by Ellen Brown
April 23, 2010
Ellen Brown developed her research skills as an attorney practicing civil
litigation in Los Angeles. In Web of Debt, 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
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
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.
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.
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
Until recently, most market making was done by brokers called
“specialists,” those people you see on the floor of the
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.
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.
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
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.
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
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.
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
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
That means high-frequency traders can do more than
just skim hefty profits from other investors. They can actually
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
“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
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
In fact, high-frequency traders may be removing liquidity from the
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
writing on Zero Hedge, notes that the HFT game is
dominated by Goldman Sachs, which he calls “a hedge fund in all but
Goldman was an investment bank until the fall of
2008, when it became a commercial bank overnight in order to
capitalize on federal bailout benefits, including virtually
interest-free money from the FED that it can use to speculate on the
opaque ATS exchanges where markets are manipulated and controlled.
Unlike the NYSE, which is open only from 10 am to 4 pm EST daily,
ATSs trade around the clock; and they are particularly busy when the
NYSE is closed, when stocks are thinly traded and easily
Tyler Durden writes:
“[A]s the market keeps going up day in and day out, regardless of
the deteriorating economic conditions, it is just these HFT’s that
determine the overall market direction, usually without fundamental
or technical reason.
And based on a few lines of code, retail
investors get suckered into a rising market that has nothing to do
with green shoots or some Chinese firms buying a few hundred extra
Intel servers: HFTs are merely perpetuating the same ponzi market
mythology last seen in the
Madoff case, but on a massively larger
HFT rigging helps explain how Goldman Sachs earned at least
million per day from its trading division, day after day, on 116 out
of 194 trading days through the end of September 2009.
taking candy from a baby, when you can see the other players’ cards.
Reviving the Free Market
So what can be done to restore free and fair markets? A step in the
right direction would be to prohibit flash trades. The SEC is
proposing such rules, but they haven’t been effected yet.
Another proposed check on HFT is a
Tobin tax - a very small tax on
every financial trade. Proposals for the tax range
from 0.005% to 1%,
so small that it would hardly be felt by legitimate “buy and hold”
investors, but high enough to kill HFT, which skims a very tiny
profit from a huge number of trades.
That is what proponents contend, but a tiny tax might not actually
be enough to kill HFT. Consider Denninger’s example, in which the
high-frequency trader was making not just a few pennies but a full
29 cents per trade and had an opportunity to make this sum on 99,500
shares (100,000 shares less 5 100-lot trades at lesser sums).
a $28,855 profit on a $2.63 million trade, not bad for a few
milliseconds of work. Imposing a 0.1% Tobin tax on the $2.63 million
would reduce the profit to $26,225, but that’s still a nice return
for a trade that takes less time than blinking.
The ideal solution would fix the problem at its source - the
price-setting mechanism itself.
Keiser says this could be done by
banning HFT and installing his
VST computer program in its original
design in all the exchanges. The true market price would then be
established automatically, foreclosing both human and electronic
He notes that the shareholders of his former firm have
a good claim for voiding out the sale to Cantor Fitzgerald and
retrieving the program, since the deal was never consummated and the
investors in HSX Holdings have never received a penny for the sale.
There is just one problem with their legal claim:
proving it was shipped to Cantor Fitzgerald’s offices in the World
Trade Center several months before September 2001.
Like free market
capitalism itself, it seems, the evidence has gone up in smoke.