Wall Street and the World of Flash Stock Trades

July 29, 2009 — -- It was only last fall that Wall Street firms like Goldman Sachs were staggering, in danger of collapse without bailouts from the government's Troubled Assets Relief Program -- TARP, for short.

Now, with Goldman Sachs in at least the symbolic lead, many of them are back in the black. Goldman Sachs reported a record quarterly profit of $3.44 billion on July 14. The stock market has been going up. The government has been getting its money back.

But with unemployment still rising, and with people still wincing when they check their retirement plans, you still get headlines like the one in New York Magazine: "Is Goldman Sachs Evil? Or Just Too Good?"

At issue, beyond the tremendous profits at the major survivors of last year's near-collapse, is the way they make all that money. Very little of Wall Street's money is actually made on what most people would think of as "Wall Street" -- the floor of the New York Stock Exchange, where harried-looking traders yell orders to buy and sell.

Instead, an investment bank's most powerful weapons are high-powered computers. A brash, risk-taking trader may decide to buy or sell a stock very quickly -- but that's nothing compared to a firm's supercomputers, which detect market trends, and act on them, in milliseconds.

The algorithms, or mathematical formulae, that firms devise for their computers are usually corporate secrets, and can be quite valuable. In early July, a former Goldman Sachs employee was arrested and accused of stealing formulae from the company.

High Frequency Trading

The computers have become traders in just the last few years, say market people. One particularly visible part of what they do is called High Frequency Trading, in which machines, programmed to look for market trends, may buy or sell a stock in milliseconds.

A subset of this phenomenon is known as "flash trading," in which stock exchanges let firms place super-fast orders to buy or sell stocks -- often based on information they receive a fraction of a second before the rest of the world does. Large firms pay fees for the advance information, and may be able to profit by moving so quickly.

Goldman Sachs is among them, though it said less than 1 percent of its corporate revenue comes from this kind of trading. Companies make money by buying low and selling high, but they may also get fees for executing so many trades so quickly.

"We allow our clients to decide how their trades are disclosed," said Ed Canaday, a spokesman for Goldman Sachs. "If they want to perform flash trades, we will execute them."

Flash trading is legal, but to some people on Wall St. and in Washington, it smells.

"This kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions," wrote Sen. Charles Schumer, D-N.Y., in a letter Friday to Mary Schapiro, the chairwoman the Securities and Exchange Commission.

High-Speed Trading: Legal, for Now

The New York Stock Exchange wrote a letter to the SEC, too, saying it does not allow flash trading -- but warning that unless the law is changed, it may have to start, just to remain competitive with the Nasdaq and smaller, private exchanges.

"I think it's a practice that opens up a lot of questions with regard to markets and orders," said Joseph Mecane, executive vice president of NYSE Euronext, the company that runs the New York Stock Exchange.

The issue may be reaching critical mass; Schumer said on Tuesday that the head of the Nasdaq had assured him he supported a ban on flash trading.

Goldman Sachs called for curbs as well: "Anyone who has access to non-displayed information should assume the obligations of a market maker," said Canaday, using the term for a firm powerful enough to help set the prices for a stock. "Stronger standards are needed to make sure there is not a misuse of information."

It remains to be seen whether stronger standards will be imposed. A debate has broken out over the fairness of such super-fast stock trading.

"It does put more money in the marketplace," said Rick Bookstaber, a veteran risk manager at firms such as Morgan Stanley and Salomon Brothers. "What needs to be answered is whether it's money that does anything of social or economic value."