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Democracy Is Coming To A Financial Fraud Near You …

Or How To Rob EVERYONE

Background

You don’t need to look beyond the past year to realize that financial fraud fines are on the rise. And these are all big names — as you don’t wear shorts to such big boys’ parties:

· Goldman Sachs agrees to pay $110 million to settle forex claims

· Citi fined for exposing ‘dark pool’ clients to trading sharks

· Big investors sue 16 banks in U.S. over currency market rigging

· HSBC to Pay $101.5 Million to Resolve Federal Fraud Charges

· Deutsche Bank in $190 mln currency-rigging settlement

· Bank of America pays $42 million fine in New York ‘masking’ probe

· Credit Suisse Fined $135M for Forex Misconduct

The overwhelming attention of regulators has been directed toward the so-called Foreign Exchange (FX) fraud — due to the sheer size of such market of $5.1 trillion-a-day. However, considering its magnitude, the above penalties look more like a balance sheet rounding-error — and are often viewed by many financial institutions as …. “the cost of doing business”.

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It won’t take you long to stumble on the following fraud categories, such as:

Front-running — defined as: “the prohibited practice of entering into an equity (stock) trade, option, futures contract, derivative, or security-based swap to capitalize on advance, nonpublic knowledge of a large pending transaction that will influence the price of the underlying security. Front running is considered a form of market manipulation in many markets. A front running firm either buys for its own account before filling customer buy orders that drive up the price, or sells for its own account before filling customer sell orders that drive down the price. Front running is prohibited since the front-runner profits from nonpublic information, at the expense of its own customers, the block trade, or the public market”

Ghosting“an illegal practice whereby two or more market makers collectively attempt to influence a stock’s price. Corrupt companies use ghosting to affect stock prices so they can profit from the price movement”

Spoofing“a practice in which traders attempt to give an artificial impression of market conditions by entering and quickly canceling buy or sell orders onto an exchange, in an attempt to manipulate prices”

And the list goes on …

To make things worse, there is not a single more damaging and more profound fraud-enabler to all such shenanigans than High-Frequency-Trading (HFT):

“a program trading platform that uses powerful computers to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds”

The original HFT concept was designed to take the manipulation out of markets. It was supposed to match buyers and sellers through algorithms and eliminate front-running — COMPLETELY. Well, what happened — is the exact opposite.

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Electronic Communication Networks (ECNs) are regulated as an exchange. Alternative Trading Systems (ATS) — are not. By combining the two, one ends-up with a computerized system that automatically matches buy and sell orders for securities in the market.

Brokerages and retail investors can now trade directly between themselves “without going through a middleman and make it possible for investors in different geographic locations to quickly and easily trade with each other”

Since computer systems now automatically match buy and sell orders — there is less need for conventional Market Makers. Welcome to the dawn of Automated Market Making (AMMs) …..

Market Makers (MMs) essentially post the “bid” and “ask” prices, manage “limit” orders, and execute trades. And since they can sell or buy stock out of their own inventory — it gives them an opportunity to trade for themselves using inside knowledge to make a profit.

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In fact, MMs are mandated by their own brokerage houses to make as much profit as they can. I can’t speak for yourself, but it smacks me like the most obvious conflict of interest on the planet! But it’s all good, in the name of so called…liquidity.

And indeed, at the time stock exchanges were open from 9:30 AM till 4:00 PM — liquidity was in some cases a big problem. Today, with the proliferation of ECNs and ATS networks — the trading never stops. The stocks trade on ECNs during Extended Hours after the closing at 4:00 PM, and during Pre-Market Hours — before the opening bell rings. It’s a de-facto 24 hours trading day…

As long as AMMs run programs aimed at providing liquidity to exchanges — we all win. The problems start when they begin to work and trade against investors….

In some cases, trade orders are passed to AMMs by client’s brokers as Flash-Trading. Such information reveals the incoming trade instruction, but not the limit price — at which the buyer or seller is willing to trade.

Even if confidential limit instructions are not passed — HFTs come to the rescue. Such programs have the ability to probe, or “ping” stocks by Spoofing — and learn the hidden information. From that moment, AMM will use it to its own advantage — and rob you blind, without anesthetics….

Problem

Initially, front-running was mainly aimed at institutional investors. But as large pension funds realized that the game is rigged against them — they turned to Dark Pools: “a private financial forum or exchange for trading securities. Dark pools allow investors to trade without exposure until after the trade has been executed. Dark pools are a type of alternative trading system that give investors the opportunity to place orders and make trades without publicly revealing their intentions during the search for a buyer or seller”

Did it help? To a degree …. until some of the largest financial institutions have been recently accused of selling confidential transactions information to a third party — for a handsome profit, of course.

Some even told institutional clients that their trades were taking place in-house, in a specially created dark pools for their clients. In reality, the trades were still going to AMMs, in exchange for kickbacks.

However, as the volume of dark pools transactions increased and reached 14% of a total — the voices of Dark Pools Scrutiny became louder. And since louder calls for a greater transparency are working against the fraudsters — AMM’s focus shifted from institutional investors to retail.

On the one hand, it doesn’t seem plausible. Institutional orders are huge and the ability to make a quick profit of them, is very tempting. However, what retail transactions lack in size — they make up in volume. The amount of retail transactions delivered to AMMs by their fraud partners at various brokerages — dwarfs the number of institutional trades by an order of magnitude.

You may ask: does it make sense? The best example I can give you reflects the proliferation of distributed solar PV installations on family homes. On its own merit, such systems are small in size (eg. 4kW electricity generators). But take Australia for example. It already exceeded installing 1GW of such Distributed Energy Resources (DER) on Australian roofs.

When fully aggregated under Virtual Power Plant (VPP) software, such retail resources can replace 3 natural gas Peaker Plants. And this is nothing to sneeze about — not by any grid operator.

As it was recently reported by Bloomberg, even well-funded startups offering a commission-free stock trading product to Millennial customers — make a large percentage of their revenue directly from AMM trading firms. Not only do they accept payment for order flow — they also sell their Millennial customers’ orders. So, you’ll be the judge, if nowadays Robin Hoods still take the money from the rich and give it to the poor….

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Solution

Reversing the trend is not going to be easy. Since stock exchanges are now catering to AMMs who are their biggest customers — high frequency trading generates huge revenues to exchanges, regardless the fact that it adversely affects investors….

Of course, making fines more significant, or forcing CEOs and BOD Chairmen to appear in public and make public apologies may help. Especially, if it becomes mandatory for them to explain in public what exactly did happen, and how are they going to prevent it from happening again.

A much more pragmatic solution, however, would be to introduce fully transparent HFT-free ECNs. Would there be a demand for HFT-free ECNs? Well, we already check every plastic bottle for a BPA-free logo, so HFT-free concept is not that far behind….

Let retail investors decide what kind of exchanges they prefer. We already pay extra for organic foods to prevent toxins enter our bodies. Stopping financial toxicity is not less important — as it may affect both: your health and your wealth, combined.

IMHO, it’s time to get rid of outdated Market Makers all together. And we should scrap the most obvious conflict of interest — that comes with it. Instead, it’s time to encourage a massive deployment of fully transparent ECNs — that disallow HFT practices from the get-go.

To make HFT irrelevant, all it may take is allowing for only one trade per second — not 1000 trades, nor 1,000,000. Just step back and ask yourself: is Warren Buffett changes his mind about investment opportunity 1000 times a second? Please…

Fintech is undergoing a massive disruption, already. With the amount of never-ending financial fraud, it’s time to stop worrying so much about how to improve CRM front ends at existing financial institution. Instead, let the IT giants such as Microsoft, Googles, Apple or Amazon — get into HFT-free trading business aimed at retail investors.

It’s a perfect, large-scale business opportunity for such companies — to bring Value Innovation around the globe in a true sense of Blue Ocean Strategy.

According to Reuters: “a group of large institutional investors including BlackRock Inc and Allianz SE’s Pacific Investment Management Co has sued 16 major banks, accusing them of rigging prices in the roughly $5.1 trillion-a-day foreign exchange market. The lawsuit was filed in the U.S. District Court in Manhattan by plaintiffs that decided to “opt out” of similar nationwide litigation that has resulted in $2.31 billion (£1.76 billion) of settlements with 15 of the banks.

Those settlements followed worldwide regulatory probes that have led to more than $10 billion of fines for several banks, and the convictions or indictments of some traders. The banks being sued are: Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, Japan’s MUFG Bank, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Chartered and UBS”

I’m convinced that large IT companies could easily form new banks that don’t subscribe to such unabated greed and disregard of Market Integrity. Enough is enough — and it’s time to break the vicious cycle! Better yet, instead of utilizing HFT bots, the leaders in AI technologies could use AI innovation — to monitor and prevent securities fraud and abuse patterns.

In Conclusion

Fraudulent and manipulative HFT schemes corrupt the efficient market pricing process on all exchanges, and cause irreparable harm and damage to retail AND institutional investors.

Sophisticated manipulations aiming to defraud and manipulate securities markets and the trading of equities on those markets — rob billions of dollars annually from buyers and sellers of securities.

Blinded by substantial kickback payments in exchange for providing HFT firms access to material trading data — financial institutions abandoned their fiduciary duty to clients, and their mandates to regulate the markets and benefit the public interest.

Train robbers needed significant logistics in place to perpetrate their crime. In comparison, HFT traders make train robbers to look like boy scouts. They can get away with a much bigger loot without ever leaving their offices, glued to a workstation. And it takes them less time to do so — than sipping on a cup of cappuccino from a nearby Starbucks…..

Without a decisive action to ban HFT practice and forego AMMs, we might as well all brush-up on the famous lyrics of Leonard Cohen’s song: “The Future”

Oleg Feldgajer is President & CEO of Canada Green ESCO Inc. Oleg is positioning the company to become a leader in financing AI enhanced green energy projects and ventures. CGE’s mission is to guide DISRUPTIVE businesses in ENERGY & TRANSPORTATION toward profitable business models. Oleg is passionate about such mission, and firmly believes that without AI based innovation, we will all prematurely choke on polluted air and dirty water. CGE delivers 100% financing (levered and unlevered) to its clients — and utilizes large equity pools, and non-recourse debt. Oleg offers creative, fresh ideas to open-minded businesses — that embrace both: logic AND opportunistic intuition. CGE stands against mediocrity & its modus operandi is quite simple: If CGE is not invited to join your BOD, or Advisory Board — we failed!

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