Crony Capitalism -- Statistical Evidence that the Government and the Investment Banks Have Rigged the Stock Market

Earlier this week, financial news junkies heard that investment banking giants Goldman Sachs and J.P. Morgan achieved improbable proprietary trading performances this past quarter. Each had a record number of profitable, prop-trading days: all of them.

Proprietary trading refers to the trades that are executed on behalf of the investment bank itself. In other words, not for clients.

In fact, for all of 2009, the majority of GS' prop-trading days resulted in profits of over $100 million each.

What are the odds of this sort of thing occurring in a natural market, in which all participants are on a level playing field? According to Karl Denninger, about 1 in 1,000,000,000,000,000,000 -- or roughly the odds that Juliette Lewis will be named the next Pope.

I will leave it to you, and those who investigate frauds, to determine whether the application of skill, without any sort of cheating such as front-running client orders, insider information or other forms of rigging the markets, can turn the random chance odds of 8.67 x 10-19 into an event that has, in fact, actually occurred.

To see the Goldman trading platforms in action, one need only examine the 90-degree "ramps" in equity prices that seem to occur when normal investors have dropped out of the market. Like most of us since 2008. And today after the whip-saw insanity last week.

"The market is melting straight up without interruption, and without any volume. Retail is now completely out of the market, and our advice to everyone is to stay out and let the computer blow themselves up again. In the meantime, please don't ask how and why Goldman and JPM can both have a perfect quarter. The chart below says it all."

This is a four-day trading chart. Notice the rightmost quadrant, representing today (Tuesday), in which volume went to nil while the Goldman and Morgan trading computers ratcheted the market up as they have for months on end.

How do they do it? And, more importantly, how do they get away with it?

Earlier today, Themis Trading published a white paper (PDF) that describes these trading operations as pure "theft on Wall Street".

Most institutional and retail investors have no idea that the private trade information they are entrusting to the market centers is being made public by the exchanges. The exchanges are not making this clear to their clients, but instead are actively broadcasting the information to the HFT's in order to court their order flow. The exchanges are likely to counter that when a subscriber signs up to their exchange they then allow the exchange to use this data as they see fit.

However, how many investors would have signed that agreement knowing that their hidden orders were being exposed? This practice has been going on for years but not many investors have read the market data specifications. Every day high frequency traders are using the information that some exchanges are supplying to disadvantage unsuspecting investors.

Every time a trader places an order in certain market centers, whether at the market centers directly, or through a third-party DMA, those market centers are collecting data regarding the trader’s order flow. They are supplying the information to HFT's that allows them to track when an investor changes price and how much stock has been accumulated. This information is helping HFT's predict short term price movements.

Institutional as well as retail footprints are being detected, and 'modus operandi' and trading profiles are being created. Traders believe that their trading strategies are protected, when actually their strategies (personal data) -- including variables such as displayed quantity, time stamp, side, revisions, reserve orders, linked executions, order id numbers, accumulations, number of shares -- are being misappropriated for sale by the market centers.

The exchanges seem to think that they own the data and have the right to sell it. Why are the exchanges allowed to do this? We think this is an outrage and demands immediate action by the SEC. How can the public trust the very organizations that are supposed to be protecting them, when these organizations are turning around and selling their personal data. The only difference between personal data theft, and the data-feed issue we highlight in this paper, is the degree of public awareness.

HFT stands for "High Frequency Trading" and, in general, refers to the proprietary trading arms of Goldman, Morgan and certain hedge funds. They use massively scalable computing platforms and custom software to -- in the words of Themis -- disadvantage normal traders.

This sort of activity is outrageous. It's apparently tolerated by the SEC and Congress, despite insiders' knowledge of precisely what's going on. That goes for Tim Geithner, Ben Bernanke and others whose livelihoods depend upon a Dow Jones average that gives normal folks a warm-fuzzy feeling despite the real and ongoing economic debacle.

Investment bankers have been collecting billions in bonuses using sordid tactics that could legitimately be called criminal. And the SEC and Congress are simply looking the other way. Meanwhile, the public is backstopping all of the risk and eating the trading losses.

Now that's change you can believe in.