#94: Smart Corruption

S2N Spotlight

I came across a story by financial blogger Goshawk Trades. This is my explanation and interpretation.

The whole story came out based on a patent that the CME had to put in place as a number of high-frequency traders had cracked the code to make profitable trades ahead of the market. It is quite ingenuous; let me try and explain it.

You might have heard of TCP (Transmission Control Protocol), which is the internet’s core way of transporting data from a sender to a receiver. It does it in what is called a three-way handshake. That third handshake is where the genius steps in.

Think of it like this: I am oversimplifying. Data is sent in packets that have number sequences; let’s call them packet 1, packet 2, packet 3, packet 4….. The receiver gets all the packets and assembles them in order to be able to read the data, sends back a message, and the sender then confirms all is kosher.

The high-frequency firm sends 2 orders: one is a buy and the other is a sell order, with 90% of the TCP packet just before a major market event. When they know what happens with the major event, say a jobs number. They send the 10% balance of the packets with a confirmation (3rd handshake) to the order that is going to benefit from the news. They send a corruption message with the 10% packet of the order they don’t want to execute. This little trick gets their good order ahead of the market: TIME TRAVEL, and the bad order gets cancelled.

The CME had to patent a process for introducing 3 microseconds (a microsecond is a millionth of a second) to neutralise the corrupt order messaging trick. I know this gave the big boys an advantage, but I love the creative thinking.

It reminds me of that saying, heads, I win, and tails, you lose.

S2N Observations

The Japanese TOPIX made a new all-time high yesterday, breaking its previous high set in 1989. We celebrated a new all-time high in the Nikkei in February, but the TOPIX is a more representative index. You would think that with the currency falling out of bed and a government that has spent more than any other government, the market would be under pressure.

The ISM (Institute of Supply Management) survey’s latest data came in below 50, which indicates that the economy is contracting. Financial commentators can often make a big thing of it, like the world is about to end. The backtest below is not trying to suggest a great ISM trading strategy. What I am trying to show is that a reading below 50 on its own is not a good signal, as it produces a cumulative return and Sharpe Ratio lower than buy and hold.

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