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A New Definition of Slippage?

Monday, July 13, 2009 | Barbara Cohen

Last week, we witnessed the creation of an entirely new definition for the concept of "slippage."

If we look at Wikipedia, its definition for "slippage" is the difference between estimated transaction costs and the amount actually paid. How amateurish and naive can Wikipedia be?

No, these days the new definition for "slippage" seems to be defined -- at least by Goldman Sachs -- as "let's trade in front of everyone. We'll get filled and what's left to fill is what anyone else gets. Why? Because we, at Goldman Sachs, are 'risk-averse.'"

Now, I'm not picking on GS for the fun of it. But last week, supposedly GS was very quietly told that it could no longer do computerized quant trades at the New York Stock Exchange.

What exactly is "quant trading"?  Quantitative (or quant, for short) trading encompasses investing techniques employed by sophisticated, technically advanced hedge funds or brokerages.

Quant shops use ultra-fast computers to predict trading patterns inside financial data.  A "quant," also known as a "geek,"  now refers to programmers who code quantitative-analysis algorithms for insider computer trading.

Is quant trading illegal?  Ordinarily, no, but the way Goldman Sachs coded the program seems suspicious. And, by the way, it is reported that GS represents 60% of program trading.

In order to trade from your desktop, your computer program sends your offer to buy or sell to the exchange.  The computer program that is behind the scenes of your desktop-trading platform uses what is known as a "FIX" protocol.  FIX is now generally considered the industry standard. 

Seems what the GS program can do is intercept the FIX messages being sent to the exchange from the large institutions, interpret what was is being bought or sold, and then put their trade in ahead of those trades for the same buys or sells.  Then the trades coming in afterward may or may not get filled, depending upon how large GS's trades were. 

How would this work in the marketplace? Say an institution wanted to sell 10,000 shares of IBM.  GS would intercept the message, and sell 10,000 ahead of the institution.  Say only 12,000 shares were available to sell.  GS would sell its 10,000 and the institution could only sell 2,000. 

A new definition for "slippage," right?

What is being investigated is whether GS illegally used security-access codes to acquire the messages prior to "transaction_commit" timepoints at the NYSE.  This may have only resulted in a nanosecond trading advantage but, with ultra-high-speed computers, a nanosecond is a lifetime.  

How was GS found out?  Because quant trading recently hit an all-time high of 48.6% of all NYSE trading.  And since GS represents 60% of all program trades ... hmmm, well, you do the math.  The NYSE keeps close tabs on program trading and was startled that nearly half of all trades suddenly came from program trading.

Wasn't it Goldman Sachs that received $12 billion in bailout money to help it overcome complete disaster?  One might opine that GS makes money the old-fashioned way ... by stealing it.

Who leaked the story? Matt Goldstein at Reuters.

We'll keep an eye on this to see how it unfolds and whether we're looking at a scandal or just another day on Wall Street. But since truth tends to turn out far stranger than fiction, it all makes you wonder why anyone would want to buy stocks. 

Thanks, but for my money, I'll just stay on the Chicago Mercantile Exchange (CME) side, where I trade futures -- away from the NYSE!
Barbara Cohen
Contributing Editor
The Tycoon Report
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