Not too long ago, a Russian programmer was picked up by the FBI for circulating what may be Goldman Sachs proprietary HFT (High Frequency Trading) software. Essentially, much of the volume in today’s markets is entirely driven by computers making minute decisions about penny trades on the smallest of fluctuations to derive an arbitrage situation and exploit it through volume. To make it even more interesting, the software is designed to carefully layer its moves in attempts to hide its intended activity from rival HFT algorithms doing the exact same thing; this reminds me somewhat of an old school programming game CoreWar where code was designed to annihilate it’s competitor in RAM and hide what it did from that same competitor. All of this makes sense from a trading perspective, get the edge on your peers and do so in a way that makes you the most money. My problem with HFT computing is that it seems diametrically opposed to the concept of opening a company to the public for investment as a means to raise capital. With HFT, the markets are not a forum for raising capital anymore or making investment in a company, they’re simply a place to exploit mathematical trends causing the sale of what could be a fantastic organization or the purchase of crap simply based on a prediction model. Granted, according to the article on HFT there are variables allowing for human input to lean the algorithms towards certain less tangible abstracts like hunches … but at its core, it’s still a math program looking for the same thing as everyone else’s math program which makes the market react in swings.

CBS aired a 60 Minutes episode that provides an excellent overview of Wall Street’s High Frequency Trading systems. It very accurately hits on the points that the system exists to capitalize on penny sized arbitrages executed in huge volumes to profit against probability. HFT has grown from 30% to nearly 70% and then fallen to about 50% of all trades. Their cryptic and proprietary algorithms have been implicated directly in what is now called the Flash Crash. Goldman Sach’s technical director gave a lecture to Princeton on the very topic, detailing (as much as their legal department let him) the evolution of HFT systems, how they played out the Flash Crash and possible remedies for the future.

The sad part is the Wall Street firms will be very successful (and rightfully so) in protecting their algorithms from public review. The SEC will implement some weak regulations and fines (which pale next to the profits made) that at first will be ignored because the fines can be written off as operating expenses. Each investment firm will pass off the blame to their auditors – one of the big four like PWC, E&Y, etc – such that they can say they performed all due diligence by having an external review to show everything was fair. But I’ve worked there. Most of the people don’t have the ability to comprehend the data they’re seeing, understand the mathematics or the code. So in the end, that audit review will be a faulty model that shows a couple of trends and graphs that seem to support “fairness” between supercomputers and humans. It’ll all fail in the end and everyone will point fingers at each other but they’ll have made so much incestuous money off one another that they really won’t give a damn. The only losers are the general public.

How did the stock market manage to plunge 1000 points in a matter of minutes? Software. A one hour window between 2 and 3 pm saw an incredible amount of volatility triggering the computer system to open particular investments onto other markets. The system was designed to slow activity down to prevent traders from engaging in a rapid sell-off. This seemed to be exactly what traders were doing anyway in a fit of uneasiness over Greece and the future of the EU and Euro. Instead of cooling the market, the wild price swings (some stocks dropped down to pennies momentarily) led traders to sell even more further driving down prices. Ultimately, the NASDAQ acknowledged the glitch and indicated they are canceling a series of 296 trades based clearly on junk prices. But what of the other businesses ruined by system inaccuracies leading traders to completely tank their capital? It’s certainly not the first time that software glitches have compounded or instigated trader fervor, and the HFT systems behind the scenes make it worse through their automated triggers. Kind of makes you wonder about what basis truly establishes the value of an investment as portrayed to the consumer.