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by Free Market Duck

"Black box" trading on the Big Board...is it legal... is it moral?
Part 1
(Dec 19, 2006)

New York, NY – In the 1970s when high-speed mainframe computers ruled the banking world, clever programmers discovered that many banking transactions involved calculations carried out to several decimal places.  Since America's monetary system only goes out to two decimal places, cents or 1/100 of a dollar, many transactions had to be rounded off to the nearest 1/100, or two decimal places to the right of the decimal point.  Values of .005 or larger would round up by +.01 while values of .004 would round down by zero.  This round-off algorithm (computer calculation method) provided a slick method by which a clever programmer could gather the round-off differences into his own special banking account and, after several million transactions per day, build into a sizeable amount of money, while simultaneously balancing all the "real" customer banking transactions so that nobody was the wiser.

   This form of white collar crime, however, was eventually detected and the clever programmers who were essentially creating money out of thin air by mathematically manipulating round-offs inside the bowels of their mainframe computers were sent to jail.

   Fast forward to today, 2006.

   It now takes Tradebot computers 1/1000 of a second to trade a stock.  It used to take 20/1000 of second.  So what?  Tradebot computers are programmed to detect tiny differences, say 1-cent, between bid and offer prices of the same stock and immediately execute the buy and sell of that stock electronically, i.e. without intervention of human traders.  Tradebot computers, physically positioned near the stock exchanges to gain a fraction of a second in speed against competing computers, can buy and sell 100 million shares a day, raking in hundreds of millions of dollars for its hedge fund managers.

   This type of stock trading is called "black box" or "algorithmic" trading.

   Tradebot is not the only company in the computerized trading business.  Dozens of firms do it, such as Citadel for J.P. Morgan Chase, SAC Capital Advisors, and Renaissance Technologies.  Not only that, media publishers such as the Wall Street Journal's publisher, Dow Jones, provide its news in computer-readable formats for the computer programs to use in their decision-making calculations.

     The big question: Is "black box" trading legal?  Is it moral?  Is "black box" trading simply a "democratization" of what human pit traders on the floor have always been doing, albeit much more rapidly by computer, or is "black box" trading simply another method of white collar crime?  More later...  -- FM Duck

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