Conspiracy Theory About Goldman Sachs
Monday, April 13, 2009 at 6:17PM 
People keep sending me articles about some Goldman Sachs proprietary trading conspiracy that is responsible for recent market advances. (Most notably, Zero Hedge.com and the seriously angry goldmansach666.com. 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 activies 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.
Disclosure: While I have engaged in and managed all the activities mentioned above, I have not been associated with or consulted on any them since 2004. I left Morgan Stanley in 2003 and "retired" from investment banking and institutional trading at the end of 2004.
My activities since 2005 have included the following: Director of summer camp in Vermont, Part-time teacher of 5th grade in the Bronx, co-founder and blogger for a website on socially consciousinvesting and helping to design a web application to make investing easier, more democratic and more fun.
Further Disclosure: I own Morgan Stanley (MS) shares and am vested in their executive compensation and pension plan. I do not currently own Goldman Sachs (GS), though I did own it in 2008
New York Stock Exchange Program Trading Report.
Reader Comments (10)
I am including most of a comment that I have submitted to Zero Hedge and a couple of other sites, asking for review and response. So far, no response. Anyway, I wonder if the recent Goldman trading activity isn't sufficiently explained by looking at Rule 107B - Supplemental Liquidity Providers - of the NYSE Rules on Dealings and Settlements, adopted October 29, 2008. Goldman and the NYSE have both announced Goldman's participation in this program. The program's description reads a lot like the trading activity described on Zero Hedger and referenced elsewhere these past few weeks: a group of securities assigned to Goldman, the provider (Goldman) to use program trading and the providers own accounts rather than client accounts, etc. And, the purpose is to generate liquidity. Isn't this exactly what Zero Hedge has been describing? But, if so, it is not a conspiracy - it is an announced program being run on a 6-month pilot basis.
There is a rule about liquidity providers for NYSE specialists and another for stock offering that allow an exception to the market manipulation rules of the regulator. I'll have to look into another rule concerning general market liquidity.
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good post. I'll have to look into another rule concerning general market liquidity.
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