classical economics
for analysis,  forecasting
and policy design

Goldman Sachs' Dog
The Dog That Didn’t Bark

By Wayne Jett © August 8, 2009

    Though silence on the topic of secret software codes owned by Goldman Sachs capable of manipulating markets worldwide appears to be an article of faith among mainstream media, the Wall Street giant itself has not remained entirely mute. Existence of secret codes worth “millions and millions” to Goldman Sachs was revealed by an assistant U. S. Attorney to a U. S. magistrate judge at a criminal bail hearing in Manhattan on July 4. Goldman was using the codes to earn hundreds of millions of dollars, the prosecuting attorney reported. Alleged pilfering of the codes could endanger Goldman’s profits and imperil security of U. S. and other financial markets
    News of the secret codes with manipulative capabilities was publicized by Reuters on July 5 and by New York Times on July 6. The Wall Street Journal carried an abridged report on July 7. The largest surviving U. S. investment bank (which became a commercial bank in formality to qualify for low-interest loans from the Federal Reserve) owns and profits richly from computer software capable of manipulating financial markets in high frequency trading.  Sensational connotations of the story are self-evident.
    Yet elite media, even including financial and news cable television, treated the story as a skunk at a garden party. They avoided mentioning it even during heavy coverage accorded Goldman Sachs when the firm reported net profits of $3.44 billion in the second quarter of 2009. All of this is old news examined here previously on July 7, July 30 and August 3.
Goldman Addresses “Clients”
    Then, in a brief letter dated “August 2009” directed to “our Goldman Sachs & Co. clients,” the oracle of 1 New York Plaza spoke of “Goldman Sachs Practices Relating to High Frequency Trading” and of “complex landscape surrounding it.” In the letter, Goldman stated “key facts” as follows:
•    “Goldman Sachs does not make use of “Flash” programs in the execution of client agency orders.
•    “The vast majority of Goldman Sachs’ HFT activity is a function of acting as a Supplemental Liquidity Provider (SLP) on the NYSE, where over 98% of our transactions YTD is liquidity providing rather than liquidity taking.
•    “Goldman Sachs’ HFT does not see client order flow. Client order flow is either contained within a separate broker-dealer – Goldman Sachs Execution & Clearing LP – or is walled-off from HFT, both physically and systematically.
•    “Even using the broadest definition, HFT accounted for less that 1% of Goldman Sachs’ total revenues, used less than 1% of Goldman Sachs’ balance sheet, and contributed less than 1% to the firm-wide VaR during the first half of 2009.”
The balance of Goldman's letter asserts “a long history of providing liquidity to the marketplace,” willingness to accept additional obligations and regulation in order to do HFT, hopes that regulation will keep pace with “rapid … innovation,” and undying commitment to clients’ interests, “the firm’s reputation” and “utmost … integrity.”
No “Flash” for Clients
    Experience teaches that words of Wall Street’s lawyers or investment bankers ought to be parsed carefully. Beginning that process with this letter tells that Goldman speaks in it only to its clients, not to the investing public. Goldman tells its clients that, when executing an order as a client agent, the firm does not use “’Flash’ programs.” This is a significant representation so far as the clients are concerned because, if true, it might clear the clients of potential liability (civil or criminal) for profiting from front-running orders of non-client investors in the markets.
    Remember, “flash programs” are computer software capable of rapidly reading “flash” communications of buy-sell orders flowing into securities trading exchanges and responding to that data by rapidly issuing buy-sell orders for profitable trades in advance of the orders read by flash communication. Senator Edward Kaufman (D-DE) sent another letter this past week to the SEC chairwoman urging fast action to ban the practice, along with “dark pools” of unmonitored trading among institutions. Kaufman called regulatory treatment by the SEC “separate and unequal” bias against ordinary investors. Senator Charles Schumer (D-NY) previously urged the SEC to ban HFT as “unfair.”
Clues at the Scene
    In its letter to clients, Goldman makes no assertion that “flash programs” are not used when trading for the firm’s own account. The world learned July 5 that Goldman uses secret software codes to make many millions daily in securities trading, and that its secret codes could be used to manipulate financial markets if used “unfairly.”
    Since Goldman is dedicated to preserving the firm’s reputation and to utmost integrity, Goldman presumably would not use its secret codes unless the firm could prove to the public’s satisfaction that its use of the codes is fair. If that presumption is correct, however, then why has Goldman failed to step forward with clear and complete disclosure to the public proving its fair practices in HFT? Something is askew.
     Goldman’s letter spoke only to its clients and said nothing about whether the firm’s practices in HFT were fair to other investors, only that the firm places great importance upon its reputation and utmost integrity. But, if Goldman’s use of the secret codes was fair and Goldman can prove it, then why has Goldman not used the secret codes on behalf of its clients? Goldman certainly was using the flash programs very profitably on its own behalf. If that use was fair and legal, then why not use the secret codes for the benefit of esteemed clients? Something is amiss.
    Goldman holding back its secret codes from use on behalf of its clients is surprising and incongruous in light of reports that Goldman has practically captured the entire market for high-frequency-trading. The “entire market” includes many investors other than Goldman who wish to profit from HFT. How could Goldman attract so many clients for HFT if the firm was not even using its “secret codes” for HFT on behalf of clients? Is it even possible to do HFT at all without using “flash programs?” Something is awry.
SRO Alibi
    One of the great advantages big players on Wall Street enjoy in U. S. financial markets is  permission granted by the SEC to regulate their own practices. The big players do this through self-regulatory organizations (SROs) like the New York Stock Exchange and its regulatory successor, FINRA. The new SEC chairwoman, Mary Schapiro, headed FINRA before moving to the SEC earlier this year.
    Goldman’s letter to clients asserts the “vast majority” of its HFT was done to provide liquidity as a service to the NYSE, with 98% of HFT transactions YTD adding liquidity rather than draining it. Goldman even assigns itself an acronym (SLP) as Supplemental Liquidity Provider to NYSE, although it is said Goldman de facto is the only SLP of NYSE.
    Strangely, providing “supplemental” liquidity is supposed to mean reducing bid-offer spreads. Yet Goldman’s record, “very, very high” profits of $3.44 billion in the second quarter appear to be attributable to “very high spreads.” Fifty-six profitable days in the second quarter versus only 8 unprofitable days, with profits exceeding $100 million per day in 34 days is a truly remarkable quarter anytime – especially in 2009. Even many days in the awful fourth quarter of 2008 were $100 million profit days for Goldman.
Service to the investor community (as SLP) is its own reward.
Let's See the SLP Deal
    NYSE has been preeminent among securities exchanges for a century and presumably knows that markets – not a single player – determine liquidity. So why did NYSE engage Goldman Sachs to provide “supplemental” liquidity? What are Goldman’s obligations under that agreement? Indeed, let’s see the agreement! Is Goldman obligated to buy or sell shares even while incurring losses? Almost certainly, it is not. Goldman must retain discretion to trade as it pleases. So what did NYSE hope to achieve by the deal?
    On the other hand – and this is crucial – what did Goldman get under the SLP arrangement? Goldman might have gained the right to see advance “flashes” of buy-sell orders flowing into the exchange. Goldman could argue that early access to buy-sell orders was essential to its role in providing “supplemental” liquidity. Goldman might even get the flash quotes for free, while other exchanges such as NASDAQ charge for flashes. NASDAQ announced it will stop selling flashes September 1.
    Terms of the NYSE deal with Goldman are unknown, because the public is not Goldman’s client and NYSE has not disclosed. When you can make a deal with NYSE which enables you to make hundreds of millions per day and call it “public service,” you will know you have arrived in the circle of the Inner Elite.
Goldman Clients Treated Fairly
    Goldman’s letter assures its clients that the firms HFT software “does not see client order flow.” This appears to assure those clients their buy-sell orders are not being front-run by Goldman, and thus are not in positions of unfair disadvantage. If that is the case, then how can it be said that public investors are treated fairly by Goldman’s HFT if their buy-sell orders front-run? Fairness to public investors and to Goldman clients ought to be on a level playing field.
Tiny Flash HFT
    Finally, the last “key fact” in Goldman’s letter minimizes the significance of HFT by stating it to be less than 1% of Goldman’s total revenues, balance sheet and firm-wide value-at-risk. This seems more obfuscation than disclosure. Why not disclose how much HFT contributed to profits, not revenues? The low percentage of HFT to balance sheet and VaR attests more to relatively meager capital demands for HFT than it attests to HFT’s insignificance. Indeed, no close observer of market dynamics believes HFT as practiced by Goldman Sachs is insignificant.
Anyone Hear a Bark?
    What is to be distilled from media silence and Goldman’s reticent representations? One needn’t have Sherlock Holmes to sift clues before noting that stock accounts have been and are being looted. Sifting clues is not the problem here. Holmes did not have to deal with corrupt constabulary or captured Scotland Yard. Justice in U. S. financial markets is more problematic. ~