Christopher Rad of Cedar Park, Texas, was just sentenced to 71 months in prison for executing a technologically advanced update of a very old stock scam. Mr. Rad enlisted the aid of hackers and spammers to spread rumors and interest equity investors in various stocks, including RSUV, QRVS, VSHE, SVXA, and ASIC. The scheme involved infecting other computers with a virus to create botnets, other peoples’ computers that would then send out spam in massive quantities.

The idea was to promote bogus interest in certain stocks to drive up their prices at which point Rad and his conspirators would sell at a huge profit. The government calculates that Rad made about $2.8 million as a result of this “pump and dump”.

But where Christopher Rad heads off to prison, purveyors of high frequency trading (HFT) are celebrated as an innovation in trading market liquidity and stability. There is some truth to that statement, as with all good misdirections, since HFT has indeed created market conditions where bid/ask spreads have fallen and volatility (narrowly defined) has improved.

HFT supporters rarely acknowledge the darker side though. In early December 2012, Credit Suisse published a series of reports on HFT that examined both sides of the issue. Since the bank was ostensibly selling its own trading platforms it was essentially forced to acknowledge some of the darker elements to assure potential customers it could handle them.

“In this piece, we have presented a number of concrete examples of “bad” HFT – including quote stuffing, order book fade and momentum ignition – as well as some broader details on the prevalence of those HFT strategies.”

That last “bad” strategy, momentum ignition, is particularly interesting in the context of Christopher Rad. Momentum ignition involves the sudden disappearance of the bid/ask spread. As spreads precipitously widen due to an HFT algorithm, momentum-based strategies follow along in the same direction. If an algo can “trick” the order book into widening the spread in one direction or the other, it can trade into the follow-on movement of other traders playing on that trend. It is essentially a trade strategy where you create your own arbitrage solely on the numbers in the order book.

There are additional factors and variations here, as Nanex aptly chronicles here, that all end up with the same result – a situation not at all unlike what Christopher Rad is now sitting in prison for. Momentum ignition dislocates price from its previous or “natural” place so that the perpetrator can profit from other investors following into that artificial dislocation. It is easy to see why Rad’s use of computer technology constituted an illegal “pump and dump”, but difficult in practical terms to accept HFT’s use of momentum ignition does not.

At the moment, HFT enjoys the legal shield of being a “liquidity provider” to the various exchanges. They actually get paid to carry out these strategies in the name of investors (the benefits cited above). There are other means to accomplish these ends, including the pernicious quote stuffing strategy. The result is the same, a market where trading is done on extremely short time scales under questionable and dangerous tactics (remember the Flash Crash? Individual stocks crash and smash every day and exchanges simply cancel trades) that emulate the basic approach of the “pump and dump” – a misdirection to create price dislocation.

But HFT is not the only legal means of the scam being used. Central banks actually do very much the same as Christopher Rad, but with different intent. I wrote a couple years back in analyzing extreme monetary policies that the whole idea of investing is to purchase something “valuable” before the wider world recognizes that value, to arbitrage the natural difference between price and value. Pump and dumps do the opposite: artificially create an arbitrage in price away from value by instigating conditions where the investing public never finds out what the value truly is.

“In a way, central banks are engaged in nothing more than a modified “pump and dump”. They are attempting to create the illusion of value through price action. By maintaining high valuations due almost solely to their own purchases, they hope to “attract” additional investors into the process. Whereas the exit plan of the traditional version seeks a higher price to disgorge the schemer’s original holdings, the legal, central bank version is trying to buy public faith in order to disgorge a larger acceptance of a return to normalcy. In both cases, the public gets abused – suckered investors in the first, taxpayers in the second.”

It is entirely legal when a central bank, such as the ECB, pumps up the price of Greek bonds in 2010 and 2011, for example, only to fool investors into not one, but two defaults. How is that not a pump and dump? Is there a real legal distinction solely because the ECB did not profit monetarily?

The end results from Christopher Rad and the ECB’s Greek program were exactly the same – investors were fooled by artificial pricing into buying securities they likely would not have otherwise, creating artificial losses upon true price discovery. Rad intended to defraud to personally benefit; the ECB intended to defraud to benefit institutionally from a “normal” marketplace.

This aspect of monetarism is never explored, which is particularly frustrating given the level of price artificiality across the entire face of global markets. Not only are central banks buying bonds everywhere, many are also buying equities and other assets. Investors are following them. However, as we saw after 2008, the only culpability is the cleanup bill passed to taxpayers.

There is a reason QE/ZIRP are permanent fixtures once they are instituted, their removal causes true price discovery. Christopher Rad rightfully sits in jail, but he should not be the only one.

 

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