Monday, July 27, 2009


To add some clarity to this New York Times story, there's some distinction between "frontrunning" and the legal-but-of-dubious-value practice described here.

"Frontrunning" is a form of insider trading. It's when a broker is trying to place an order for one of its clients that's so large that it will move the market. In this case, the broker has inside information -- the fact that someone wants to execute the order -- that it then uses to execute other trades and make a quick buck. This is, in effect, the broker stealing from the client.

What the Times article is talking about is an effort by a number of Street firms, of which Goldman-Sachs is one, who purchase the right to view what are called "flash orders"--orders that no one else wants to fulfill, but that these firms might be able to fill in a pinch. Combined with other data, the high-frequency traders are able to do things such as figure out when market-moving trades are about to occur, respond, and make a quick buck. This is, in effect, one Wall Street firm stealing from another Wall Street firm, or, in the worst case, the client(s) of another Wall Street firm.

Now, the price for viewing "flash orders" is not that high. And Wall Street is teeming with folks who would sell their mother into slavery if it helped bost next quarter's earnings. So either the NYSE is giving the flash order purchasers a sweetheart deal, akin to the one the BLM gives to miners or that the regular players in foreclosure markets get, or the information gain from flash orders isn't that high. It's hard to tell which is the case from the outside, but high-frequency trading involves a number of other components besides flash orders.

This is not to say the high-frequency traders are really doing anything meritorious; how, exactly, there's positive utility for the rest of the world in this sort of behavior is unclear to me. And since Goldman-Sachs is one of the few large firms that survived 2008 relatively intact, it's been given special status in several places, as part of the "Plunge Protection Team" and as a sort of liquidity provider of last resort. Unsurprisingly, with minimal competition and certain special advantages, it appears they may be abusing that position. This is, I think, another reason why it's best to get out of the idea that certain firms ought to have this sort of privileged status in the marketplace.

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