A case of financial espionage raises questions about Wall Street’s proprietary trading practices and exactly what role they play in the market. The perpetrator of the espionage, Sergei Aleynikov, is a former computer programmer and equity specialist at Goldman Sachs. He is alleged to have downloaded secret software at Goldman that is used to direct large volume, rapid-fire trades to exchanges and commodity markets, often just before the close of regular trading.
At a bail hearing for Aleynikov, now in custody in New York, U.S. Assistant District Attorney Joseph Facciponti said Goldman Sachs stands to lose millions of dollars from its proprietary trading based on the stolen software. Moreover, if others in the market obtain access to these trading secrets, ”œthere is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways,” according to Facciponti.
This naturally raises several questions about the software and the trading algorithms incorporated in the program. What do these algorithms do, and how do we know that Goldman Sachs isn’t already using the software ”œto manipulate markets in unfair ways”?
The algorithms fall under the category of ”œquantitative trading”, created by ”œquants” who are often Ph.D’s in the hard sciences or mathematics. Many of them are like Aleynikov, a Russian Ã©migrÃ© and former student of applied mathematics in Moscow, who was earning $400,000 a year and left Goldman Sachs to take a job in Chicago that he described paid three times as much. Quantitative trading is only possible in the modern marketplace because so much trading is now electronically based, sent to the exchange by computers, and often without any human intervention beforehand. In the first quarter of this year, it is estimated that over 25% of all New York Stock Exchange trades were computer generated, dwarfing the volume of trades sent in by individual investors.
Quantitative trading algorithms can perform many functions, but one of the principal things they do is research many thousands of stock, bond, foreign exchange and commodity prices in search of anomalies that can be exploited for profit. The algorithm carries an historical data base that reveals typical relationships between or among financial assets. The relationship between, for example, crude oil for three months vs. six months delivery falls into a certain statistical distribution, or to use another case, transportation stocks may trade inversely to energy stocks (as the price of oil goes up, energy stocks go up but transportation stocks go down).
If the algorithm finds that a price relationship is currently trading well beyond its typical range, the computer will shoot off trading instructions to buy and sell the respective financial assets in anticipation of a return of this trading relationship to normal conditions. Since these anomalies are expected to be short-lived, the computer algorithm is required to monitor the market real time and send out follow-up instructions, often by the end of the day, to close out the position and take profit (or cut the firm’s loss if the trade did not go as planned).
This sort of quantitative trading seems to be one of the features of the Goldman program, and Mr. Aleynikov is being accused of downloading this program to an outside computer so he could bring it to his new firm and use it for trading there. But there could be many other types of quantitative trading, some of it ”œdirectional” in nature, wherein the algorithm is searching for a financial asset or market that is overbought or oversold and likely to reverse direction. These types of algorithms often compare current prices to a five, thirty, and fifty day moving average of prices for that asset or market, and if the current price violates one of these averages, a buy or sell order will be generated. These programs are so prolific that many individual investors follow these moving averages as well, and ”œpile on” to the computer trades once an average is violated.
The main criticism of these program trades is that they become self-fulfilling in at least two ways. First, the sheer volume submitted by a firm like Goldman Sachs starts moving the market back to the direction desired by the firm. As such, it sends a signal to the market that a directional change is occurring, and this tends to attract others to the trade, adding to the self-fulfilling nature of what Goldman initiated in the first place. Second, when such trades are done publicly, many individual investors join in and create the momentum necessary for Goldman to profit. Goldman need not publicize its intentions (in fact it operates with intense secrecy), but if it uses something like a moving average strategy that is monitored by tends of thousands of firms and investors, the trade can easily become self-fulfilling.
This is a polite way of describing computer algorithm trades, but less politely, it can be said that firms like Goldman Sachs bully their way to profitability. Their volume is so huge that they become the 800 pound gorilla which dominates the market. There is nothing especially proprietary about their computer algorithm under such circumstances, if large volume can more often than not compel the market to move in a particular direction.
The US district attorney suggests that Goldman did in fact own a proprietary model and it will be harmed if this computer algorithm reaches the public. Presumably, other investors could trade before Goldman initiates its trades (front running). It may also be the case that Goldman has indeed found the Holy Grail ”“ the secret behind how the markets work that allows one to create eternal profits as long as the secret is maintained. Thirty years ago a small group of traders noticed the stock market tends to trade in nine day cycles, after which it reverses direction, or based on certain rules these traders discovered, resets and travels in the same direction for another nine days. This secret provided profitable trading until more and more people learned about it; now it is widely known and used, and seems to work more than 50% of the time, but can now lose you money if you are not careful.
Goldman may have latched onto a secret such as this, the efficacy of which becomes diluted over time as others learn about it. This may be what it wants to protect. It may also be doing its own form of front running. It processes so many proprietary trades for investors that it must have a good institutional sense of the buying and selling pressure in the market. By harnessing this information across its customer base, it can take directional trades as the market does, before it becomes evident to the investing public what is happening. Tying its computer algorithms into its customer data base might generate significant profitable trades, especially since its customer base includes so many major hedge funds which dominate the market.
If you are of a conspiratorial bent, you might assume that Goldman Sachs is operating at least on occasion for the fabled Plunge Protection Team, a cadre of top government officials like Treasury Secretary Geithner and Fed Chairman Bernanke, who purportedly use government money to prop up the stock market or other markets. The PPT really does exist ”“ it is mandated by a regulatory act ”“ but whether it secretly operates to prop up the stock market is certainly questionable. If it did, we can at least say that Goldman Sachs would be the most logical candidate for the government to use.
One of the most famous theories on Wall Street is the Random Walk theory propagated by Burton Malkiel, who has asserted that it is impossible to make speculative profits trading equities because Wall Street prices move randomly. No one can predict a truly random market. This theory has achieved great credibility because of the considerable anecdotal support it receives. Anyone who has invested in a mutual fund or listened to a Wall Street broker knows that these ”œexperts” seem to be right 50% of the time. In fact, these experts tell you not to invest short term because the randomness of prices will kill you.
The U.S. government is telling us something different, through Assistant District Attorney Facciponti. Random Walk may well be the situation facing such investors as you and me, but it is not the case for select insiders such as Goldman Sachs. In the first quarter alone, they generated $2 billion in trading profits just from equities trading. They may have access to inside information, or they may have discovered the Holy Grail of markets, or they may have sophisticated proprietary algorithms, or they can simply bully their way to profits. Whatever the answer, they will profit in good markets and bad markets. Life is anything but random for them.
When someone like Mr. Aleynikov interferes with their exclusive and very profitable and very non-random situation, he deserves to go to jail. Nothing should stand in the way of Goldman Sachs profiting from a market that benefits no one else.
Which brings us back to the suspicious statement that if someone other than Goldman Sachs were to have access to this software, they could ”œmanipulate markets in unfair ways.” This is opposed to Goldman Sachs, which is using the program to manipulate markets, but somehow their manipulation is fair. At least so thinks the U.S. government, but it is very unlikely the average investor agrees. The performance of the global equity markets in 2008 was atrocious, but worse still ”“ investors have nothing to show for their investments now going back to 1999.
A decade of waste, or worse if you were among the many millions who borrowed against your home or traded up to a house that you can no longer afford. All during this time, one firm at least has prospered. It now dominates a stock market in which at least a quarter of the trades are unrelated to the buying and selling of stocks as long term investments. It has seen many of its traditional rivals such as Merrill Lynch, Lehman Brothers and Bear Stearns disappear. It routinely shuffles its executives back and forth to high positions in the government. Should anyone trample on its prerogatives, even if it is a foolish individual, it can bring the full weight and majesty of the federal government to bear on the transgressor. While Goldman Sachs thrives, and the rest of us pay the price for their profitability and extraordinary bonuses, is anyone ”“ anyone at all ”“ asking whatever happened to free markets as the linchpin of a capitalist economy?