Fortune Looks at Automated Trading After a Code Theft

It’s been a week and a half since news broke of the computer-code theft at Goldman Sachs threw the automated-trading business out of its preferred shadows.

Fortune’s William D. Cohan is one of the first reporters I’ve seen with a real look at this business since the theft. He focuses on a little-known Chicago company called GETCO, or the Global Electronic Trading Company.

Fortune’s report relies heavily on a source named Robert Iati from something called TABB Group, but the magazine doesn’t tell readers anything about what TABB Group is (it’s a financial-markets research and advisory firm*). It should have.

Weirdly, for a story with a Goldman peg there’s zero in here about Goldman. Actually, that’s not really so weird—Goldman is a tough nut for reporters to crack (and a funder of The Audit). But GETCO ain’t exactly thin-shelled:

Sophie Sohn, a spokeswoman for GETCO, declined to make additional information about the company available, such as the founders’ background, where they used to trade, or the firm’s revenues and profits.

Alrighty then! Thanks for your help, Sophie.

Fortune tells us about automated trading. This is hardly new information, but it’s still interesting:

In an interview with Fortune, Iati recounted how these proprietary trading companies are vying to locate as close to the New York Stock Exchange’s new multi-million-dollar data center — being built in Mahwah, N.J. and set to open in 2010 — as they can to get the information about trading activity as quickly as possible. “Proximity is everything now,” he said, since the data travels over fiber-optic cables at light speed and the less distance it travels, the more quickly it arrives, and the more quickly the price discrepancies can be exploited.

Here’s an example of how they take advantage of inefficient markets:

…a typical trading strategy for GETCO and its ilk would be to exploit the momentary pricing differences between a stock index — say the S&P 500 (SPX) — and the stocks that comprise that index. It’s a new form of arbitrage that relies primarily on proprietary computer programs, high-speed computers in huge data centers and proximity to various exchanges to be able to get the proprietary information before competitors via high-speed fiber optics cables.

Cohan quotes the TABB Group guy saying GETCO makes hundreds of millions of dollars a year. Not bad for a ten-year-old company.

Here’s the most interesting part of the story. This is not new information either, but it needs to be pointed out:

GETCO also has a separate business from its proprietary speed-of-light arbitrage business that provides customers, such as money managers and hedge funds, with fast-trade execution often with an “immediate or cancel” feature that insure that the trades cannot be traced. These hidden stock-trading venues, also known as “dark pools” — in part because the trading takes place away from any exchange and therefore without any reports being filed — have captured an increasingly large share of U.S. equity volume in recent years.

The leading “dark pool” is Goldman Sachs’ “Sigma X,” which executed about 162 million external orders in April 2008 followed by CrossFinder (owned by Credit Suisse), Knight Link (owned by Knight Capital Group) and then by GETCO, which started its GETCO Execution Services dark pool in March 2008, also according to TABB Group.

It’s hard for me to understand how these dark pools could possibly be in the best interest of the overall market. How are these regulated—if they are at all?

Regulation is the major missing piece in Fortune’s story. There’s nothing in here about how and whether regulators oversee automated trading and if they do, whether it’s likely they know what the heck they’re doing.

But I’m glad to see this story. As Cohan says in the kicker:

So while these firms are making money hand over fist while trading at the speed-of-light, the ongoing civil and criminal litigation will make it much harder for them to keep out of the limelight.

So, too, will reporters like Cohan snooping around.

* Corrected from “stock markets research and advisory firm.”

Has America ever needed a media watchdog more than now? Help us by joining CJR today.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.