Friday, April 24, 2009

Kapitall Blog Defends Goldman Sachs Against Conspiracy Theory

People keep sending me articles about some Goldman Sachs proprietary trading conspiracy that is responsible for recent market advances. (Most notably, Zero and the seriously angry Specifically, they blame program trading and quantitative trading.

I was the head of program trading at Morgan Stanley from 1996 to 2002 (both Global and U.S.), which, at the time, was the NYSE volume leader. And while I always enjoy a good conspiracy, in this case I find little evidence of one. As the managing director in charge of a trading desk and an ex-rival of Goldman Sachs I'd love to trash them, but I cannot. I find myself defending them.

First, the numbers in the ZeroHedge article shows an increase in program trading volume and Goldman Sachs' position at the top of the list as an indication of market manipulation pushing the market up. Program trading volume on a proprietary basis can come from many things, but all of which make pushing the entire market higher difficult to nearly impossible.

1. Quantitative (black box) trading:

Basically, most black box strategies involve something called mean reversion. This means when a stock moves too much relative to the stocks to which it is normally correlated the strategy buys the stocks that have have moved higher the least (or lower the most) and does the opposite with everything else. Actually, it is way more complicated than this and requires loads of academic explanations and complex statistical mathematics. But I hope you get the idea. Days of great volatility and fast market moves (like last week) provide lots of market dislocations (black box trading volume). Almost no black box strategy creates net buys or sells (every stock bought is offset by another that is sold.)

2. Index Arbitrage:

Index arbitrage is the risk neutral trading of index futures (like the S&P500) and stocks. In the case of last week, selling overpriced futures and buying stocks. While the program trading reports show Goldman reporting zero in this category, the complex NYSE rules on the subject of what kind of trading fall into which category leave the reporting firm lots of leeway on interpretation. Thus, much of what could be reported as index arbitrage by one firm is reported as principal trading by another.

3. Customer Facilitation:

The vast majority of customer facilitation occurs after the close and in the form of something called an EFP (Exchange for physical) in which a basket of stocks is exchange for an equal value of futures. Customers are typically pension funds, foreign government investment funds, index funds and other mutual funds. These can run in the billions of dollars at times - but with both sides relatively hedged. The unwind of these transactions by the facilitator is slow, lasting several days as the investment bank liquidates stock and futures positions. This dual liquidation doubles the initial EFP. Technically, these are proprietary trades not reported as customer facilitation but as principal.

4. ETF Creation:

In the normal course of providing liquidity to Exchange Traded Fund (ETF) investors, a market maker must trade a basket of the underlying stocks in order to create and sell and ETF. These transactions are generated electronically and very quickly in order to keep the ETF market efficient. Buyers of ETFs (as I expect last week) creates buyers of baskets of stock.

Now imagine all of these activities, mostly quantitative trading and index arbitrage, being done by several different departments at the same time (but in different ways) in a volatile and fast moving market. None of these activities create a net bias by Goldman Sachs to either be net long (buyer) or net short.

The only thing that can drive a market higher is buyers willing to pay more than current market prices. Buyers can include pension funds, corporations, mutual fund investors, speculators like hedge funds and individuals. These buyers use many instruments other that direct buying and all of them eventually find their way into stock prices. Futures, options and ETFs most notable among them.

Among the many financial market abuses that have occurred in the past few years, portfolio (program) trading is not among them.

(Excerpt from David Neubert's post in Kapitall Blog, April 13, 2009)


  1. Thank you for the auspicious writeup. It in truth used to
    be a enjoyment account it. Glance advanced to far introduced agreeable from you!
    However, how can we be in contact?

    My site; top penny stocks

  2. This info is invaluable. How can I find out more?

    my blog post ... Binary trading cedar financial