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Flash Crashers Ready to Feast on Corn: Street Whispers

According to Wall Street Journal reporter Scott Patterson's history of high frequency trading Dark Pools, robotic traders oftentimes put in outrageously high and low bids for shares as a way to be the first to catch market price orders.

The practice, called 'stub trading,' was seen to be the reason that Apple's (AAPL) stock briefly rose to $100,000 a share during the 2010 flash crash, while Accenture (ACN) fell to a penny.

Part of the theory behind the trading strategy is that any actual execution at an absurd price ($70.54 in the case of PowerShares DB Commodity Short ETN on Friday or $100,000 for Apple) is likely to be cancelled by exchanges like NYSE.

The May 6, 2010 Apple and Accenture trades were subsequently cancelled, amid nearly 20,000 cancellations of trades that were 60% off market during the crash.

That's where Friday trading in a short commodity ETN raises eyebrows. Has a zombie wasteland of ETN products become the next profitable idea for algorithmic traders, as wildly distorted trades are cancelled by exchanges, while only mildly ridiculous ones stand?

The PowerShares short commodity ETN, issued by Deutsche Bank (DB - Get Report), was created in mid-2008 amid a boom in the product to offer investors unique leverage and risk-reward characteristics compared with ETF's or other index products. After Wall Street nearly came unraveled and regulators subsequently overhauled the financial system, the products - at risk to the collapse of an issuing bank -- became less attractive to investors and less profitable for banks.

In February, Deutsche Bank suspended the issuance of new shares in its PowerShares DB Commodity Short ETN and six other seven commodity-linked ETNs with a combined $40 million-plus in assets. Also in February, Credit Suisse Bank (CS) suspended the issuance of new shares in its VelocityShares Daily 2x VIX Short-Term ETN (TVIX). After suspending new ETN share issuance, Deutsche Bank, Credit Suisse and many other bank issuers warn that stock prices of an ETN versus underlying assets may vary widely, creating either a premium or discount.

For instance, while the PowerShares DB Commodity Short ETN trades at a significant premium to its assets, its sister Double Short ETN [also suspended on Feb 9] trades at a near 20% discount.

Highlighted by Friday's trading, are algorithmic traders now feeding profits by manipulating a litter of broken Wall Street-issued ETN products? In the increasing frequency of major and minor flash crashes it is still unclear who stands to win from the trading, as market volatility bruised the psyche of already scarred long-term investors. In the flash crash, Knight Capital's blowup and the BATS IPO debacle, many hugely discrepant trades stood, to the clear benefit of some.

If there is any solace in the mystery rise in the PowerShares DB Commodity Short ETN, it's that even though the index tracks highly watched commodity products like corn, crucial to Main Street America, the trading appears to be confined to the realm of Wall Street's darkest and opaque corners.

Still, if trading algorithms manipulate increasing distortions between closed ETN stocks and their underlying assets, regulators like the Securities and Exchange Commission and exchanges like NYSE should explain why the practice stands.

-- Written by Antoine Gara in New York
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