Secrecy in Trading – Protecting Intellectual Property in Markets

Secrecy is common in trading and investing as firms and individuals compete for an edge. 

This article explores why secrecy is so prevalent in trading, the methods used to maintain it, and its impact on institutional and retail investors.

Key Takeaways – Secrecy in Trading

• Intellectual property protection is important in the industry
  • Trading strategies, algorithms, and analytical methods are the lifeblood of financial firms.
  • Keeping these secret preserves competitive advantage and business value.
• Information is compartmentalized
  • Firms often use employee silos, limiting access to information on a need-to-know basis. 
  • This prevents any single person from understanding the full picture and limiting the spread of IP to other firms or to the public.
• NDAs and tech safeguards are ubiquitous
  • Expect strict confidentiality agreements and advanced security measures like encryption and access controls in professional trading environments.
• True edge often comes from creativity and lateral thinking
  • While basic strategies may be widely known and are public, success often stems from innovative application of knowledge and lateral thinking in strategy development.
  • Be cautious of “secret” strategies/indicators being sold to the public.
• Some traditional sources of information may not help in trading markets
  • Information from academia, policymakers, and the press will generally not help create a trading edge.
  • Patents are also not popular in finance.
• Secrecy impacts market dynamics
  • The knowledge gap between institutional and retail traders creates opportunities for those with privileged information, raising questions about market fairness.

The Value of Secrecy in Trading

Protecting Intellectual Property

Finance tends to be a fairly secretive industry because of the protection of intellectual property.

Trading strategies, algorithms, and analytical methods are the core of financial firms.

Proprietary data, infrastructure, models, and techniques are often the result of years of research, development, and refinement.

Keeping them secret isn’t only about maintaining a competitive edge, but about preserving the foundation of a firm’s business model.

Maintaining Competitive Advantage

The zero-sum nature of some aspects of trading (e.g., alpha generation), one’s gain is often another’s loss.

Keeping their methods and strategies under wraps enables traders and firms to:

1. Prevent competitors from replicating their success
2. Avoid telegraphing what they’re doing to the market
3. Maintain the effectiveness of their strategies for longer periods

Many institutional traders look at alpha strategies as something they’d like to maintain for at least a generation or, perhaps more practically, at least 10 years in order to get the value from it.

It’s not overly different from an author wishing to earn royalties on a book they publish as long as possible.

Of course, there are exceptions for highly tactical ideas in markets (just as authors might want to take advantage of a fleeting trend).

But even then traders put heavy emphasis on replicable strategies with clear cause-effect mechanics.

Avoiding Market Impact

Large trades can move markets.

Large institutional traders can minimize their market impact and execute trades more efficiently by keeping their intentions and activities secret.

Methods of Maintaining Secrecy

Employee Silos

One of the most common practices in maintaining trading secrecy is the use of employee silos.

This approach involves:

• Compartmentalizing information within the organization
• Limiting employee access to only the information necessary for their specific role
• Preventing a comprehensive understanding of the firm’s overall strategy

This is done so that when employees leave the company, they can’t take the entire playbook with them to competitors or use it to start their own ventures.

Employees might know on a high level what the firm does – e.g., global macro, statistical arbitrage – but won’t know specific algorithms or trades.

For example, risk managers might specialize in developing a certain aspect of the risk system, but won’t have much information on strategic asset allocation, tactical market opportunities, optimization of the firm’s portfolio, and so on.

Non-Disclosure Agreements (NDAs)

Confidentiality agreements are popular.

Firms typically require:

• Employees to sign NDAs upon hiring
• Contractors and suppliers to agree to confidentiality terms
• Customers (in some cases) to maintain secrecy about the services or products they receive
• Serve as a deterrent against leaks

These legal documents create a binding obligation to maintain the confidentiality of sensitive information, with potential legal consequences for breaches.

Limited Information Sharing

Even within a firm, the full picture of trading strategies is often closely guarded.

Only one or a few (typically those with significant ownership interest in the firm) might understand everything or at least have access.

This practice involves:

• Sharing information on a need-to-know basis
• Restricting access to sensitive data and systems
• Using code names or obscure terminology for projects and strategies

With limited information sharing, firms reduce the risk of leaks and unauthorized use of their proprietary methods.

Information shared externally (such as with the press or other external parties) might also be distorted if shared because they have their own agendas or biases that influence how they present the information.

Technological Safeguards

Technological measures are important in maintaining secrecy:

• High standards of encryption for data storage and communication
• Strict access controls and multi-factor authentication
• Monitoring systems to detect unusual data access or transfer patterns

These technological barriers help prevent both external hacking attempts and internal data theft.

The Institutional vs. Retail Divide

The Knowledge Gap

Institutional trading can be very different from retail trading.

What may be unknown to the average retail trader might be common knowledge among institutional players.

For example, people with a background in finance know the basic concepts and models of theoretical pricing (e.g., discounted cash flow, option Greeks, Black-Scholes).

They might talk about things that are publicly known.

But they typically won’t talk about information they know that isn’t public or exact decision-making criteria.

This knowledge gap creates:

• Potential misconceptions about what truly gives traders an edge
• Opportunities for institutions to capitalize on information asymmetry
• Retail traders might believe basic information can give them an edge
  • And market variance can make it difficult to understand the skill vs. luck question

The Real Source of Edge

Basic strategies and market mechanics may be widely known among professionals, but a true edge often comes from:

• Creative application of known principles
• Lateral thinking in strategy development
• Combining multiple concepts together to create something new
• Unique combinations of data and analytical approaches
• Superior execution and risk management

It’s not just about what you know, but how you apply that knowledge in novel and effective ways.

The Role of Creativity and Lateral Thinking

Breaking Away from Convention

When it comes to alpha generation (excess returns), successful traders often need to:

• Approach problems from unconventional angles
• Synthesize information from diverse sources
• Coming up with an out-of-consensus view (because the consensus is in the price)

This creativity is often what separates successful traders from those who merely follow the crowd.

The Limits of Traditional Analysis

Standard analytical approaches (while valuable as a foundation) have limitations:

• They are often based on historical data and may not account for how markets change over time
• They can be widely known and therefore priced into the market
• They may not capture complex, non-linear relationships in the data
• Algorithms can be easily overoptimized (i.e., overfitted) on past data and not work well on future data when novel things occur

Innovation look beyond these traditional methods to find new sources of insight and advantage.

Other Factors Involved in Trading Secrecy

Regulatory Considerations

Secrecy is often necessary, but needs to be balanced against regulatory requirements:

• Compliance with reporting obligations to regulatory bodies
• Adherence to insider trading laws and regulations
• Transparency in client communications

The Debate on Market Fairness

The secrecy surrounding institutional trading practices raises questions/concerns about market fairness:

• Does it create an uneven playing field for retail traders/investors?
• Balancing the need for market integrity with the protection of intellectual property
• Potentially introducing new disclosure requirements for certain trading practices (e.g., what constitutes insider information)
• Addressing new challenges created by algorithmic and high-frequency trading (e.g., circuit breakers, minimum tick sizes, market surveillance enhancements, kill switch requirements)

These questions continue to be debated among traders/investors, regulators, and academics.

Implications for Traders

For Retail Investors

Understanding the inherent secrecy in the trading industry can help retail traders by:

• Recognizing the limitations of publicly available information
• Focusing on developing their own edge through education and unique insights – whether that’s within the sphere of day trading or public markets or elsewhere
• Being cautious of claims about “secret” trading strategies sold to the public

The baseline for traders should be, before all else, to understand best practices when it comes to personal finance.

Budgeting, how to save, investing, insurance needs, and so forth.

From there, they can consider pursuits like trading and how to make the most of it.

For Aspiring Professionals

Those looking to enter professional trading should:

• Expect to encounter strict confidentiality requirements
• Focus on developing creative problem-solving skills
• Understand that success often comes from innovative application of knowledge, not just acquisition of information
• Not necessarily expecting their education or what they’ve accomplished in other pursuits to teach them practical skills for doing well in markets – ultimately, experience will be most important

Why Are Patents Not Popular in Finance?

In many industries, patents are popular and help those in the industry and broader public understand how things work.

But in finance this isn’t the case primarily due to the competitive nature of the industry.

Financial innovations, such as trading algorithms or strategies, can quickly become obsolete as markets re-adapt, making the lengthy patent process impractical.

Naturally, firms prefer to keep their innovations secret, as publicizing them through patents may expose proprietary methods to competitors.

In finance especially, the difficulty in proving infringement of abstract financial concepts also reduces the appeal of patents.

Instead, many financial institutions rely on trade secrets and other forms of intellectual property protection to maintain their competitive edge without the risks and delays associated with patents.

The Role of Academics in Spreading Information

Academics generally don’t focus on helping the public compete in markets better because finance as an academic discipline evolved later and separately from its commercial applications.

Academic finance emphasizes theories and models, and while commercial finance does this too, it’s more focused on real-world, profit-driven strategies.

For example, liquidity, bid-ask spreads, and market depth/impact considerations matter a lot in the real world but are often ignored in the academic study of finance.

The gap between the two means that academic research often doesn’t address the realities of the decisions faced in markets.

Additionally, academic finance is more about explaining market behavior, while commercial finance is about exploiting it for competitive advantage.

As a result, there’s limited overlap between academic insights and the practical knowledge needed in markets.

Knowledge in markets generally flows through via people changing jobs and not from academic papers.

Another reason is that academics in finance generally don’t rely on funding from the industry like others do (e.g., engineering).

The Role of Policymakers in Spreading Information

Policymakers often don’t focus on informing the public accurately because their roles are shaped by consensus-building and reacting to past events, unlike traders who anticipate the future and take risks with their money.

Policymakers operate in environments where political negotiations, not market-based decision-making, are prioritized.

Without the immediate feedback traders receive, it’s difficult to assess the decision-making effectiveness of policymakers.

Additionally, policymakers are often entangled in political struggles and the political systems they navigate can be dysfunctional.

The Role of Journalists in Spreading Information

Journalists often lack the specialized knowledge and training required to fully understand complex financial systems and trading strategies.

Unlike financial professionals, journalists typically don’t have deep expertise in market structures, algorithms, proprietary trading practices, or anything that goes into modern market knowledge.

Their focus is on reporting information to the public, often relying on simplified explanations that miss the nuances of market operations.

Additionally, they may lack access to the inner workings of financial institutions, making it difficult to uncover the proprietary details that drive market secrecy.

As a result, journalists generally aren’t equipped to help “pierce the veil” effectively.

Conclusion

Secrecy in trading remains a fundamental aspect of the financial markets.

It protects intellectual property, maintains competitive advantages, and drives innovation in strategy development.

It nonetheless also creates challenges for market fairness and regulatory oversight.

The balance between secrecy and transparency will remain a critical issue for all market participants.