Thursday, August 13, 2015

"Project Omega" - Why HFTs Never Lose Money: The Criminal Fraud Explained

Two weeks ago, without knowing the details of the most recent market-rigging and frontrunning scandal involving "alternative" market veteran ITG's dark pool POSIT, which issued a vague 8-K it would settle with the SEC for "irregularities", we explained what we thought had happened:
ITG had an in house prop trading group, or "pilot", which operated for nearly two years, whose only signal was client order flow, which it would frontrun, and make millions in profits. In other words, once again precisely what we have claimed since 2009. But oh yes, not everyone is guilty of such manipulation. Only Liquidnet... and Pipeline... and ITG... and countless other ATS and HFT firms for whom clients are better known as either "easy money" or muppets.

And yes, we get the "trading experiment" narrative: calling it "criminal market manipulation and order frontrunning scheme" just does not sound like something the Modern Markets Initiative would spend millions of dollars to get Congressmen to agree on.
It turns out we were spot on, the only thing we missed was the name of this market manipulation exercise. Now, thanks to the SEC, we know: "Project Omega" (or as it was also correctly dubbed here the "criminal frontrunning scheme") is how ITG dubbed its secretive prop-trading desk whose only purpose was to frontrun clients.
Here are the details for all you suckers who still read the HFT apologists and believe the bullshit that all these algos do is provide liquidity, when in reality all the really do is frontrun your orders, assuring them of 6 years of trading without a single day's loss (or in the case of Virtu, one trading day loss). From the SEC:
Between approximately April 2010 and July 2011, ITG violated the federal securities laws and regulations in multiple ways as a result of its operation of an undisclosed proprietary trading desk known within ITG as “Project Omega” (“Project Omega” or “Omega”). During the period of April to December 2010, Project Omega accessed live feeds of ITG customer and POSIT subscriber order and execution information and traded algorithmically based on that information in POSIT and in other market centers. In connection with one of its trading strategies, Project Omega identified and traded with sell-side subscribers in POSIT and ensured that those subscribers’ orders were configured in POSIT to trade  “aggressively,” or in a manner that benefitted Omega by enabling it to earn the full “bid-ask spread” when taking the other side of their orders.

Project Omega, which operated as part of AlterNet, traded a total of approximately 1.3 billion shares, including approximately 262 million shares with subscribers in POSIT. ITG’s proprietary trading gross revenues resulting from Project Omega totaled approximately $2,081,304.
A quick point here: since ITG was quick to settle at a cost of $20 million, one can be absolutely certain that the true damages to clients, aka Project Omega revenues, were orders of magnitude higher, however since it wasn't the SEC's intention to disclose just how criminal HFTs are in general but just to put a black eye on ITG's dark pool (as Goldman flexes its muscles and prepares for world algo domination by taking down its competition one by one), and since it is difficult to capture all the "externalities" and dollar benefit from rigging, the SEC was happy to only point out the absolutely bare minimum of damages which were probably the explicit documented loss by those traders who brough this case to the SEC's attention in the first place. Everyone else will have to wait in line for the class action lawsuits to begin when laying out their damages.
But back to the SEC's big picture "explanation" of what we have said for years:
While Project Omega was engaging in proprietary trading, including with ITG’s own customers, ITG was simultaneously promoting itself, and POSIT, as an independent “agency only” broker that did not have conflicts of interest with its customers and that protected the confidentiality of its customers’ trade information.

Project Omega was managed and overseen by an ITG senior executive who at the time served as the firm’s Head of Liquidity Management (the “Liquidity Executive”). The Liquidity Executive designed and directed Omega’s trading strategies even though they violated written policies set by ITG’s compliance department restricting Omega’s access to customer information.

ITG Inc. and AlterNet violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by engaging in a course of business that operated as a fraud and by failing to disclose to ITG customers and POSIT subscribers, among other things, that: (i) ITG was operating a proprietary trading desk while at the same time promoting its brokerage services and POSIT by describing ITG as an independent “agency-only” broker; (ii) the proprietary trading desk, until December 2010, accessed live feeds of highly confidential order and execution information and used this information to inform its own trading decisions; and (iii) one of the proprietary trading desk’s strategies involved identifying sell-side subscribers with which the desk wanted to trade in POSIT, and ensuring that those subscribers’ orders were configured to trade “aggressively” in POSIT.

ITG Inc. violated Rule 301(b)(2) of Regulation ATS by failing to file an amendment on Form ATS at least 20 days before it launched Project Omega disclosing the commencement of its proprietary trading activities and that one of its primary trading strategies would involve accessing confidential information regarding subscribers’ identities and orders and trading algorithmically based on a live feed of highly confidential information regarding open orders bound for the POSIT dark pool.
And here are the details of Project Omega, ör as we called it in July for what it really was "the criminal market manipulation and order frontrunning scheme":
During the period of late 2009 to early 2010, ITG explored initiatives to increase diversification and revenues for the firm, including launching a proprietary trading operation that would engage in algorithmic high frequency trading. Thereafter, on the recommendation of senior management, Group’s Board of Directors approved a proprietary trading desk that was limited in scope to inform whether ITG should launch a fully-scaled and disclosed proprietary trading operation. This initiative at ITG, which was managed by the Liquidity Executive, became known as Project Omega.

When he began managing Project Omega, the Liquidity Executive had overall product management responsibility for all of ITG’s electronic brokerage products, including its entire suite of trading algorithms, its smart order routers, and for the POSIT dark pool.  Prior to becoming Head of Liquidity Management in 2009, for several years the Liquidity Executive had been the Head of Product Management for ITG’s algorithmic trading group. In that role, he was responsible for designing and building ITG’s entire suite of trading algorithms and managing a team of software developers who wrote the computer code for the algorithms.
As a reminder, it was Zero Hedge who broke, and subsequently BBG and WSJ confirmed, that the "Liquidity Executive", aka criminal frontrunning mastermind, was none other than Hitesh Mittal, the same person who left ITG in 2011 and went on to become the head trader of the world's 4th largest hedge fund, Cliff Asness' (formerly of Goldman Sachs) mega quant fund, AQR Capital. It was this same "liquidity executive" who, after making hundreds of millions in HFT profits for AQR, was unceremoniously fired early this month. Per the WSJ:
Hitesh Mittal was terminated from his position as head of trading at AQR Capital Management LLC in a move related to an enforcement action the Securities and Exchange Commission brought against a former employer.

Mr. Mittal was head of trading at the $136 billion hedge fund since 2012. Brian Hurst, AQR’s former head of trading, resumed his role on July 31, AQR said in a statement. Mr. Mittal wasn’t formally named in the action, but his role in the project was reported by The Wall Street Journal and Bloomberg News in recent weeks.

“AQR has ended its employment relationship with Hitesh Mittal,” the company said in a statement. “Mr. Mittal has been referenced in reports about an SEC investigation of ITG. This investigation reportedly relates to misconduct that occurred in 2010 and 2011 while he was employed at ITG.”

Mr. Mittal didn't respond to attempts to reach him Wednesday.
His boss, Mr. Asness, did not respond to twitter inquiries if the reason he "loves High-Speed Trading", as he admitted in a 2014 Bloomberg Op-Ed, is because of the criminal frontrunning profit it may have afforded him courtesy of the hiring of the "liquidity executive."
And just so there is no confusion, ITG's "prop trading" group was all HFT and algo-based.
None of the Omega team members had experience with proprietary trading. Instead, the Omega team consisted almost entirely of ITG employees with significant experience in ITG’s algorithmic trading group designing, building and/or writing computer code for ITG’s trading algorithms. Based on that experience, the Omega team had detailed knowledge regarding how ITG’s algorithms operated.
Not surprisingly, the whole criminal scheme was shrouded in secrecy:
From the start, and during the entire time it was in operation, Project Omega’s existence and trading activities were kept confidential and were not disclosed to ITG customers or POSIT subscribers or to the Commission.

Proprietary trading represented a significant departure from ITG’s core “agency-only” business model and public profile, and ITG had concerns that Project Omega or proprietary trading at ITG could result in reputational risk for the firm. If ITG decided to increase the scale of Omega’s proprietary trading activities, ITG planned to disclose its existence publicly and to customers at that time. However, before reaching that point, ITG decided that Project Omega and its proprietary trading activities were to be kept confidential.

Even within ITG, Project Omega was only to be discussed on a “need-to-know” basis, and even the customer-facing side of ITG was not informed of Omega’s existence.
The company was smart: it would only rip off sell siders, not the buyside, because as everyone knows the biggest idiots on Wall Street are on the sellside; buysiders tend to be at least modestly smarter on average.
Project Omega was subject to the limitation that its total open positions could not exceed $500,000 at any time. In addition, it was designed to trade only against the orders of sellside subscribers in POSIT, and not against buy-side subscribers. Based on these limitations, and that ITG initiated Project Omega to determine whether it could profitably engage in proprietary trading and/or market making on a larger scale, ITG considered Project Omega to be an “experiment.”
In short, Project Omega was this:

That's right: dark pools, HFTs, and so on, are nothing more than the Office Space scam: steal a little, millions of times, just don't get caught.
However, just like in Office Space, they eventually got caught.
And here's why:
For the period of approximately April to December 2010, Omega’s Facilitation Strategy, which was designed by the Liquidity Executive, involved trading based on a live feed of information (the “Aleri Feed”) relating to open orders routed by sell-side subscribers to ITG’s trading algorithms for handling. 8 The Omega team accessed the feed by connecting to a software utility called “Aleri” that was used by ITG’s sales and support teams. The feed contained various categories of real-time information regarding “parent” orders routed through virtually all of ITG’s algorithms, including: (a) client identifier, (b) symbol, (c) side, (d) quantity of shares, (e) filled shares, (d) target price, (e) the ITG algorithm in which the order was located, and (f) time parameters.

The Facilitation Strategy was designed to detect open orders of sell-side subscribers being handled by ITG via the Aleri Feed and, based on that information, open positions in displayed markets on the same side as the detected orders, and close its positions in POSIT by taking the other side of the detected orders. The Facilitation Strategy was designed to earn the full “bid-ask spread” by opening and then closing positions.

* * *

For the entire time that ITG’s proprietary trading desk was in operation, the Omega team had access to the identities of POSIT subscribers and used this information to identify the full range of potential sell-side subscribers for Omega to trade with in POSIT. In addition, the Omega team used the information to which it had access to analyze the Facilitation Strategy’s profits and losses by contra party. Based on these ongoing profit and loss analyses, and without POSIT subscribers’ knowledge or consent, the Omega team made decisions about whether to stop trading with a small number of subscribers and to continue trading with others.

The Facilitation Strategy was designed to trade only with the sell-side subscribers identified by Omega. In order to effectuate this aspect of the strategy, the Omega team needed assistance from the POSIT development team – a group that also reported up to the Liquidity Executive. At the direction of the Omega team, ITG’s POSIT team implemented the required configurations in the dark pool to “enable” sell-side subscribers to trade, or interact, with Omega in POSIT.

* * *

Despite the strategy’s goal of earning the full “bid-ask spread,” there were times when Omega executed trades in POSIT at “midpoint” and did not obtain the “full spread.” In certain instances when this happened, the Liquidity Executive directed his team to investigate by coordinating with the POSIT development team to determine why the trades executed at midpoint, instead of at the bid or the offer, as the Liquidity Executive thought they should have.

No market participant other than Project Omega had access to the information provided in the Heatmap Feed.

From approximately April to December 2010, Omega’s Heatmap Feed included live trade execution information for all of ITG’s customers, including both sell-side and buy-side customers.
In December 2010, ITG’s Senior Management and Compliance Department Learned that Project Omega was Improperly Accessing Subscriber Order Information.
In the late fall of 2010, ITG’s CEO directed two other ITG executives to speak with the Liquidity Executive to gather information concerning the operation of Project Omega for the CEO’s information and to assist the CEO in making a presentation to Group’s Board of Directors in February 2011.

In early to mid-December 2010, ITG’s compliance department and senior management learned – based on the Liquidity Executive’s admissions – that Project Omega was trading based on a live feed of information regarding sell-side customers’ orders that had been sent to ITG’s algorithms. As a result, ITG immediately suspended Project Omega’s trading. Shortly thereafter, the compliance department and ITG’s senior management learned additional detail regarding the Facilitation Strategy and Omega’s use of the Aleri Feed, as well as certain information about Project Omega’s use of the customer execution feed in connection with its Heatmap Strategy.

The Liquidity Executive had not previously disclosed to ITG’s compliance department or senior management that Project Omega’s strategies involved accessing and trading based on the Aleri Feed and the Heatmap Feed. Instead, prior to December 2010, the Liquidity Executive had misrepresented to ITG’s compliance department the manner in which Project Omega’s trading strategies were operating.

On approximately December 20, 2010, a meeting among ITG’s senior management and compliance department was held to address Project Omega. During this meeting, the CEO reprimanded the Liquidity Executive for violating ITG policy and placing the firm at risk. Thereafter, Project Omega made certain changes to its trading strategies and was permitted to restart live trading.
As a reminder, this same liquidity executive went on shortly thereafter to become head of trading at Cliff Asness' AQR hedge fund.
But wait, despite being "reprimanded" Hitseh Mittal continued to defraud clients:
On or around December 21, 2010, Project Omega restarted a modified Facilitation Strategy that did not involve access to the Aleri Feed. In addition, Project Omega restarted a modified Heatmap Strategy on or around January 24, 2011, without direct access to the Heatmap Feed.
When Project Omega resumed trading, no changes were made to its organizational structure. As before the temporary suspension, the Liquidity Executive continued to manage Project Omega and direct its trading strategies while also continuing his overall product management responsibilities for ITG’s trading algorithms, smart order routers and POSIT, which included access to confidential customer order and trade information. The other members of the team also continued in the same roles they had before the temporary suspension.

Despite the removal of the improper direct feeds, in connection with the Facilitation Strategy, Project Omega continued to have improper access to information identifying POSIT subscribers. In addition, the Omega team continued to coordinate with ITG’s POSIT development team to identify the sell-side subscribers for Omega to trade with in POSIT and to ensure that such subscribers were configured to trade “aggressively” in POSIT.

After resuming trading in late 2010, Project Omega continued to engage in live trading until on or around July 11, 2011, when ITG terminated the Liquidity Executive as an employee and discontinued Project Omega’s operations.

During and after the temporary suspension of Project Omega’s trading activities in December 2010, ITG continued to keep Project Omega and its trading activities confidential and made no disclosure of it publicly, to subscribers, or to the Commission via an amendment to the POSIT Form ATS.
That's ironic: at the time Traders Magazine reported that Mittal had been fired in what was a "cost-cutting measure." That was incorrect. He was caught rigging markets. At this point he wasted no time to move to AQR where he was welcomed with open arms, and make his boss Cliff Asness millions in profits which in turn gave Cliff the green light to write pandering op-eds about why he loves HFT.
* * *
The fraud was so blatant not even the staunchest supporters of the HFT lobby could come up with anything even remotely relevant to justify this fraud:
... one thing to say about this is: Hahahaha, that's really bad! Like, paranoid-fantasy bad. The deep worry of modern equity market structure is that high-frequency traders, brokers, exchanges and dark pools are conspiring in some combination to front-run unsuspecting customers: The bad guys know, somehow, that the customers are trying to buy a particular stock, and can, somehow, race ahead of those customers to buy the stock and re-sell it to them at a higher price. And that's exactly what happened here! So, terrible. ITG will pay the SEC $20.3 million, a record dark-pool fine. "'The conduct here was egregious,' Andrew Ceresney, director of the SEC’s enforcement division, said during a conference call Wednesday," and it is hard to argue with that.
The "analysis" could have just ended there, and spared itself the footnoted embarrassment.
* * *
But none of the above is really shocking: after all the only business model of HFT is criminal order frontrunning, pure and simple, which is why it allows multi-millionaires to become billionaires even as they profess their love of said crime, under the guise of "high-speed trading."
What is shocking is the following, from the filing:
... on the recommendation of senior management, Group’s Board of Directors approved a proprietary trading desk that was limited in scope to inform whether ITG should launch a fully-scaled and disclosed proprietary trading operation. This initiative at ITG, which was managed by the Liquidity Executive, became known as Project Omega.
So the company's board was ultimately responsible for Project Omega, a board among whose members was the following :
Mr. O’Hara worked in the Division of Enforcement of the U.S. Securities and Exchange Commission and as Special Assistant United States Attorney at the U.S. Department of Justice

As we reported before, O'Hara promptly quit the day ITG announced the SEC settlement - after all it wouldn't look very good  to have a former SEC enforcer oversee a market rigginal, and criminal client defrauding prop trading group which was busted by, well, the SEC... but by then it was too little, too late.
And there you have it: open, outright, market rigging and criminal fraud, and best of all, with the explicit blessing of former SEC enforcers. As in, the fox is not only not guarding the hen house, but telling the hens to come right in: the water is warm.
And that's why the US equity market is a farce, broken beyond repair and will never be fixed until everything comes crashing down to be rebult from scratch.