Sunday, August 28, 2011

Financial Warfare Using High Frequency Trading, Quote Stuffing and Naked Short Selling

This is a passage from an essay I've recently written on the subject of financial warfare. These are tools of financial warfare because the use of these weapons is almost exclusively the purview of very wealth elite individuals and organizations. The weapons are used to extract value from the larger population without adding value or providing goods or services.

High frequency trading (HFT) technology enables profits to be gleaned from “movement” itself within markets by skimming the purchasing and selling activities of other traders, especially large institutional investors such as pension funds (Brown, 2010). HFT involves powerful computers located immediately next to exchanges that rely on computer code to automatically purchase and sell vast quantities of securities. The speed and proximity advantages of computers used in HFT enable advantageous insight into sellers and buyers price points. HFT leverages privileged information using flash orders to outmaneuver other investors, by ferreting out price points and by subsequently buying and selling large quantities of orders in micro-seconds: “HFT allows the program trader to peek at major incoming orders and jump in front of them to skim profits off the top” from large institutional orders by pension funds, mutual funds, etc (Brown, 2010, High-frequency trading often involves “quote stuffing,” characterized high volume, high frequency trades that are cancelled almost immediately after being placed (Lauricella & Strasburg, 2010).

Ellen Brown recently observed that HFT has become a major source of stock market trading volume: “High frequency trading firms now account for 73% of all U.S. equity trades, although they represent only 2% of the approximately 20,000 firms in operation.” It does not matter which way the stock market fluctuates: so long as stock markets “move,” high frequency traders make money. High frequency trading illustrates how extreme capital accumulation can occur outside the circuits of production.

Critics of HFT refer to it as a parasitic process that essentially “taxes” slower trading entities (Brown, 2010; Keiser, 2010e). There is little doubt that high frequency trading privileges investors whose speed allows them to buy and sell before other traders. However, critics such as Max Keiser (2010d, 2010e) argue that HFT can manipulate markets by triggering other (slower) traders’ buy and sell protocols. For instance, if HFT “short”[i] a set of highly monitored stocks, other traders’ computer algorithms may be activated, precipitating huge sell-offs, as occurred on May 7, 2010. In this event, traders, pension funds, and investment firms lacking the computerized apparatuses of high-frequency trading run the risk of losing all in seconds, as their unwieldy, stop-loss programs dump securities for the HFT traders to pick up in micro-seconds at bargain prices. HFT traders can even “short” stocks they do not own or possess. The speed at which HFT occurs allows traders to post sell or buy orders and then withdraw them within micro-seconds. This type of activity is not intended to achieve actual transactions, but rather to manipulate slower traders’ market activities by tipping activity toward buying or selling (Kesier, 2010e). As will be explored presently, this capacity to manipulate markets can be deliberately politicized.

 Monitoring HFT is difficult for regulatory agencies such as the Securities and Exchange Commission (SEC) because a considerable portion of securities transactions no longer occurs within the formal exchanges, such as the New York Stock Exchange. Trading has moved from these transparent exchanges into “dark pools” that are invisible to regulators. In fact, in 2009 only 36 percent of daily trades in stocks listed on the NYSE occurred on the exchange as the vast majority of transactions were executed in dark pools or on new electronic exchanges (Bowley, 2009). Dark pools allow HFT to go unmonitored: as explained by Bowley, “These stealth markets enable sophisticated traders to buy and sell large blocks of stock in secrecy at lightning speed, a practice that has drawn scrutiny from the U.S. Securities and Exchange Commission” (p. 17). Dark pools also allow for naked short selling to occur, despite the practice being banned in domestic securities transactions.

Naked short selling is another type of activity commonly pursued that allows traders to create value outside of the circuits of production. Naked short selling is a variation of short selling. Short selling occurs when a trader borrows a stock or bond and sells it in anticipation of the price of the stock/bond falling. The trader can then re-purchase the stock/bond at a lower price, enabling the trader to return the stock/bond back to the lender after having made a profit on the difference between the selling and purchasing prices. Naked short selling occurs when traders sell stocks/bonds they do not own or have in their possession in anticipation of the price of the stock falling. Naked short selling in the U.S. cash markets is technically illegal, but is commonly practiced in U.S. and European derivative markets (Denninger, 2010; Keiser, 2010a, 2010c). Naked short selling of derivatives created from stocks or bonds is not technically illegal, since the 2000 Commodity Futures Modernization Act deregulated the derivative market (Johnson & Kwak, 2010).

Naked short selling of bonds and derivatives derived from bonds (e.g., CDOs) is both a lucrative strategy and a powerful tool capable of bringing down companies and countries (Keiser, 2010a, 2010b, 2010d). Traders who hold credit default swaps (i.e., insurance) on bonds (or other securities), profit from the bonds’ default and therefore may actively “short” bonds, even if they do not have those bonds in their possession (in other words, “naked short selling” them). Credit default swaps (CDS) are sold by insurance companies to investment and commercial banks alike. They “insure” risky investments, often in excess of the value of the underlying insured investment. CDS were not regulated and companies that issued them typically failed to hold adequate reserves against outstanding contracts (see Levisohn, 2008). American Insurance General (AIG) sold credit default swaps to the large investment and commercial banks, among other buyers, on securities (particularly CDOs) derived from mortgages. The collapse of mortgage-back securities that was precipitated by the subprime meltdown overwhelmed AIG’s capability to pay out on credit default swaps to counterparties until the U.S. Federal Reserve Bank of New York opened up a credit line to AIG that eventually exceeded $182.3 billion (Teitelbaum & Son, 2009; Walsh, 2009). By virtue of this government lifeline, AIG paid out approximately $13 billion to Goldman Sachs, alone in credit default swaps (Dylan Ratigan Show, 2009). AIG’s counter parties were not required by the Federal Reserve Bank to take a “haircut” (Teitelbaum & Son, 2009). Credit default swaps continue to be a lucrative investment strategy for banks and hedge funds because they allow these entities to bet against leveraged companies, public entities, and countries without even owning their bonds (Levisohn, 2008; Rickards, 2010a, 2010b).

Naked short selling and credit default swaps together allow investors to attack companies, countries, or even municipalities using electronic market exchanges. Naked short selling was implicated in driving down Bear Stearns’ stock value (Taibbi, 2009a) and in the collapse of Greece’s bond market, particularly when participating traders held credit default swaps, or insurance contracts paying out in the instance of default (Lawder &Youngla, 2010). Jim Rickards, a financial analyst who consults to the U.S. government on financial security, described the “weaponization” of finance (2010b) as banks and hedge funds in 2010 shorted sovereign debt (bonds) in Europe in what Rickards termed as “attacks on sovereign credit” (2010a). Rickards (2010a) explained that derivatives trades allow speculators to short companies or nations on electronic exchanges with no money down: “You can attack a country with no money, no money down, just create a credit default swap out of thin air.” Rickards observed that the European Union’s $1 trillion dollar rescue package for nations facing exorbitant interest rates for refinancing their debts (due to these types of attacks) would easily be outmaneuvered by the banks and hedge funds, which are capable of naked shorting with essentially no financial backing. The deliberate and punitive (naked and legitimate) short selling of bonds or derivatives by acquisitive capitalists who lack national allegiance has been described by Max Keiser as “financial terrorism” (2010a).

A final way discussed in this paper for acquiring wealth through financial transactions, external to any productivity activities, entails carry trades. In 2008 and 2009 a “carry trade” enabled by the Federal Reserve’s low-interest lending within the US also allowed considerable speculation and capital accumulation by investors. U.S. dollars, borrowed at low interest rates, were used abroad to purchase other assets whose values were appreciating. Appreciating assets could then be sold at a profit. Accumulated profits could be used to push up more asset bubbles overseas (Sheehan, 2010). In 2010, the European bank crisis precipitated in part by naked short selling of Greek bonds produced a carry trade of the Euro (see Shah, 2010). Carry trades have the effect of producing downward pressure on the borrowed currency while inflating the value of the currencies or equities that are purchased (Shah, 2010). Carry trades undermine sovereign entities such as the European Union’s capacities to control currency values, but provide unlimited speculative opportunities for traders.

In sum, although sub-priming mortgages have been identified as the security base responsible for precipitating the financial crisis that began at the end of 2007, these instruments were merely the bottom of a speculative bubble of derivatives contracts and credit default swaps that were created out of, or that insured, debt-backed bonds deriving ultimately from mortgages, consumer loans, municipal bonds, etc. Len Bracken (2009) claims that the U.S. “banking system’s total notional derivative exposure (comprising interest rate, currency, and CDS derivatives) is estimated to be $200 trillion” while the worldwide “notional value of outstanding derivatives is now estimated to be $1.405 quadrillion, up 22 percent [in 2009] from the 2008 level” ([ii] The quadrillion valuation (quadrillion equals 1015) of outstanding derivatives compares with an estimated world GDP for 2009 of $70.29 trillion (trillion equals 1012) (CIA, 2010,

 Efforts to investigate the causes for the crisis have discovered that the push for securitization by financial entities actually promoted outright fraud of the underlying assets (e.g., mortgages) that were bundled, spliced, diced, insured, and traded. To reiterate: much of the underlying consumer and corporate debt used as leverage for this mountain of securitization was infused with fraud (see Black, 2010a; Galbraith, 2010). William Black claims that the U.S. Congressional hearings on the crisis conspired to “cover up” the degree of fraud infused throughout the entire system (Black, 2010b). Hence, Max Keiser recently described the business in America today as fraud (Max Keiser, 2010a). While Keiser’s quip may be an overstatement, it does capture the strong sense that the financial service sector’s dominance of the U.S. economy did not produce tangible rewards for the vast majority of the populace and, moreover, contributed to the working class’ impoverishment by facilitating debt-based transactional wealth creation outside of productive activities that employ the populace and by creating incentives for predatory lending and excessive consumption. To put this otherwise, one of the most important implications of the financialization of the U.S. economy is that citizens’ productive contributions to the national GDP waned in significance as more capital was generated from electronic transactional speculations upon debt-based securities, rather than from the profit margins of manufacturing activities.

[i]           Short selling occurs when a trader borrows a stock or bond and sells it in anticipation of the price of the stock/bond falling. The trader can then re-purchase the stock/bond at a lower price, enabling the trader to return the stock/bond back to the lender after having made a profit on the difference between the selling and purchasing prices.
[ii]               I attempted to verify the amount of outstanding derivatives with the Bank of International Settlements’ data for 2009 published in the June 2010 Quarterly Review (pp. 121-126 I totaled the numbers provided in the BIS tables for derivatives to $5626883 in billions. Wayne Madsen uses data from the U.S. Federal Reserve Bank to put the total outstanding derivatives value in the quadrillions (2010, and notes that “DK Matai of the Asymmetric Threats Contingency Alliance notes that a conservative 10 percent default or decline could result in $100 trillion of payouts.” Although these numbers are simply unintelligible, it is clear that the notional value of derivatives outstanding exceeds the world’s GDP exponentially.

1 comment:

  1. High frequency trading has become very popular among traders in short span of time as it is very fast and efficient..It is the best tool for earning lot of success and money in trading..