Tag Archives: SEC

Defining Insider Trading

Recently there have been a slew of insider trading probes and lawsuit against Wall Street traders.  The recent surge of cases has lead to some interesting questions regarding what is and isn’t insider trading.  The case at the center of the questions is a 2012 case against two traders, Todd Newman and Anthony Chiasson, who were convicted of insider trading.  They have since appealed their conviction on the grounds that they received their non-public information not from the original leaker, but indirectly through a network of analysts.  They claim that since they didn’t know the the original source personally benefitted, they didn’t commit true insider trading.  There are other cases waiting on this appeal to provide more legal clarity about what should be counted as insider trading.

The above case is certainly not a cut-and-dry case of insider trading.  Some cases are easier to determine.  For example, a BP employee recently agreed to pay over $200,000 to settle an insider trading charge relating to the 2010 BP oil spill.  In this case, the employee had access to private information on how much oil was leaking, and responded by selling off a large amount of shares anticipating a huge drop in BP’s stock price.  BP stock lost 48% following the oil spill crisis, saving the man and his family hundreds of thousands of dollars.

The presence of intermediaries between he original leak and  Newman and Chiasson acting on the information makes their case more foggy when it comes to determining right from wrong.  When a trader gets a piece of information from an analyst, how are they supposed to determine if that information was truly private.  Firms have been known to intentionally leak information, and therefore it can be difficult for a trader to determine what is really private information and what isn’t.  If the trader doesn’t act, they are mission out on lost profits on information that wasn’t actually “insider”.  Not to mention that if many people know about a leak, the information ceases to really be insider.  As one organization put it, “At some point, a leak of nonpublic information about a company’s anticipated results…becomes just one more piece of market intelligence that is circulating among analysts and portfolio managers.”  When does proprietary information become public?  If that line isn’t clearly drawn, I believe that honest people search for profits could be punished for something that isn’t insidious at all.

On the other hand, if a trader know they have information that is non-public, one might argue that they just simply shouldn’t use that information to their advantage because it is wrong.  However, I don’t really think that this is a plausible solution.  Once someone knows a piece of private information, they know it, and cannot un-know it.  Regardless of their desire of whether or not to use that information to their advantage, that information can guide other decisions they make without them really even knowing.  I think its not too far of a stretch to believe that a lot of traders make a lot of indirect insider trades without realizing it.

Furthermore investing, at its core, is about having a more accurate idea about a firm that the next person.  But at some point, the government has said that having too much information should be illegal.  I agree that there are many instance where insider trading feels wrong and that a select few are talking advantage of a much larger shareholder base, I’m not sure I believe that insider trading is as odious as some make it out to be.

 

The Murky Waters of Dark Pools

Recently, an article in the WSJ about Goldman Sachs recent strategies had a long section about “dark pools.”  Although I had heard about them briefly, I didn’t really understand what exactly they were, and so I decided to read a bit more about them and learn what they were and how they operated.  The resulting blog post is what I found.

A dark pool is essentially an alternative market where firms can trade with orders that are unavailable to the public market.  On these markets, firms are able to trade more anonymously; when they set and order, others who are in the dark pool can see that someone has placed an order, but cannot tell the position of the order.  This is often used when institutional investors want to move large amounts of an assets without changing the price in the market.  For example, if a large firm like Goldman Sachs wanted to buy a large amount of a certain type of asset, the price of that asset would shoot upward as they repositioned themselves.  However, if they made the purchase in a dark pool, they could buy at a lower price, and the transaction would hit the public books only after the purchase was complete.  Although relatively unknown to laypeople, a substantial portion of trades (12% in 2012, and rising).

Dark pools also play an important role in the current high-frequency trading controversy.  HFTs buy access into Wall Street bank’s dark pools, and then use their access to this private to benefit themselves.  HFTs will send out many small orders to these dark pools, fishing for a counterparty.  If an order gets executed, then the trader can guess that the large firm is taking a larger position that they cannot see.  When a HFT makes this inference, they then take the same position on a public market.  When the large firm’s order is filled in the dark pool, the transaction moves the asset’s price in the market in the way that benefits the HFT.  They pay a fee to have access to these banks dark pools, so both sides end up winning.  In Flash Boys, Michael Lewis argues against this strategy, commonly called “front-running”.

In 2012, Pipeline Trading Systems was accused of front-running people who made orders with their affiliate, and eventually was shut down after pressure from the SEC.

Dark pools seem to be queer bit of financial engineering.  They reduce the amount of information a typical market participant knows about the demand for an asset at any given time, because they don’t have access to who is trying to buy what in dark pools.  Dark pools seem to be a way for large firms to circumvent the market forces of supply and demand in order to buy lower and sell higher than would be possible on the open market.  I understand that someone making a large investment position change doesn’t necessarily want to broadcast it to the rest of the world, but I’m not sure if dark pools are the solution.

 

SEC considers the value of a nickel

High frequency trading (HFT) is a topic that many find difficult to understand.  The premium placed on speed of execution makes it seem a bit sketchy to the average investor despite research that says it actually decreases trading costs and adds liquidity to the market.  In order to bring back consumer trust, some think that trading should be slowed down, to roughly 20 times per second.  While it may make people think markets are fairer, it would take away some of the demonstrated benefits of such trading, like the increased liquidity and decreased cost of trading.  Instead of limiting trading to 20 times a second, in order to restore investor confidence while keeping the benefits, trading could be limited to tick sizes of .05, or one twentieth of a dollar.

As reported in the Wall Street Journal, the SEC is considering increasing the tick size from .01 to .05.  The change is to be tested on stocks with a market share under 750 million.  It is argued that this would make trading these smaller companies’ stocks easier.  While the program is for stocks with small market capitalizations, I believe that such a policy could be instituted on all stocks to curb the types of HFT that is not benefiting investors. In order to see how the tick size rule would affect this “bad” type of HFT, we first need to good trading from bad.  The good types of trades are trades that add the beneficial aspects, like market making and low latency trading. A market marker essentially takes either side of a deal in order to capture the “spread”, the difference between the bid and ask prices.  This provides liquidity.  The increased speed allows the traders to get the best prices in order to make a profit, and competition narrows the spread, decreasing cost for investors.  Low Latency trading is trading that tries to take advantage of a mis-pricing of similar assets in different markets.  This enforces the law of one price and adds efficiency and liquidity to markets.  Increasing the tic size has little to no affect on HFT algorithms like these since by increasing the tic size, they have made the spread even larger, benefiting the market makers.  Low latency trading is unaffected if all markets have the same tick size, since the relationship between the assets price would still hold.  HFT trading like this is beneficial to the market and could continue unchanged. What would be affected by changing the tic size is so called “predatory” trading.  To see this, we first need a concept called market resilience.

High-speed traders often rely on a feature called market resilience (or market depth) to make their profits.  Intuitively, a deep market is one that can fill a large order without a large change in price.  When an order is filled (and removed) from the limit order book, one replaces it quickly.  In this way the bid and ask prices move very little with large orders as there will be enough shares to fill it at that price eventually.

Trading ahead of mutual and index fund rebalancing is an example of HFT that is little suspect.  While technically legal, the high-speed traders use common knowledge (at least on Wall Street) and their speed advantage to profit.  At the end of the month, index and mutual funds rebalance their portfolios based on the current market weighting of the index. The funds, being very large, need a large amount of shares.  Executing an order for the amount of shares they need would cause a massive change in price against them.  Instead, the large orders are cut up and entered in over time so as to lesson their market impact and hide the transactions.

To profit, traders spam “feeler” limit orders to search out the pending transactions.  Upon finding them, they place orders at optimal places in the limit order book, which will inflate the price of the security as the fund executes its orders.  A resilient market will return to its normal level quickly after a large order, so the high-speed traders, if they are fast enough, can effectively buy back the asset they just sold for a cheaper price, pocketing the difference.  This trade, and similar algorithms, depends on a high level of market resilience.

Changing the tick size would absolutely decrease market resilience.  Market resiliency is defined as the size of an order needed to move the market by a given amount.  It is about a trade off between the quantity I can sell and the price I can sell it at.  If the increments are farther apart, the market will move more with big orders, as it can only move in 5-cent increments vs. the previous one-cent.  This decreased resilience would make such predatory trading more difficult. While the proposed change would most certainly decrease the resiliency of the market, was the market in 2000 really not deep or liquid enough?

The opposition’s argument that it will result in increased cost to investors is trivial. The investors would be put in an immediate loss that is the spread, and now it would be larger. However, they shouldn’t be too much worse off by getting a price a few cents higher, since they benefit from the larger steps up as well.  More over, if decreasing the increments when we went to decimals in 2001 didn’t make investors significantly better off, why would moving them back the other direction make them significantly worse off?

The federal government has thought about getting rid of the penny due to its inefficiency.  It costs far more then a penny to make a penny.  The SEC should do away with it as well.  While the decrease in market resilience may be considered a bad thing, the United States went until 2001 with a wider gap (1/16th, as opposed to the proposed 1/20th), and the economy, as well as traders’ profits, where fine.  Moving to a tick size of 5 cents could be a step that increases investor confidence in the markets as well as in regulators to do their job in the quickly changing landscape of modern finance.