Cyber Wars: Robot Traders Spoof High Frequency Trades

Alexis Madrigal writes at The Atlantic about robot traders that spoof market orders and introduce potentially dangerous “noise” into high-frequency trading that could end up in a flash crash. The spoof trades can be used to coordinate what is effectively a denial service attack on certain nodes in the financial network. Essentially this is the same as what happens in the other DNS attacks in infrastructure critical to national security. It amounts to clogging the system with data so that it slows down and eventually seizes up.

“High-frequency traders have become a target for all kinds of people, but most of them appear to make their money being a little faster and little smarter than their competitors. And if they are playing by the rules, they improve the quality of markets by minuscule amounts trade after trade after trade.

But the algorithms we see at work here are different. They don’t serve any function in the market. University of Pennsylvania finance professor, Michael Kearns, a specialist in algorithmic trading, called the patterns “curious,” and noted that it wasn’t immediately apparent what such order placement strategies might do.

Donovan thinks that the odd algorithms are just a way of introducing noise into the works. Other firms have to deal with that noise, but the originating entity can easily filter it out because they know what they did. Perhaps that gives them an advantage of some milliseconds. In the highly competitive and fast HFT world, where even one’s physical proximity to a stock exchange matters, market players could be looking for any advantage.

“They are moving the high-frequency services as close to the exchanges as possible because even the speed of light matters,” in such a competitive market, said Stanford finance professor Peter Hansen.

Given Nanex’s data, let’s say that these algorithms are being run each and every day, just about every minute. Are they really a big deal? Donovan said that quote stuffing or market spoofing played a role in the Flash Crash, but that event appears to have had so many causes and failures that it’s nearly impossible to apportion blame. (It is worth noting that European markets are largely protected from a similar event by volatility interruption auctions.)

But already since the May event, Nanex’s monitoring turned up another potentially disastrous situation. On July 16 in a quiet hour before the market opened, suddenly they saw a huge spike in bandwidth. When they looked at the data, they found that 84,000 quotes for each of 300 stocks had been made in under 20 seconds.

“This all happened pre-market when volume is low, but if this kind of burst had come in at a time when we were getting hit hardest, I guarantee it would have caused delays in the [central quotation system],” Donovan said. That, in turn, could have become one of those dominoes that always seem to present themselves whenever there is a catastrophic failure of a complex system.

There are ways to prevent quote stuffing, of course, and at least one of the members of the Commodity Futures Trading Commission’s Technology Advisory Committee thinks it should be outlawed.

“Algorithms that might be spoofing the market are something that should be made illegal,” said John Bates, a former Cambridge professor and the CTO of Progress Software. But he didn’t want this presumably negative practice to color the more mundane competitive practices of high-frequency traders.”

Market Take-Down

Well, I know I promised to stay away from my blog. But a 1000 point drop in the Dow is reason enough to renege on a promise.

I’m going to state my considered judgment that that was no accident. It looked deliberate (like September, 2008) and seems to follow on other deliberate attempts to induce panic….(not that anyone needs to try very hard to do that, since the way governments are behaving nowadays is panic-inducing enough)

Why do I monger conspiracy thus?

Let’s review.

Rewind to the early part of April, a period that has occult significance, as it includes Hitler’s birthday (April 20). It also carries dark overtones from recent history in the US the Columbine shootings (April 20, 1999), the Federal assault on Waco on April 19, 1993, and the WTC Oklahoma City bombing (April 17, 1995) and from WW II history (the NKVD’s massacre at Katyn in April 1940 , and several other important incidents related to the Nazi prison camps).

1. On April 10 we witnessed the “decapitation” of a large part of the leadership of Poland under the strangest of circumstances. Poland is a country that has been resisting the economic demands of the EU one-worlders and rearing its reactionary nationalistic head on several occasions, to wit., the devaluation of the zloty. The plane crash erased the bulk of the nationalists in government at one shot.

2. This mysterious crash was followed by another smaller but equally strange incident when Eurocontrol (correction: I read that the ultimate decision was not made by Eurocontrol but by EU members acting with coordination from Eurocontrol) over-reacted to the eruption of the Icelandic volcano and grounded the entire airline industry in many northern and western European countries, shutting down 70% of European flights and hitting the economy severely again. Hit two to the markets.

3. Around the same time we had whistle-blower Andrew Maguire outing JP Morgan market manipulation (March 23) and nearly becoming the victim of a hit and run driver (March 27).

This was followed immediately by widespread panic (around April 7) about the lack of physical gold in a number of vaults and behind the majority of contracts. That was hit three.

4. At the same time (April 16), there was the SEC filing of charges against Goldman Sachs. I’m all for flaying Goldman alive, but there’s no denying the “staged” elements of the case, its tardiness, and its potential to set off more litigation that could maul the banking industry badly. Hit four.

5. Now, against the background of street riots in Greece, with the EU tottering on its gouty feet, comes hit five –  a market plunge of historic proportions apparently from a bizarre trading “mistake.”

Update: 6. April 20, blow up of BP oil rig/

Add in a few other suspicious developments, and malice aforethought rather than chance seems the more plausible explanation….

Now was it Goldman’s High Frequency Trading programs sending a warning to investigators? Or was it the infamous Plunge Protection Team? Perhaps this was a message from the Federal Reserve to those who want to audit it…..that bill has now been “gutted.”

Was it a “fat finger” at Citigroup (denied by the firm) or a “black swan” out of Nassim Taleb’s Universa hedge-fund, as the latest reports suggest?

Taleb has denied it.

Who knows.

I have my own ideas, of course. But they’re no more than theory at this point.

Whoever did it, I suspect money was made both on the way down and the way up.

Jim Rogers on Goldseek radio had the best word for the whole frightening mishap. He said someone should suffer for it. This is New York, the HQ of the world capital markets. If the NYSE can’t get it right, time to get rid of them.

But of course, no one is going to go anywhere. No one is going to suffer for their mistakes. The only people who will suffer, as usual, is you, me, and the rest of the investing public.

Sith-Lord Sweep: AG’s Pending Indictments Cover Major Hedgies, Journalists, and Regulators

Corporate finance generalist, investment banker and expert in derivatives, Austin Burrell, sums up last week’s announcement by Attorney-General Eric Holder that there are 5000 pending indictments [sic] arising out of the investigation of fraud in the capital markets:

[Note: the DOJ is involved in some 5000 odd cases of fraud related to the financial industry… Continue reading

Fall-Out from Dubai World (Update)

I´ll try rounding up the reaction in the market and the punditry to Dubai World´s threat of default.

Two clarifications.

First: Dubai World´s problem is being referred to as a sovereign debt problem, but as far as I can understand, it´s not. The Dubai government is the 100% owner of Dubai World, which is itself a holding company. But, as William Buiter points out in the Financial Times, the Dubai government has only limited liability, just like any other limited liability company.

It wouldn´t have to reach into its pockets to make good any obligation unmet by Dubai World or its subsidiary Nakheel.

Second. The debt crisis is being referred to as a Black Swan. Again, this is inaccurate. A black swan is an unexpected event that doesn´t fit (and in fact upends) the prevailing paradigm. This debt crisis has been on the horizon for a while. And the announcement of the standstill in payment was obviously calculated to roil the markets as little as possible – being made during the Thanksgiving holidays, when the market is partially shut, and also at the start of Eid which lasts until December 6.

Update: With those caveats, I was going to try and list the banks and sectors that might be affected…but I found that Bob Wenzel´s site  had already got a chart of Dubai World´s obligations to Nakheel Holdings from Izabella Kaminska at the Financial Times. You definitely need your coffee before you read this one.

However, the text below the chart, although just as abstruse, does make it clear that investors are not going to be able to get any blood out of the Dubai government.

“Investors should note, however, that the Government of Dubai does not guarantee any indebtedness or any other liability of Dubai World.”

Update: I should add here that while technically the government of Dubai is not responsible for the debt, it is implied everywhere that the safety of the debt derives from its backstopping by the government. The reaction of furious investors that Dubai would never be able to raise a penny again implies that default would taint the government and not simply the company.

Speculation Drives Metal Prices

Geologist Brent Cook at Mineweb explores the speculative frenzy behind metal prices:

“Now I do not know if Paul’s [Van Eeden] thesis on gold is accurate or not: if it is it could still take many years to play out. Likewise, I do not know how or when the base metal prices will re-equilibrate to the reality of end demand-whatever that is. What is obvious is that gold and now base metals have become speculative investments that in addition to being bought as hedges against inflation and a falling US dollar are the latest get rich quick scheme. The end result is that absent the faith that metals and markets are all headed higher, we here at Exploration Insights are finding it difficult, although not impossible, to find value in junior mining and exploration companies.

Hot money on the other hand is not.

Over the past few months we have witnessed bought-deal equity financings for individual mid- to junior tier gold companies in the 10’s to 100’s of million dollars. These are being bought at nearly the absolute 52-week highs by funds that I know have not looked into the mining, metallurgical, social or political intricacies that make or break a mine. This fearless hot money jumping into the sector worries me. It always precedes a market bubble and correction: sometimes serious, sometimes temporary- sometimes by weeks, sometimes by years.

Adding to the absence of fear and proper due diligence in the market, my recent discussions with corporate financiers confirm that both large and mid-sized gold companies are being offered substantial unsolicited bought-deal financings-no questions asked. At the same time, some of the very same companies being offered the quick money are being hit with heavy selling when a fund manager becomes “concerned” because there has been no news for a couple of weeks or gold backed off $15.

Hand in hand with heavy fund demand for new metals investment ideas most of the major research firms have increased their commodity price assumptions to reflect the “new reality”. The primary advantage afforded by the commodity price revisions is that previously overvalued mining companies can instantly become “Buys”. Recall that the last major upward revisions from many of these same research firms came as the new reality of higher prices set in 2008.

The problem is that greed is driving the market and so any small hiccup or change in sentiment and the hot money tends to bolt. As last year taught us (remember last year?) when the fast money going in is the liquidity, there ain’t no liquidity getting out.

I remain cautious and somewhat concerned by what appears to be hot and fickle money jumping into a sector that is apparently taking its cue from pig farmers”.