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) -- The rise of algorithmic trading and the flood of data that it generates has created a battleground between traditional brokers looking to trade millions of shares a day and high frequency trading firms looking to ride on their trading coat tails for a profit.

On one side are the "gamers"; small firms with big technology budgets that attempt to follow large stock orders in an effort to benefit from minuscule price changes.

On the other side are the "anti-gamers"; trading shops that attempt to protect billions of dollars in trades made the nation's largest mutual funds and pension fund investors.

The battle between the gamers and the anti-gaming professionals has gone on for years off traditional exchanges and in private stock trading platforms called "dark pools."

However, the "Flash Crash" and the recent regulatory kerfuffle over "quote stuffing" reveals that the gamer-anti-gamer battle has moved into the public markets and that regulators and investors will need to prepare themselves for the fallout.

"Gaming and anti-gaming is a bit of a cat and mouse game," says Doug Rivelli, co-chief executive officer at securities trading software company Pragma Securities. "But as high frequency traders have become more prevalent

gaming has become more of an issue."

The concept of gaming the markets came about with the development of dark pools liquidity, which are private exchanges created as a venue to move large blocks of securities. Some of the largest dark pools are run by the world's largest banks, like

Goldman Sachs

(GS) - Get Free Report

' Sigma X and

Credit Suisse


(CS) - Get Free Report


In a dark pool a trader looking to game the market will employ a host of tricks -- usually through automated electronic orders -- in an effort to understand the intentions of larger investors looking to buy or sell huge blocks of securities.

In one gaming method, trader may "ping" a stock order -- or make an offer to buy or sell a stock for a small amount of shares -- as a means of trying to figure the size of the order on the opposite side of the market. If the order is quickly gobbled up, the gamer will assume there is a much larger trade is being made and run to the

New York Stock Exchange Euronext


or other public exchange to trade off that information.

"Some firms legitimately ping in order to understand the liquidity of a particular stock in a dark pool," says Cheyenne Morgan, research analyst at TABB Group. "But there are times that you are interacting with "predatory" order flow, and that's what anti-gaming attempts to prevent."

While gamers have been a particular problem in the multi-billion world of dark pools and institutional investors, their methods are beginning to show up in the "lit" pools of liquidity such as the NYSE or




The most obvious example is last spring's Flash Crash that caused the Dow Jones Industrials to fall over 900 points in a matter of minutes. While a report from the

Securities and Exchange Commission

on the causes of the Flash Crash is expected in the next few weeks, a speech by SEC Commissioner Mary Shapiro laid some of the blame for huge swings in market volatility squarely at the feet of algorithmic traders that attempt to game the markets.

"The SEC has seen aggressive liquidity-seeking algorithms flood the market with executable orders far beyond the normal volume for a stock," Schapiro said in a statement before the Securities Traders Association meeting in Washington D.C. earlier this week "For example, one of the new, individual stock circuit breakers was triggered when an algorithm attempted to execute 10% of the stock's average daily volume in two seconds. Orders like this can create sudden liquidity imbalances that quickly drive prices up or down."

In fact, published reports have said the SEC is also investigating the practice of "quote stuffing," a gaming method similar to pinging. Rather than simply buying up a small amount of shares to test the size of a trade, a quote stuffer will execute thousand small trades and the cancel them before execution in order to run up the price of a particular stock.

While both pinging and quote stuffing are opposite sides of the same gaming coin, Rivelli says the effect on the markets is the same: increased prices for mutual funds and other institutional traders looking to execute an order. "If a market maker sees certain changes off market they will start asking a wider spread on a particular stock," Rivelli says. "Effectively, the retail investor will get a worse price."

Not everyone feels that gaming is abhorrent behavior in the markets. Jeff Parent, CEO of the Canadian-based hedge fund Quadrexx, argues that gaming is simply a time-tested method for traders to extract information from opaque markets such as dark pools.

"If you think about it, gaming is simply trying to gain additional knowledge about a market order, and the whole gaming, anti gaming thing is getting a little silly," he argues.

Parent, who says that he is a "technical investor" and does not practice gaming techniques, adds that fund clients can simply avoid the problem by asking the broker to direct its trades to venues that are not open to gamers. "The clients can simply say, 'I don't want to interact in this pool. And when you go out to the lit markets, don't send it to this particular exchange."

For public markets looking to put a stop to gamers and high frequency traders exploiting a market hole, the solution may be a simply to follow the trades and penalize firms that cancel too many orders, says Lawrence Harris, a professor of economics at Marshall School of Business at the University of Southern California.


Quote stuffing is very similar to a denial of service attack online," Harris says. "It should be fairly easy for the regulators to figure where that attack is coming from and prevent it from happening again."

For dark pools and other off-market venues where billions in investor assets are traded each day the answer may be as simple as diligence.

"Every year we talk to dark pools and every year the anti-gaming needs to be ramped up," says TABB Group's Morgan. "It takes constant monitoring."


Written by Christopher Westfall in New York