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by Free Market Duck

"Black box" trading on the Big Board...is it legal... is it moral?
Part 2
(Dec 26, 2006)

New York, NY – Is "black box" trading legal?  Is it moral?

   In order to answer both questions, we must re-examine what the function of the stock market is and what money really is.

   First, the major function of a stock market is to raise capital for start-up or existing businesses and to trade the securities, buy and sell the ownership papers, of companies and commodities.  How this is done ranges from the very simple to the very complex including going long, short, buying on margin, futures, options and whatever methods you can think of.  Many investors are trying to earn money through dividends or simply the difference between the buy and sell prices of their ownership papers, i.e. stocks, bonds, commodities.  Note that all ownership papers should be backed by physical collateral and/or future anticipated collateral.  These are contracts or promissory notes.  If the collateral is hot air, you should be careful.

   Since we’re getting close to talking about the definition of money, we should clarify that stock market forms of tradable ownership papers should be distinguished from a nation’s proper form of money, which should be a measurable and easily divisible form of a hard commodity, such as gold.  Paper money is not true money per se but represents a paper receipt, an I.O.U. or redeemable promissory note (which is a contract) for the hard money usually stored in a bank or a nation’s treasury.  Each piece of paper money must have hard money as collateral or it is simply a counterfeit or fiat piece of paper (fiat money means forced money).  Real bills of credit, as discussed by Nelson Hultberg and our forefathers, Adam Smith and John Locke, can serve as temporary forms of paper money (promissory notes) if, and only if, the contractual obligations are ultimately fulfilled by both parties.  (Theoretically, one could issue verbal “monetary” contracts as long as the verbal promises are fulfilled but this is not a good basis upon which to establish a nation’s money supply any more than fiat paper currency.  Today’s Federal Reserve Notes are examples of fiat currency backed by nothing but hot air.)

   Now that we’ve defined what a stock market is, what tradable securities are, and, in general, what real and fake money are, let’s tap dance back to the scene of the crime:  “black box” or “algorithmic” trading on the stock market.  Is it legal?  Is it moral?

   Since the WSJ ran a big article on Dec 15, 2006 about the ins and outs of how companies – including its parent company, Dow Jones -- are obtaining a huge edge and making big profits through “black box” computer trading, and have done so since the year 2000, it apparently is not considered illegal in the eyes of the Securities and Exchange Commission (SEC). The SEC’s and various brokerage houses’ only complaint is that “black box” computer programs tend to clog up the computer’s guts by issuing so many simultaneous buys and sells of the same stock that trading is, relatively speaking, slowing down the non “black box” trading.

   In the same WSJ edition, an article entitled “Street Chiefs in for Big Paydays” illustrates why nobody on Wall Street is complaining.  “Record profits at Wall Street’s big brokerage firms are expected to translate into record bonuses for Wall Street’s chief executives, with some expected to top the $50 million mark for the first time,” reports the WSJ.  One notes that the names of the “Big Payday” companies and firms who gain from “black box” trading are, whoop-tee-doo no surprise here, one and the same.  Nobody on Wall Street is complaining about “black box” trading because they’re getting rich from it.

   Before we jump on the “is it legal” and “is it moral” bandwagon, let’s review something called arbitrage.

   Arbitrage is defined as the simultaneous buying and selling of the same securities to take advantage of price differences in different markets or at different points in time.  In days of old before computers, arbitrageur Wiley E. Coyote would buy low in one market, say London, while simultaneously selling the same securities high in another market, say New York, because he got the buy-sell news faster than everybody else or knew inside info about the company or stock.  While many forms of arbitrage are legal today, insider trading is not legal and “algorithmic arbitrage” can be looked upon as a special method of insider trading because the computer algorithm only buys and sells the same security when it detects a price differential.  Otherwise, the program’s algorithm doesn’t commit to arbitrage.  You can’t lose.

   Therefore, “black box” or “algorithmic arbitrage” trading is the ultimate form of insider trading and should be considered a white-collar crime since its only function is to mis-use the buy-sell methodology, high speed computer algorithms, to gain the ultimate insider information in the market to make money outside the original function of the stock market.  -- FM Duck

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