The Trade Secrets of Trading Profits Made in Milliseconds

Fortune's William Cohan has penned an interesting piece on a hot topic in trade secrets circles right now: what are these code-based trade secrets that these people are alleged to be stealing from big outfits like Goldman Sachs and UBS? The answer, it appears, is computer code that enables these firms to make bags of cash trading faster and better than their competition.

Cohan notes:

The reason that trade secrets are so highly coveted in this world is that firms like Teza and GETCO use their own money to exploit tiny discrepancies in the price of securities from one millisecond to the next. When it comes to computer-driven mega-trades, milliseconds count.

For instance, a typical trading strategy for GETCO and its ilk would be to exploit the momentary pricing differences between a stock index -- say the S&P 500 -- and the stocks that comprise that index. It's a new form of arbitrage that relies primarily on proprietary computer programs, high-speed computers in huge data centers and proximity to various exchanges to be able to get the proprietary information before competitors via high-speed fiber optics cables.

"Electronic routing and execution has become the mechanism by which our capital markets operate," according to a recent report by Robert Iati, a partner at TABB Group. "Algorithms account for more than 25% of all shares traded by the buy side today -- a number steadily rising for several years now." Iati said that the "incredible capabilities" offered by technology have given meteoric rise to a relatively few high frequency proprietary trading firms, and that familiar names like "Merrill [Lynch] are being replaced by less familiar ones like Wolverine, IMC and Getco."

In an interview with Fortune, Iati recounted how these proprietary trading companies are vying to locate as close to the New York Stock Exchange's new multi-million-dollar data center -- being built in Mahwah, N.J. and set to open in 2010 -- as they can to get the information about trading activity as quickly as possible. "Proximity is everything now," he said, since the data travels over fiber-optic cables at light speed and the less distance it travels, the more quickly it arrives, and the more quickly the price discrepancies can be exploited.

Do source code strings that are designed to capture millisecond derived profits in trading satisfy the definition of a "trade secret"? You betcha.