XII. TRADING GONE AWRY
12.1. The Dark Side of Finance
When unfair or dysfunctional markets fail to draw traders, they cannot draw capital.The mere perception of dysfunction or unfairness is disruptive and can break down markets (Guiso,SapienzaandZingales, 2008).
Costs of Financial Fraud
U.S. financial firms paid $139 billion in fines during the two-year period 2012-14.Many more fines that would have been assessed if not for failures of the affected firms or success in avoiding detection (Zingales, 2015).Dyck, Morse andZingales(2014) note that the “main challenge in assessing the cost of fraud is that we only observe detected fraud.”Based on their study of firms switching auditors after the demise of Arthur Anderson,Dyck, et al were able to estimate that only about a quarter of frauds are detected.The successor auditors to Arthur Anderson, who presumably had fewer disincentives to catch frauds, unveiled about three times as many frauds. They extrapolated this “detection failure” rate to the economy.While most of the frauds relevant to this study were not trading frauds, the study might be suggestive of detection rates.
Indirect Costs of Financial Fraud
The difficult to observe indirect costs of securities fraud almost certainly exceed the direct costs.Securities fraud distorts investor capital allocation decisions.Gurun,StoffmanandYonker(2016) argue that investors significantly change their investment behavior as a result of a failure of trust.Residents of communities with zip codes that were more exposed to theMadoffPonzifraud “withdrew assets from investment advisers and increased deposits at banks.”Over $363 billion was moved, 20 times the direct effect of the fraud itself, large enough to imply that securities fraud has a significant impact on how investors allocate their capital.More generally, based on several extrapolations,Dyck, Morse andZingales(2014) estimated the net annual costs of financial fraud at $380 billionRoughly a fifth of the market value of directly affected firmsRoughly one in seven firms engaged in fraud.Again, these frauds are not specific to trading, but trading fraud rates, extremely difficult to estimate, might be similarly pervasive.
12.2. Illegal Insider Trading
Capital markets perceived as being unfair fail to draw capital.Illegal insider trading is traditionally defined as the execution of transactions on the basis of material non-public information.
Insider Trading Legislation and Regulation
Section 10(b) of the Securities Exchange Act of 1934 prohibits “in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”Section 14 of the Securities Exchange Act and SEC Rule 14e-3 impose a “disclose or abstain from trading” obligation on any person who trades in securities that will be sought or are being sought in a tender offer, while that person is in possession of material nonpublic information that he knows or has reason to know has been acquired directly or indirectly from the offer or, the subject corporation …The Insider Trading Sanctions Act of 1984 authorized penalties for illegal insider trading equal to three times the illegally obtained profits plus forfeiture of the profits.The Insider Trading and Fraud Act of 1988 was intended to help define exactly what constitutes an insider and to set penalties for illegal insider trading activity.
Additional Insider Trading Regulation
SEC Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”These rules are extended to identify elements of a Section 10(b) or Rule 10b-5 insider trading claim:Possession of material nonpublic information;Trading while in possession of that non-public information;Violation of a relationship of trust and confidence
Insider Trading and the Judicial System
A 1909 Supreme Court decision in Strong v.Repideinterpreted inside trading by corporate officials without appropriately revealing that information to be a form of fraud.A 1980 Supreme Court decision (Chiarellav. United States) defined an insider as one who maintains a "relationship of trust and confidence with shareholders.
Early Insider Trading Cases
All of the individuals named in the cases that follow were very successful in their businesses, and in most cases, quite wealthy.WilliamDuerwas appointed Assistant Secretary of the Treasury in 1789 under Alexander Hamilton.Duerused information and connections obtained in his official position to speculate in U.S. debt and various bank stock issues.His speculation and subsequent failure was a major cause of the Panic of 1792.Albert H. Wiggin became chairman of Chase Bank in 1917.Engaged in M&A activities over the next 15 yearsThrough 6 of his own corporations, including three in Canada to avoid reporting taxes on capital gains, Wiggin regularly traded Chase stock.During the Fall of 1929, he began short selling shares of stock of Chase.The short selling of shares of his employer's stock broke no laws at the time, but the public certainly reacted badly.His insider trading served as a rationale for the ban on insider trading provision of the Securities and Exchange Act of 1934.
1985, Dennis Levine, an M&A specialist and managing director at Drexel, Burnham Lambert.One of his trading account brokers, a Bahamian subsidiary of a Swiss bank began "piggy backing" off his trades as did the bank's account executive at Merrill Lynch.Merrill Lynch became suspicious of these trades and notified the SEC.Levine implicated Martin Siegel and Ivan Boesky, to whom he had passed illegal tips.Boesky, considered the expert on merger arbitrage, had been paying Levine a percentage of his trading profits gained from Levine's tips.Boesky agreed to a plea, whereby he implicated Michael Milken and Drexel Burnham, along with his friend, John A.MulherenJr.The investigation into the relationship between Boesky and Milken uncovered a $5.3 million payment in 1986 to Drexel that Boesky had characterized as a consulting fee.Much other evidence of insider trading was uncovered, but the bulk of the SEC's weak case against Milken and Drexel would be based on testimony of Levine, Boesky and other felons.The SEC began to focus on Milken's brother Lloyd, who might have played a minor role in the insider trading activities and other relatives, including their 92 year-old grandfather.Milken agreed to a plea arrangement.Milken’s co-defendant, Alan Rosenthal, took his case to trial, whereby it was tossed by the judge, lending credibility to the argument that the case against Milken was weak.
Martha Stewart sold shares ofImCloneafter learning that its new prescription drug would not obtain FDA approval.After learning about the drug's setback, SamWaskal, CEO ofImClonequickly sold shares of hisImClonestock.His broker, PeterBacanovic, who also served as Martha Stewart's broker, apparently notified her thatWaskalwas selling shares of his company's stock.The SEC investigatedBacanovicandWaskal, who were ultimately imprisoned.Whether Stewart had engaged in illegal insider trading was not known at this point, and still is not completely clear.The SEC's insider trading case against her would have been weak at best.Ms. Stewart conspired withBacanovicto fabricate a story about a stop order at $60.This led to charges of conspiracy, obstruction of an agency proceeding, and making false statements to federal investigators.She was convicted and sentenced in 2004 to serve 5 months followed by 5 months of incarceration and 2 years period of supervised release.After she was charged in the alleged insider trading incident involvingImClone, but before the general public knew of the investigation, Ms. Stewart sold shares of her own company, Marta Stewart LivingOmnimedia, Inc.This exposed her to additional insider trading charges. She was charged but not convicted for manipulating the price of her company's stock.
In 2011, RajRajaratnam, billionaire and founder of the defunct hedge fund, the Galleon Group, began serving an 11 year sentence in the Federal Prison system after being convicted on 14 counts of conspiracy and fraud.This was the longest sentence ever imposed for illegal insider trading. Mr.Rajaratnamwas also fined $92.8 million and faced civil and other actions.Mr.Rajaratnamhad been accused of having taken more than $50 million in insider trading gains based on tips provided by fellow conspirators at Goldman Sachs, McKinsey & Co., Intel, Google, etc.Two interesting facets of this case were:The large number of co-conspirators (around 60) andthe use by authorities of wire and tapes to record conversations, including more than 40 wiretapped phone conversations between Mr.Rajaratnamand his accomplices.
SACCapital: Part A
The investigation ofRajaratnamled to an SEC pursuit of S.A.C. Capital Advisors and Steven A. Cohen.SAC had imposed among the highest fees in the hedge fund industry, up to 50% of annual profits and 3% management fee.Nevertheless, SAC averaged annual returns over 18 years of approximately 25%.In 2008, technology analyst Jon Horvath, who pled guilty to insider trading, sent his boss at SAC Michael Steinberg an email indicating that he learned from someone at Dell that its upcoming earnings report would be poor.Steinberg shorted shares in his portfolio and the email was forwarded to Cohen who, within 10 minutes of receiving it, closed his $12.5 million share position in Dell, avoiding losses of approximately $1.7 million.Later in the month, Cohen complimented Steinberg, Horvath and others in their group “Nice job on Dell.”Cohen’s defense on the insider trading charge was that he never read the email that he was forwarded prior to his sale of Dell.
SACCapital: Part B
MatthewMartoma, a portfolio manager at SAC had ongoing communications with Dr. Sidney Gilman, a neurology professor at the University of Michigan concerning anAlzeimer’sdrug under development atElanand Wyeth.Gilman received $108,000 in consulting fees from SACGilman providedMartomawith a summary of the drug’s failing trial results prior to their public announcement.The day after a call betweenMartomaand Cohen, SAC sold approximately $700 million (including $400 million from Cohen’s personal account) of Wyeth shares andElanADR shares and short sold an additional $260 million in shares just prior to the public announcement of the trial results, producing $276 million in profits and avoided losses – possibly the largest discovered insider trade series in history.Gilman testified in exchange for avoiding prosecution.Martomahad been rewarded with a $9 million bonus, but was convicted of conspiracy and securities fraud and sentenced to 9 years.More generally, the Department of Justice argued that SAC regularly engaged in insider trading.It argued that traders were compensated on the basis of the quality of information provided to Cohen for his personal trading and were hired on the basis of their being able to produce inside information.
The SEC filed a civil action for insider trading against SAC in 2012.In 2013, SAC agreed to pay $616 million to settle charges of trading Dell,Elanand Wyeth.The S.E.C. instituted administrative proceedings against Cohen for failing to reasonably superviseMartomaand Steinberg.In addition, theDoJfiled criminal charges against SAC for wire fraud and securities fraud, and against 8 former employees for insider trading.SAC pled guilty to all counts, agreed to stop managing funds on behalf of outside investors and pay an additional $1.2 billion, $900 million of which was a criminal penalty and the remainder as profit forfeiture.Five employees pled guilty to insider trading charges.Cohen, who was never personally criminally charged, later began operating another fund including approximately $9 billion of his and employees’ money.As of mid-2017,Cohenwas preparing to launch a new $20 billion fund in early 2018, after his ban on accepting outside money was to be lifted.
Monitoring Inside Trading Activity
Successful insider tradingprosecutionsusually require cooperation from codefendants or damaging informationonother crimes such as tax evasion.There have been recent improvements to enforcement efforts.Surveillance techniques have improved significantly.The SEC, all of the major markets and companies themselves are purchasing software systems to monitor for illicit activity.The SEC is using more resources to monitor insider activity, including formation of special surveillance teams, wire tapping and payments of bounty to informants.The SEC currently contends with roughly 700,000 tips per year from informants.NYSE,Nasdaqand CBOE are making greater use of technology to monitor trading activity for suspicious activity.FINRA hasusedan intelligent surveillance application known as the Securities Observation, News Analysis and Regulation (SONAR) system to detect suspicious patterns.Regardless, insider trading enforcement remains difficult.
12.3. Front Running and Late Trading
Front-Runningoccurs when a broker uses his knowledge of a large pending order to buy (sell) the relevant security in front of the pending buy (sell) order so as to benefit from the market reaction to the large order.The U.S. Attorney's Office and the SEC accused brokers from Merrill Lynch of allowing certain clients to listen to conversations involving other clients through broadcasts on Merrill Lynch internal speaker systems. In this “Squawk Box Scandal,” some clients were privy in advance to other clients’ trades.
Tailgating, a form of parasitic trading where the broker places an order immediately after the client’s order.Penny-jumping, a parasitic trading scheme where the broker places a buy (sell) order one uptick above (downtick below) below the client’s buy (sell) limit order, expecting to benefit either from the market’s reaction to the client order or to limit his losses by transacting with the client.For example, if the client were to place a large buy order at 50.00, the broker would penny jump by placing her buy order at 50.01. The broker’s order will execute ahead of the client’s order due to price priority.If the client’s order then executes, the broker will profit from any favorable price reaction due to the client’s large buy order.If the price declines, the broker can quickly sell his shares to the client at a $.01 loss.
Market timingis the fund trading strategy intended to exploit stale security prices and NAV deviations from fundamental values.While market timing is not illegal, it can transfer wealth between fund shareholders and necessitate that funds maintain higher levels of cash to accommodate share redemptions.In 2003, New York State Attorney General Elliot Spitzer filed a complaint against the New Jersey based hedge fund Canary Capital Partners, run by Edward Stern.Spitzer’s complaint alleged that Canary Capital entered into illegal agreements with mutual fund companies to defraud investors.For example, Canary made a secret agreement with Security Trust to enable it to engage in market timing-related trades.In another case, PIMCO agreed to permit Canary a specified number of trades in exchange for fees to be earned on $25 million it would manage for Canary.
Spitzer also accused Canary oflate trading. Apparently, Canary maintained arrangements with funds to purchase or redeem shares after daily NAV’s were computed.Late trading is always illegal.Late trading was described by Spitzer as “betting on a horse race after the horses have crossed the finish line.”According to Spitzer’s complaint, Canary purchase mutual fund shares after 4 p.m. exchange closing times with the assistance of certain Bank of America fund employees.Technically, Canary allegedly submitted trades in question prior to the 4 p.m. deadline so that they could be time-stamped before 4 p.m.However, Spitzer alleged that the Bank of America employees would hold transactions until after the market closed, providing Canary the opportunity to “confirm” its trades.Bank of America employees purportedly reconciled the “late” trades the following day.Canary settled Spitzer’s complaint for $40 million and was permitted to not admit guilt.Spitzer and the SEC also charged Janus, Bank One's One Group, and Strong Capital in other alleged incidences of late trading.The founder and chairman of Strong Mutual Funds, Richard Strong was charged with late trading in his own fund.
12.4. Bluffing, Spoofing and Market Manipulation
Bluffingis the act of fooling other traders into making unwise trades by convincing them that the bluffer has superior material information about security values.Can be legal or illegal.A trader can bluff the market by placing a bid or offer at a price or in a quantity that exaggerates his or her own true position, interest or lack of interest in a security.Then execute a larger quantity of shares after a positive price response to the initial offer.As long as such orders are executed, they are usually legal.Bluffers may also simply spread rumors or false information about share values. Such false rumor spreading can represent deceit or fraud, illegal when used to manipulate markets, and perhaps otherwise as well.
Spoofingis the act of placing a quote that is intended to be canceled prior to its execution.Spoofing is a form of bluffing.Motivations behind spoofing:to overload the quotation system of a market, inhibiting its ability to execute trades,to delay a specific trader's trade execution by placing that trader's quotes behind a series of quotes with higher priority,to create the appearance of false market depth or direction, particularly by submitting then later cancelling multiple bids or offers.This type of spoofing is calledlayering.Layering is frequently accomplished through an HFT program designed to submit many quotations that are canceled after an executed transaction.Orders, modifications, and cancellations are not considered to be spoofing if they were submitted as part of a legitimate, good-faith attempt to execute a trade.
In 2001 AlexanderPompersubmitted a phantom limit order on NASDAQ to purchase 300 shares of the thinly-tradedGumtechInternational (“GUMM”) at $11.375.This limit order improved the NBBO bid by $.3125 from $11.0625, while the NBBO offer was $11.4375 per share.Pomperimproved the bid for GUMM, but with a bid that he apparently did not actually intend to fill.Then,Pomperplaced an order to sell 2000 shares of GUMM at $11.375 per share through another market making firm.Pomper'ssell was executed at $11.375 because the best bid at $11.375 seemed to suggest a higher value and more liquid market for GUMM.However, after executing its sell order,Pompercanceled his order to buy GUMM for $11.375, realizing a profit of $625 (2,000 × [$11.375 - 11.0625]) relative to the initial bid for $11.0625.In 2002,Pomperagreed to pay $9,800 in disgorgement and prejudgment interest and to pay a $15,000 civil penalty.
Spoofing PostDodd-Frank: Panther
The Dodd-Frank Act specifically banned spoofing.MichaelCoscia, through his trading firm Panther Energy Trading LLC:Placed a small bona-fide sell order and many large phantom buy orders at increasingly higher pricesCreated the illusion of strong buying interestWhenCoscia’ssmall sell order was executed, he cancelled his phantom buy ordersThen implemented the spoof in reverse order so as to execute a small buy order after creating the illusion of strong selling interest.These and related spoofing activities enabledCosciato secure profits of $1.4 million in 2011.These profits were later disgorged along with an additional $1.4 million fine in 2013, andCosciawas banned from trading for a year.In 2015,Cosciawas sentenced to three years imprisonment.The CME and the U.K. FCA imposed penalties on bothCosciaand Panther.
Spoofing PostDodd-Frank: Other
IgorB.Oystacherand his trading firm 3Red Trading LLC paid $2.5 million in penalties) for spoofing.BiremisCorp. was fined $250,000 and permanently banned from trading for charges related to layering.UBS paid a $700 million fineHFT algorithms used in many spoofing schemes are helpful in prosecutions because their programming codes are used to evidence intent to defraud; otherwise, proving intent is difficult.
The Flash Crash
On May 6, 2010, the "Flash Crash,“ the Dow to drop almost 1,000 points in less than 30 minutes before recovering almost as quickly.Trades were executed at absurd prices, ranging from less than one cent to over $100,000.Exchanges ultimately canceled over 20,000 executions.Within 20 minutes of the start of the "crash," trading in the E-mini contract was halted for five seconds, which allowed the market to recover.When contract trading resumed, prices quickly recovered most of their losses.
The May 6, 2010 Flash Crash: Causes
As with many market crashes, it is difficult to pin-point the cause of the flash crash.There was a general concern that morning in the marketplace about whether the Greek government would default on its debt obligations.An early SEC report noted that the crash was preceded by a rapidalgo-initiated short, reportedly by mutual fund group Waddell & Reed (not an HFT), of a $4.1 billion block of E-Mini Standard & Poor’s 500 futures contracts on the CME.HFT firms were counterparties to these shorts, and covered themselves by further shorting (turning the contracts into hot potatoes), drying up liquidity in these markets.In 2015, 5 years after the flash crash, the U.S. Department of Justice filed fraud and market manipulation charges againstNavinderSinghSarao.An independent trader who operated from his parents' home near London.Singh had engaged in spoofing activities, having used his computer-based algorithms to place thousands of orders for E-Mini Standard & Poor's 500 stock index futures contracts.His algorithms had canceled over 19,000 orders by the afternoon of May 6.While it is doubtful thatSaraoror any one of the issues described above was the sole cause of the flash crash, each might have played some contributing role.An important lesson from this and other mini flash crashes is that high trading volume and market liquidity are not the same, especially when hot potato volume is involved.
Corners and Pools
Cornersinvolve the purchase a sufficient level of a given security to obtain market power over its price. The purpose of the corner is to manipulate the price of the security.Numerous corners have existed over the years in commodity and securities markets.The Hunt brothers (Nelson and Lamar), two of the then wealthiest men in the world, attempted to corner silver markets in the early 1980s.Although they succeeded in bidding up the price of silver almost ten-fold, the bottom fell out of the market before they could unload.They nearly went bankrupt.APoolis a common fund comprising participants combining their resources to obtain a large position in a security in order to manipulate its price. Pools are typically used to facilitate cornering of a market, and were a common activity prior to the 1929 stock market crash.
Vanderbilt vs. Drew
Commodore Cornelius Vanderbilt and Daniel Drew, an operator with connections to Tammany HallVanderbilt owned enough shares (with a cost as low as $8 per share) of Harlem Railroad Company stock to effectively control the companyHe intended to extend the railroad's service into Manhattan and required approval from the city.However, Daniel Drew, sold his shares and shorted 137,000 shares, almost 5 times the number of outstanding shares.He used his influence to convince Boss Tweed to repeal the railroad's license to operate in New York City, intended to ruin the railroad.The price of shares fell from $100 to $72, with Vanderbilt purchasing shares as Drew sold.Vanderbilt had, in effect, purchased the company several times over by acting as counterparty on Drew's short salesDrew needed to cover his short positions by repurchasing the stock. But only one major investor owned shares - Vanderbilt.Vanderbilt, having cornered the market, set his price at $179 per share, a price calculated to be the maximum that Drew could pay.Vanderbilt obtained his approval to extend the railroad into Manhattan and Drew was practically bankrupted in the process.Drew had fallen victim to a marketcorner, intended tosqueeze the short seller.
More Corners and Pools
Two brokers employed by Moore & Schley, Cameron & Co. were accused in the 1980s of acquiring shares ofChase Medical Groupto inflate prices. These brokers were accused of cornering the market and engaging in phony transactions to prop up the share prices.In 2008,Porscherevealed that it owned 42.6 percent of the stock of Volkswagen, along with call options on another 31.5%.The state of Lower Saxony in Germany owned another 20%, which it did not want to sell, creating a shortage of shares in the market available for short sellers to cover their positions.This shortage of available shares caused the share price to rise from about 200 Euro to over 1,000.In effect, without breaking German securities law, Porsche had, cornered the market for Volkswagen shares and squeezed hedge fund short sellers, earning significant paper profits.
Salomon Brothers Corner
Nobidder was permitted to bid for or obtain 35% or more of a given Treasury issue.In 1991,Salomon Brothersroutinely bid on more than 35% of issues, illegally bidding on as much as 105% of certain new issues.To conceal their actions, many bids were parked under names of clients.Such overbidding enabled Salomon to corner the market and fix prices for new two-year treasuries.The Treasury responded to this scandal by expanding its list of primary market participants and changing bidding procedures.Solomon fired its CEO, JohnGeutfrendand several key employees including John Meriwether and PaulMozer.Mozersubsequently pleaded guilty on two counts of lying to the FRBNY in his bid submissions, served 4 months, and was fined over $1,100,000.Warren Buffet, who owned a substantial stake in the firm through his holdings in Berkshire-Hathaway, contributed significant credibility to the firm by taking over as interim CEO.
Wash salesare sham transactions intended to create the appearance of sales where, in effect, no sales actually take place.The SEC defines a wash sale as a transaction that involves no change in beneficial ownership.Wash sales may be intended to manipulate security prices (e.g., conspirators execute transactions with one another to create records of sales prices to deceive other participants in the market).A series of wash sales at ever-increasing prices, known as ajitney game, can give other investors the impression that the value of the security is rising, leading investors to purchase the stock.Wash sales may also involve the sale of securities for tax purposes with offsetting transactions to repurchase the securities or related instruments.The I.R.S. defines a wash sale to be a sale and a re-purchase of the same security within 30 days.This sort of wash sale is not illegal, though any capital losses and associated tax write-offs generated by this activity will be disallowed by the I.R.S.
Fishingoccurs when a trader (who might also be called a "gamer" in this setting) sends a series of small orders to a dark pool to detect whether there is a large order waiting in that pool.If the fishing results in successful order fills, the trader might infer that additional orders or a very large order await in the pool.Then, the trader can submit a much larger order at a size and price that reflects the information that he has obtained through his gaming activities.An important exception to the Quote Rule is the fill or kill order.These quotes are often not publicly displayed, but may be displayed to select clients.These flash orders can result in flash trading in advance of the public quote stream.Such flash orders can facilitate fishing and have been criticized as being very unfair to the majority of market participants.
Suppose that an institutional trader has discretion reflected in hisalgoto buy shares at a price as high as 50.03 and places a bid at 50.00.The current market for the shares is 50.00 Bid / 50.05 Offer.A “fisher” or “gamer” detects thisalgoorder, but does not know its reserve price to purchase shares.The gamer “pings” thealgoby offering shares at 50.04. If the offer is not immediately executed, it immediately cancels.Then, the gamer offers 50.03 and the institutionalalgobuys.The gamer now knows that it can probably sell many more shares at 50.03 rather than the 50.00 quoted bid. Thus, the gamer submits a much larger sell order at 50.03.This sort of gaming activity is often perfectly legal.
Predatoryalgotradingstrategies are designed to exploit other institutionalalgoorders.Suppose the predatory trader detects an institutionalalgoorder to buy a large number of sharesThese shares are offered at 50.00, and the predatory trader suspects that the institution has pegged its order to the NBBO and is willing to pay as much as 50.25 per share.The predatoryalgocan seek to lock in a profit by artificially increasing the share price. Upon detection of this institutional order, the predatory trader places a small bid of 50.01, then continues placing small bids at successively higher figures as the institutionalalgotrader increases its bid with the NBBO.Ultimately, the predatory places a short sell order at 50.25, knowing that it created much of the apparent demand running the price up to 50.25.When the price falls, the predatoryalgocovers its short position.
Other Quote Abuses
Quote matchingoccurs when a small trader places a quote one tick from that of a large trader so as to profit from the large trader's transaction price pressure, or to use the large trader as a counterparty should prices reverse. Quote matching exploits the option associated with a limit orderQuote stuffingis the placement of large numbers of rapid-fire stock orders, with most or all of which being canceled almost immediately, frequently for the purpose of clogging trading HFT and other algorithms and data computations. The purpose of quote stuffing is not to execute orders, but to sabotage algorithms of other traders.Some dealers post quotes that are very distant from any reasonable market price for the security (e.g., bid for $.01 or offer at $100,000), not intending or expecting that these quotes would ever execute. However, in a one-sided market, these "stub quotes" quotes might be executed against as liquidity dries up, causing securities to trade at absurd prices.
12.5. Payment for Order Flow
Many exchanges and markets will provide rebates on orders that create liquidity, which essentially representspayment for order flow.This system, also known asmake-or-take pricing, refers to exchanges allowing patient traders to post standing limit orders that await execution until some other trader takes the other side.In effect, the patient trader is a market maker who receives payment from the exchange for making the market (liquidity rebate) and the market taker pays an access fee.Note the connection between this system and the "immediacy argument" ofDemsetzMake-or-take pricing systems has reduced spreads and improved liquidity, though the liquidity rebates normally are not reflected in bid and offer quotations.Such payments and rebating for order flow might lead to market abuses, reduce price competition for securities and reduce security price transparency.The customer may lose the opportunity to obtain an unannounced better price from a broker on the national exchange floor.The SEC adopted Exchange Act Rule 11Ac1-6 (now SEC Rule 606), requiring broker-dealers to make available quarterly reports that present a general overview of their routing practices.
12.6. Fat Fingers, Hot Potatoes and Technical Glitches
In 2005, a novice trader in a subsidiary of Mizuho Financial Group, attempted to sell one share of J-com stock on the Tokyo Stock Exchange for ¥610,000 ($5,041).By accident, he transmitted an offer to sell 610,000 shares at ¥1 each. In effect, he attempted to sell $3.075 billion worth of stock for $5,041.These 610,000 shares that he attempted to sell represented 41 times the total number of J-com shares issued by the Japanese recruitment company.Mizuho attempted to cancel and reverse the order, but not quickly enough, such that this incident (losses exceeding ¥27 billion) wiped out Mizuho's entire profit for the quarter.The absence of filters either at the bank or at the Tokyo Stock Exchange to prevent such an obviously erroneous trade played havoc with the market for J-com stock, and caused the entire Nikkei-225 to drop by 1.72%.The broader market reaction was largely in response to traders attempting to guess which firm had made the mistake, driving down share prices for nearly all Japanese financial institutions.Later litigation assessed a significant portion of the blame on the Tokyo Stock Exchange, and Mizuho recouped some of its losses.A trader at Bear Stearns caused a 100-point drop in the Dow after inadvertently entering a $4 billion sell instead of his intended $4 million buy order.Morgan Stanley made a similar mistake with a 2004 order for $10.8 billion rather than the intended $10.8 million.
Fat Finger Effects
Washington Post Co. dropped by 99% in less than one second on June 16, 2010 on NYSEArcaand Progress Energy Inc. increased by 90% in less than one second on September 27, 2010 on NASDAQ.Nikkei 225 futures contracts dropped by 1.1% on June 1, 2010 as a result of an unintentionalalgo-order placed on the Osaka Stock Exchange.Each of these occurrences illustrates the need (and failures) for effective trade filters, even in the absence of automaticalgoexecutions.
Hot Potato Volume
Hot potato trading, repeated passing of inventory imbalances among dealers seems to actually dilute the information content of trading.This type of trading tends to be more common in the presence of HFTs and where interdealer volume is high.Recall that hot potato trading does not improve liquidity despite the increased volume.
A Textbook for $23,698,655.93 (Plus $3.99 Shipping)
Consider Peter Lawrence’s 1992 developmental biology textbook,The Making of a Fly: The Genetics of Animal Design.An evolutionary biologist at UC reported that he sent one of his post-docs to purchase a copy on Amazon.comAmazon listed 17 copies for sale: 15 used from $35.54, and 2 new from $1,730,045.91 (+$3.99 shipping). The two new copies were offered by two booksellers,ProfnathandBordeebook.Their prices quickly increased from over $1.7 million to $2.8 million, and by the end of the day, to $3,536,675.57.The book's price peaked at $23,698,655.93, plus shipping.How did this price manage to evolve to over $23 million?Profnathused an algorithm to undercutBordeebook‘s, at .9983 timesBordeebook's.Bordeebookused its algorithm that set its own price at 1.270589 timesPronath'sSuchalgoprograms gone bad are not confined to markets for books, and they are not one-time isolated events.
Hansen Transmissions (HSNTF.PK) manufactures and supplies wind turbine gearboxes.On January 23, 2009, its stock price increased from $1.62, the prior close, to $143.32 on the trading of 100,000 shares, apparently on the news of an alternative energy speech given by President Obama.The next day, trading opened at $1.69.While this scenario itself was not a major market calamity, it does warn of potential meltdowns (e.g., the May 6, 2010 "flash crash") or other market disruptions that might occur with unfiltered or even filteredalgotrading.
Buy, Lie and Sell High
“Pump and dump" schemes occur when the market manipulator touts company's stock with false and misleading statements to the marketplace, causing the stock’s price to rise before selling his own shares at inflated prices.Spam operations have been linked to pump and dump operations, where operators tout shares of stock and then sell them.FriederandZittrainclaim that stock volume for touted shares increases dramatically after spam is delivered.FriederandZittrainfound that on days prior to touting, and on days touting takes place, returns are positive.Returns after touting are negative: 2-day returns average –5.25%, worsening further when the intensity of touting increases.Who would purchase stock on the basis of unsolicited spam?
Jonathan Lebed was a 15 year-old trader from Cedar Grove, New Jersey.With his AOL connection and hundreds of Yahoo Finance postings under fictitious names, Jonathan purchased shares in small companies and posted numerous buy recommendations under fictitious names, increasing share volume from 60,000 to over a million per day in the affected companies.He maintained a web site, stock-dogs.com where he published his opinions and recommendations.His gains ranged from $12,000 to $74,000 from September 1999 to February 2000.In September, 2000, the S.E.C. settled 11 cases of stock market fraud against this high school student.With interest, the S.E.C. disgorged $285,000 in illegal profits.In his settlement with the S.E.C., Lebed was permitted to keep over $800,000 in profits from other transactions.Mr. Lebed remains an active trader and distributes a newsletter, available on line through http://lebed.biz.
Banging the Close
The CFTC definesbanging the closeas a “manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract (that is, the period during which the futures settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative that is cash settled based on the futures settlement price on that day.”Amaranth Advisors, LLC incurred $6.4 billion in losses in the early Spring of 2006. The fund's failure arose from losses in trading highly leveraged natural gas contracts on NYMEX.The CFTC later charged Amaranth and its former head trader, Brian Hunter, with trying to manipulate natural gas futures prices.Hunter was accused of banging the close, flooding the then open outcry NYMEX futures markets with “series of rapid and successive” orders for natural gas during the final minutes of trading before the close, thereby forcing prices down in this less active market as buying interest diminished.The actual intent of his selling activity, according to the CFTC, was to depress natural gas prices in the ICE, where Amaranth held much larger short positions through swap contracts.
12.7. Rogue Trading and Rogue Traders
Rogue trading is systematic unauthorized trading, trading with unapproved counterparties or trading with unapproved products.Rogue trading normally traders exceeding risk limits and/or loss limitsAccompanied by efforts to conceal unauthorized actions
NickLeeson, chief derivatives trader at Barings' Singapore office, single-handedly brought down the centuries-old Barings Bank.What are the lessons to be learned fromLeeson’sfraud?The bank failed to sufficiently segregate trading and back office (record-keeping) functions.Management did not react appropriately when it was warned of increased concentration of financial risks from a relatively small trading unit.Continued trading fraud, at least initially, is often committed not for personal gain, but to cover poor performance or losses.Incentive-based compensation contributes to trading fraud, not only motivating the perpetrator, but his supervisors as well.A single rogue trader can bring down even the largest and most venerable of financial institutions.The superstar trader should merit the closest observation, not only to assure that his trading is legitimate, but to understand the secrets to his success.
Orlando Joseph Jett
Orlando Joseph Jett, an MIT graduate with a Harvard MBA, began trading strips and other Treasury instruments for Kidder Peabody in 1991, failing to report significant profits in his “rookie” year and earning a bonus of $5,000.Trading profits recorded by Jett in 1992 and 1993 were $32 million and $151 million, followed by $81 million in the first quarter of 1994. The “phantom” profits resulted from a mistaken entry in Kidder’s internal accounting system where bond payments to be made later were not discounted.Ultimately, when contracts settled, Kidder Peabody realized the losses, but Jett was able to cover them (on paper, with the help of the flawed internal accounting system) by increasing the size of his positions, realizing more phantom profits.Jett was ultimately cleared of criminal wrongdoing because it could not be proven that he knew about and intentionally exploited the glitch in the accounting system, even though he repeated transactions with almost identical results and with increasing frequency.Jett argued that Kidder ordered him to increase risks to deceive Kidder’s parent, GE, into believing that the Kidder unit was realizing profit objectives.Jett was fined $200,000 and ordered by a judge to repay $8.2 million in losses.Kidder Peabody was sold to Paine Webber, which merged into UBS.Significant contributors to Jett's losses at Kidder Peabody seem to have been:Lack of proper oversight by his supervisor who earned substantial bonuses based on Jett's phantom trading profits.Trading losses can often be covered by taking positions with increased risks, a cycle that can play out until the firm fails.As we saw in theLeesoncase, close monitoring of unusually high trading profits is as important as close monitoring of any unusual trading activity.
In 2008,JérômeKervielofSociétéGénéraleconfessed to a €4.9 billion fraud where he misappropriated computer access codes and falsified documents.It was the largest discovered trading fraud in history until BernardMadoff.Kerviel’scase was interesting because of how ordinary and unimpressive he seemed in almost all respects.Kervielwas not a trading superstar.Kervielwas formally charged in France in 2008 with abuse of confidence and illegal access to computers.He was ultimately sentenced to three years in prison and to make full restitution of the lost €4.9 billion (he has no significant assets), and a permanent ban from employment the financial services industry.
The London Whale
Not all “trading gone wild” constitutes unauthorized rogue trading.Authorized large-scale trading and poor risk controls can be just as damaging.JPMorgan Chase trader BrunoIksil, AKA the “London Whale,” lost approximately $6 billion trading credit default swaps and other instruments, partly due to inadequate risk controls.It appears that bank supervisors may have been aware of the large and risky trade positions.Chase was criticized by regulators for its high-risk trading strategies, weak management, poor response to this crisis and failing to co-operate with regulators.Ultimately, Chase agreed to pay approximately $920 million in fines to U.S. and U.K. regulators to settle charges, accepting responsibility for engaging in unsafe and unsound practices and failing to oversee its traders.In its investigation, the U.S. Senate's Permanent Subcommittee on Investigations investigated JPMorgan Chase, finding that it "disregarded multiple internal indicators of increasing risk; manipulated models; dodged oversight; and misinformed investors, regulators and the public about the nature of its risky derivatives trading."
12.8. Trading andPonziSchemes
Ponzischemes draw investors over time, paying returns to earlier investors with the investment proceeds received from later investors.Ponzischemes are not trading schemes.Ponzischemes have been used by rogue traders to mask illegal or unprofitable trading activity.
In 2008, BernardMadoffrevealed to his son that his investment firm,MadoffSecurities was aPonzischeme.Madoffpleaded guilty to 11 counts of securities fraud on March 12, 2009.Previously,Madoffhad maintained a highly successful trading and market-making business, accounting for as much of 12% ofNasdaqvolume.He was an active securities market regulator, having served on the NASD and NASDAQ boards during much of the 1980s, and had even served in 1990-91 as Chairman of the Board ofNasdaq.Madoffaccepted large sums of money from “feeder funds” such as the Fairfield Greenwich Group, Tremont Capital, as well as banks.
BernardMadoff: The Scam
Madoffregularly provided statements and trade confirmations to clients, apparently almost entirely fabricated.He claimed to be engaging in a trading practice known as “split strike conversion,” a simple collar strategy involving the S&P 100.Madoffclaimed to take long positions in a basket of stocks resembling the S&P 100, purchased S&P Index 100 puts while writing S&P calls.In a Black-Scholesframework, his strategy should have produced a return comparable to the riskless rate, much less than the 14-20% that he actually “paid” to most of his investors.Madoffengaged in aPonzischeme to make payments to investors.DavidFriehling, whose tiny accounting firmFriehling&Horowitzinin Rockland County New York auditedMadoff’srecords, was paid approximately $12,000 to $15,000 per month (after 2004), was also charged with securities fraud.
Joseph S. Forte of Philadelphia fraudulently obtained approximately $50 million from roughly 80 investors through the sale of securities in the form of limited partnership interests in his firm.JamesOssieof Atlanta was charged by the SEC along with his firm CRE after raising at least $25 million from over 120 investors offering "30 Day Currency Trading Contracts," that guaranteed a 10% return in thirty days.Sir R. Allen Stanford and the Stanford International Bank based in St. Croix sold certificates of deposit that offered "unusually high and consistent returns" (double the market average).C.A.S. Hewitt, the tiny Antiguan accounting firm that audited Stanford’s books was run by Celia Hewett who went missing at about the time the scandal broke andCharlesworth“Shelly” Hewett, who died at the beginning of 2009.Stanford “managed” $51 billion, slightly more than the amount thatMadoff, and seemed to be financing a lavish lifestyle on aPonzischeme.In early 2012, Stanford was convicted on 13 counts of fraud, conspiracy, obstructing justice, violating U.S. securities laws, and was sentenced to 110 years.