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INVESTING: High-frequency trading comes under scrutiny

July 13, 2009

A developing case of technology theft has shed light on the proprietary systems Goldman Sachs and other investment firms use to make millions of dollars.

A 39-year-old former employee at Goldman has been accused of stealing computer code used in the company’s high-frequency trading system.

The investing public may be unaware of the significant presence of high-frequency trading in the stock market. These “black box” trading models are shrouded in secrecy by the hedge funds and Wall Street firms that design them. It has been estimated that they generate more than half the daily trading volume on the stock exchanges.

These trading models care nothing about a particular company’s business, its financial statements or its outlook. They are programmed to scoop up small changes in the direction of stock prices, with their success determined by how fast they can execute trades.

Transacting at the speed of light is so crucial that firms clamber to get their computer servers as close to the stock exchanges as possible. The difference between having a computer a block farther away than their competitor can be the difference between profit and loss.

Interestingly, one of the first individuals to implement high-frequency trading was Dave Cummings, a Purdue University engineering graduate who formed Tradebot in 1999. When stock trading switched from transactions in increments of 1/16th of a dollar to pennies on the dollar in 2000, many Wall Street firms pulled back from market-making activities, figuring it wasn’t profitable anymore.

That opened the door to high-frequency traders. In 2002, Cummings moved his computers from Kansas City to New York, since being that much closer to the stock exchange allowed trades to execute in 1/1,000 of a second versus 1/50 of a second.

By 2006, Tradebot was making an estimated $30,000 to $150,000 a day and up to $20 million a year.

High-frequency trading is science versus the art of analyzing a business. Hedge funds and Wall Street trading desks hire math experts who devise algorithms to discern price movements in stocks, commodities and other markets. The general idea is that these computer programs allow a firm to buy, for example, Microsoft stock at $22.24 and sell it virtually simultaneously at $22.25. The process has been analogized to picking up pennies in front of a steamroller.

Supporters of high-frequency trading say these firms facilitate liquidity for all market participants and that technology has replaced the need for people to match buyers and sellers. Critics say they increase market volatility and create an unfair advantage over public investors. Some suggest they manipulate markets by siphoning off small profits throughout the trading day that belong in the pocket of retail investors.

In this particular case of alleged computer theft, Goldman’s lawyers, perhaps unwittingly, told the court July 4 “that somebody who knew how to use this program could use it to manipulate the market in unfair ways.” Of course, this raises the question of just how Goldman uses it.

As a sign of what’s to come in a new era of market oversight, regulators have recently announced they are considering measures to restrict speculative trading in the oil and gas markets. Consequently, one would think it is likely that high-frequency trading will come under scrutiny in the future.

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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