Flash Crashers Ready to Feast on Corn: Street Whispers

A temporary near-doubling in the PowerShares DB Commodity Short ETN (DDP) last week signaled that robotic trading programs are targeting complicated stock products as agricultural commodity prices -- like corn -- surge amid a nationwide drought.

On Friday, the underlying agricultural, energy, and industrial commodities in the PowerShares DB Commodity Short fell slightly while the publicly traded stock backed by the notes surged.

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After opening at $36, the ETN, which trades on the New York Stock Exchange (NYSE), the Cincinnati Stock Exchange, and a host of high frequency exchanges like BATS and Direct Edge, surged to $55, then $60, and even rising above $70 briefly, in a string of algorithmic trades orchestrated in thirty second intervals between 10:53 a.m. and 10:58 a.m., according to data provided by Nanex.

Those trades -- which culminated in an intraday stock rise of over 90% -- were later cancelled by the NYSE.Bloomberg intraday trading data shows that some trades were executed at $46 shortly after 11 a.m., a near 30% rise from the ETN's Friday open. The PowerShares DB Commodity Short ETN closed Friday trading at $38.50, up 8.45% for the day.

The trades come just after a near-death software glitch hit Knight Capital (KCG) in August and the initial public offering failure of high frequency exchange BATS Global Markets (BATS) in March highlighted how a new breed of algorithmic traders has wreaked havoc on stock markets.

The surge in the ETN's shares came as the underling commodity assets gained slightly for the day, rising 1.11%, according to Bloomberg data. That 8%-plus rise in the ETN's stock versus the 1.1% rise in its underlying assets pushed the funds' premium to its assets to the highest in a year, the Bloomberg data show.

As it turns out, because the publicly traded ETN and its underlying asset are a zombie Wall Street financial product -- a sort-of stock market version of a collateralized debt obligation containing complex alchemy -- there is little reason to expect them trade in relation to each other, or to reality.

That would be fine if algorithmic trades, which were subsequently cancelled, didn't appear to manipulate the actual price of the ETN stock.

When asked about the abnormal trading and what looks to be roughly 10 cancelled trades, Katrina Clay, a NYSE spokesperson confirmed that the trades were cancelled under the exchange's "clearly erroneous execution" policy, but declined to give further information and instead sent over a copy of CEE rules. Invesco (IVZ), the owner of PowerShares, declined to comment through a media representative at BC Capital Partners.

Eric Scott Hunsader, the founder of Nanex, said on Friday that the cancelled trades clearly came from algorithmic trading programs robots. While Hunsader supported the notion that such wild price swings usually lead to cancelled trades, he initially took to Twitter on Friday morning to question the near doubling of the ETN's shares, and still is uncertain how so many trades in neat 30 second intervals could go so wrong.

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), 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.

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 stocks, regulators like the Securities and Exchange Commission and exchanges like NYSE should explain why the practice stands.