The New Improved Game of Insider Trading
Fortune magazine published a series on the "new insider trading" in May of this year. The perfect antidotes for these abuses are inherent in the features of the VWAP© trading system, especially its guarantees of complete anonymity and no market impact.
In this three part series, Fortune magazine uncovers the widespread "new insider trading" that preys on leakage of information relating to big stock orders. Ashton's VWAP© trading system has been specifically designed to protect its participants against such insider trading abuses. In approving the rule change filing, the SEC described the VWAP© trading system in the following manner: "the essence of the System is its anonymity....Participants will enjoy complete end-to-end anonymity in their Orders and Commitments; as a result, their proprietary trading strategies will not be revealed to other market participants....[t]he Commission recognizes that investors desire to trade large blocks of securities anonymously and free of the price movements that often accompany such block-sized trades at the day's volume weighted average price, [the System] will be able to better accommodate the needs of investors."
The New Improved Game of Insider Trading
A decade after Ivan Boesky, insider trading has evolved into a subtle, efficient--even routine--racket that preys on mutual funds and other institutions. Regulators just shrug, and meanwhile the insiders are cheating you.
Less than an hour before the closing bell, a wealthy young Manhattan day trader we'll call "Billy" got a call from the trading desk of a major brokerage firm. A big client was buying a million shares of Network Associates. Did Billy want to sell? The caller knew quite well that Billy did not have a million shares of Network Associates lying around. And Billy knew perfectly well that the call was not really about filling the client's order. Telling his contact that he would sell shares to him at the close, Billy quickly bought 40,000 Network Associates, anticipating that the client's million-share buy order would cause the stock to rise. It did. By the end of the day, Billy had unloaded his shares at a profit of around $80,000. Not bad for less than an hour's work--as long as you're willing to ignore that Billy and his pal had just committed a crime.
To most people, "insider trading" conjures images of Ivan Boesky sending briefcases of cash to M&A lawyer Martin Siegel in exchange for a heads-up on approaching takeovers. Yes, some characters still smuggle information from within a company. But a new generation of traders has discovered there are better ways to make a dishonest living.
The classic form of insider trading has been joined in recent years by a smaller, quicker, harder-to-detect version. Instead of trying to make a killing on a few big trades in advance of headline-grabbing mergers, today's inside traders take small, sneaky positions ahead of routine "buy" and "sell" orders placed by institutional investors--and repeat the technique hundreds or thousands of times in the course of a career. To pay for the tips, they typically direct a series of trades to their informants days or weeks later. The resulting commissions may lack the glamour and melodrama of passing a satchel of unmarked bills. But should anyone get nosy, commissions are much easier to explain away.
At its heart, the new insider trading is simply an adaptation of the classic racket known as front-running (so named because inside traders would literally run up to specialists on the floor of the New York Stock Exchange and place orders moments "in front of" a big institution). Just by virtue of supply and demand, an institutional block trade will almost always move the price of a stock anywhere from a few cents to a few dollars. A seasoned day trader or hedge fund manager can easily turn a quick, low-risk profit on such blips--as long as he knows the order is coming. "The order is the inside information today," says Jack Morton, a former trader and past chairman of the New York Stock Exchange's Institutional Traders Advisory Committee. Of course, insiders' profits come out of other investors' pockets. Billy's gain on Network Associates, for example, came at the expense of the brokerage's client, which paid a higher price for the stock than it would have had its confidential trading intentions not been betrayed.
No one is sure, of course, exactly how much all this goes on. The SEC declined to hazard a guess. ("We don't do much in that line of work--estimating how many violations of the securities laws go undetected," a spokesperson said.) But many Wall Street veterans say it's widespread. "There's a third world out there of small trading firms, particularly in New York, that make a living off this kind of information," says Morton Cohen, general partner of the hedge fund Clarion Partners. One New York Stock Exchange specialist told Fortune that he regularly sees stock and option activity skyrocket in advance of big orders. "The natural assumption," he says, "is that someone made 'the wrong call' "--jargon for a tip-off, accidental or otherwise, to a front-runner. Information seeps out of even the Street's most prestigious brokerages. "It involves the best and the brightest," says one partner in an institutional brokerage firm. Adds one former principal of a day-trading outfit, who watched a couple of the firm's traders get a dozen "wrong calls" a day from a hallowed Wall Street partnership: "The regulatory organizations, they're like five years behind the times."
Some Street veterans say that this sort of front-running has been going on for decades--just another of the schemes that inevitably arise when aggressive young men and lots of money are in close proximity. (See, for example, the tangentially related NYSE floor-broker scandal now in the headlines.) In testimony before Congress ten years ago, Morton, then newly retired from his job as head of Bank of Boston's trading desk, warned that "front-runners have been operating with impunity. Sizable sums of capital are continuously transferred from pension funds to these persons operating on privileged or inside information." A 1996 SEC report on Nasdaq price fixing digressed to note that trading desks regularly share clients' secrets. "Market makers may at times be tempted to overlook their obligation to deal fairly with their customers," said the report. That seems a rather gentle way of putting it.
In fact, today's insider game includes several new twists. Traditional frontrunners, for example, tend to swap tips with each other or trade for their own (usually camouflaged) accounts. Today's operators understand that if you front-run your own client and slip the winnings into your own pocket, even the woefully understaffed SEC might catch on. It's much safer to market the information to a third party under the pretense of a routine sales call, and then collect a kickback in the form of seemingly innocent commissions later on.
Recent changes in the market have only multiplied the temptation for traders to misbehave. For one thing, the largest institutions are more likely than in the past to deal in monster blocks of 250,000 shares or more. Such orders now account for 76% of their volume, up from 20% five years ago, says Wayne Wagner, president of Plexus Group, a trading research service. In addition, the growth in rapid-fire trading systems has created a new class of investors looking to make a buck on quick in-and-out moves. Among them are individual day traders like Billy, a species of investor that barely existed ten years ago. Even more important in this hyperactive group are day-trading hedge funds. Principals and traders at several Wall Street firms identify these "fast money" funds as the real heavyweights of the new insider-trading fraternity.
Hedge funds, essentially unregulated mutual funds for the rich, have exploded in assets in this decade from 500 funds with some $20 billion in assets to 3,200 with $320 billion, according to TASS Management. Day-trading funds tend to have relatively few assets and make up only a small part of that universe, but the category has seen dramatic growth in the past two years. (To be sure, only a minority of the fast-money outfits actively seek illegal information.)
So why would a brokerage trading desk betray a huge mutual fund client to attract business from a little hedge fund? Because the latter may well be a more generous customer. The average mutual fund, big as it is, doesn't turn over its portfolio even once a year. And many funds, under pressure from shareholders and directors, concentrate on keeping commissions low. In contrast, fast-money hedge funds generate tremendous commissions, either by ripping through trades or by paying an extremely generous commission rate. Certain day-trading funds reputedly offer as much as 12 cents a share for especially good "service," compared with the institutional average of 4.6 cents. "On Wall Street, you pay for information," says Morton. "The better the information, the more you pay."
Front-running's profit potential lies in what's called market impact--the tendency of big buy orders to push up a stock's price and of big sell orders to push it down. Research by the Plexus Group found that a stock moves around 2% over the course of an extended institutional order--even more in the case of an illiquid stock or an especially large trade. After the order is filled, the price typically drifts back toward its pre-trade level.
Part of the market impact is simply a matter of supply and demand. The rest is created by traders, insider-informed or not, scrambling to cash in. Heavy buying by front-runners, for example, can move the stock even before the institutional trade hits the system. Legitimate day traders can have a similar, if delayed, effect. With help from software programs like FirstAlert, they sift publicly available volume and price data for evidence of institutional trading. When they find it, they jump on to ride the stock's move. (As long as the information is public, it's all perfectly legal.) The uninformed trader is at a distinct disadvantage, however, because he doesn't know when the institution's order will end. The front-runner, on the other hand, knows what's behind the stock's move and has a better chance of closing his position near the peak of the market impact.
Billy says he gets tips daily, typically from Ivy League business school pals or colleagues at former Wall Street jobs. "The best calls may only last about two seconds," says Billy. His trading-desk contacts tell him what stocks a big customer is buying or selling in bulk. A few even name the client. "Some people are more blatant than others," he says. "They might say, 'Fidelity is selling two million shares today. Get short.' I've heard that sort of thing, but it's rare." Usually the message is more guarded, agrees a hedge fund trader who knows how the game works. "Maybe he'll say, 'I've got an order for 100,000. You buy 10,000.' Or maybe he'll just say, 'You know, I really like GE this morning.' "
If the tip produces a profit, as it does about three-quarters of the time, a certain etiquette applies in making the kickback. To avoid suspicion, the tippee generally makes the illegal trade through a broker other than the tipster. He then may wait a few days to place his payoff trades. The players could negotiate a higher than usual commission rate (say, 9 cents a share) on their next trades, or the tippee could simply send his informant extra orders at the regular rate. "If there's a stock I want, I'll buy it through [my contact]," explains Billy of his payback protocol. "If not, I'll just have him buy me some random stock, and I'll take an offsetting short position." To pay for the particularly successful tip about Network Associates, for instance, Billy says he routed his accomplice a series of trades worth some $10,000 in commissions. (To make it easier to pay these commissions, Billy set up a special institutional custodial account that allows him to keep his money at one brokerage firm but execute his trades all over town.)
Thanks to such arrangements, the modern inside trader leaves very few tracks. "What you've outlined is a classic case of insider trading, more specifically front-running," says Rob Khuzami, chief of the Securities and Commodities Fraud Task Force in the U.S. attorney's office in Manhattan. "But it doesn't jump out at you. Nothing about the order-flow method of kickback would look suspicious unless you knew it was part of a scam."
Although regulators may have a hard time detecting the new insider trading, most institutions--the scam's primary targets--know it well. But they don't like discussing it outside their circle. Says one trader who works for an institutional broker: "Off the record: Yeah, absolutely this kind of trading happens.... It probably happens every day. On the record: No, I don't think it happens. Absolutely not." An institution's instinct is to protect its own orders, not to reform Wall Street. "As a community, we haven't really tried to address this," says Kevin Cronin, head of listed equity trading at AIM Management Group. "I think there are a lot of smart people on our side who take a lot of steps to make sure that their order flow is not being compromised.... But there are a lot of people who aren't ... concerned enough really to figure it out." According to Harold Bradley, senior vice president with American Century mutual funds, some institutions tolerate traffic in whispers about big trades because they like getting the skinny themselves--not for day trading, but rather to take the market's temperature before bringing a big order of their own. But of course information usually runs both ways. "The institutions all think they're getting info on somebody else, and nobody gets information on them," Bradley says.
Naturally, institutions do their best to hide their intentions. The standard method is to break an order into small pieces and spread it out over time, and sometimes among several trading desks. In other cases, institutions seek refuge in electronic trading systems such as Instinet or OptiMark, where there are no human intermediaries to leak information.
Some take more elaborate precautions. Cronin protects his orders by insisting that desk traders who handle AIM's business not only refrain from covering fast-money hedge funds but also avoid even sitting next to those who do. American Century's Bradley says he's had a trader fired for being too chatty, and Andrew Brooks, head of equity trading at T. Rowe Price, says he has put whole firms in what's known as "the penalty box"--freezing them out of Price's order flow for several months--to protest leakage or other inappropriate behavior on their trading desks.
Some inside traders feel there is no real crime involved here, at least none that regulators would ever bother to pursue. And in fact almost no one has been prosecuted for this kind of insider trading. But the law is clear: In 1997 the Supreme Court endorsed the "misappropriation theory," which makes an insider out of anyone who misuses information taken from someone to whom he or she owes a duty of trust. As for the tippee, the law says he is guilty if he acts on information he knew was supposed to be secret.
Some people might agree--particularly in the middle of a roaring bull market--that what Billy and his pals are doing is nothing to get worked up about. But if you own shares in a mutual fund, a 401(k), or even a large hedge fund, chances are you have been cheated by a front-runner. At its basic level, an inside tip on an institution's trading plans amounts to stealing from that institution. While the theft may be small on any given trade, the constant nibbling at the margins of trades can reduce a fund's annual rate of return.
Moreover, front-running is only part of a larger problem. Traders who solicit order information are typically on the make for all sorts of other privileged tidbits as well: advance notice of analyst upgrades, security offerings, mergers, and so on. Says Nasser Arshadi, a University of Missouri finance professor who has studied insider trading: "The law ... has not been effective in deterring what we call 'outsider inside trading.' " That's not surprising: Institutions have generally taken every measure to evade front-runners except the one that those outside Wall Street culture would consider the most obvious: alerting the authorities.
That's not doing the markets any favor. There's more at issue here than whether some operator chisels a few points on an institutional trade and ends up picking a few anonymous shareholders' pockets. As in the Boesky and Michael Milken scandals of the 1980s, and the ongoing investigations of floor brokers on the NYSE, the real danger is more abstract but ultimately more fundamental. Stealing information undermines the integrity and fairness of the markets. And that matters. |
