — Senator Charles Schumer asked the U.S. Securities and Exchange Commission to ban “flash orders,” saying the transactions give high-speed traders an unfair advantage over other investors.
Nasdaq OMX Group Inc., Bats Exchange Inc. and Direct Edge Holdings Inc. hold these orders for milliseconds, giving their customers the opportunity to gauge demand before traders on other exchanges get the chance to bid, Schumer said in a letter to SEC Chairman Mary Schapiro. Brian Fallon, a spokesman at Schumer’s office, confirmed the authenticity of the letter.
If and when such a regulation gets enforced, it would be an interesting to see how much Goldman would make in the absence of that. On the other hand, considering the ties Goldman has with the government it seems unlikely that the final regulation, which is likely to be heavily watered down, would handicap its trading strategies.
P.S. Those who seek a more complete (and more speculative) picture on Goldman Sachs should read this technical post on DKos.