smartmoney.com
July 28, 2000
It's the @#$%! Market Makers
By Matthew Goldstein
NO MATTER WHICH online stock message board you wander onto these days, you're likely to find a venomous rant against greedy, unscrupulous market makers.
Whenever a stock plunges or stubbornly refuses to move higher, according to the boards it's because market makers — Wall Street financial institutions that keep the markets ticking by buying and selling shares at the best price available — are looking to line their pockets. Posts like "It's MMs trying to take your money" are common on the Yahoo! Finance and Raging Bull message boards.
In most cases, the boards are just an easy way for investors to blow off steam about a bad investment. But in the wild-and-wooly world of penny-stock investing, investor cries of market-maker foul play have been taken to a new level. It's become an article of faith among this crowd that market makers will stop at nothing — including outright stock manipulation — to make a buck. And many investors are spreading that gospel across the Web.
“We are blind as to what is going on. Any information we could get about what the market makers are doing would be helpful. It would make it more fair for investors.”
Lisa Ulshafer
Penny-stock investor
Sites like OTC News Network fan the flames with eye-grabbing headlines like "MM Fraud Bankrupts Many OTCBB Companies" and "Who Should We Blame, MMs or Ourselves?'' There's even a special message board on Raging Bull — "How MMs Manipulate the Market" — devoted solely to discussing market-maker machinations. In many instances, market makers are pilloried right along with the stock scammers and rogue brokerages that have treated the OTC Bulletin Board as their own personal playground.
One passionate penny-stock investor, Lisa Ulshafer, is mounting her own crusade against what she perceives as widespread market-maker abuse. Visitors to her not-too-subtly named site, www.stopmmmanipulation.com, are asked to email a copy of a letter she penned protesting market-maker manipulation to the Securities and Exchange Commission. So far, federal regulators say more than 1,300 people have followed her lead.
No one disputes that there's an inherent conflict between the interests of investors and market makers. While investors try to buy at the lowest price and sell at the highest price possible, big market-making firms like Knight Trading Group (NITE) and Herzog Heine & Geduld make most of their money off the "spread," the difference between the price at which they buy a stock from one investor and sell to another. Executing a trade is a zero-sum game, with a winner and a loser. And the market maker is always the winner. But because each stock has several market makers, it's a fairly competitive business: Brokers shop among the market makers to find the best price. (Market makers shouldn't be confused with specialists on the auction-style exchanges like the New York Stock Exchange. Brokers use market makers to trade in Nasdaq and Bulletin Board stocks; specialists are supposed to provide emergency liquidity in a stock when no one else will trade it.)
Penny-stock investors, though, do have a legitimate beef about the way market makers operate on the Bulletin Board in at least one respect: the reporting of outstanding short positions. When market makers — or other traders — short a stock, they're betting it will drop in value. They borrow shares and sell them to someone else at the current price. If they've guessed right, they'll be able to buy back those shares later at a lower price and return them to the lender — keeping the difference between what they paid and what they sold the shares for as profit. Of course, if the stock goes up, the trader's sunk.
Traders aren't required to publicly disclose their short positions in a penny stock, something they must generally do for all Nasdaq- and NYSE-traded stocks. The much looser reporting requirements on the Bulletin Board, a marketplace of 3,600 small-company stocks, have led to allegations that market makers and other traders aggressively short penny stocks much more so than they do on the Nasdaq. Since there's no reporting requirement, no one knows for sure.
The National Association of Securities Dealers, which runs both the Nasdaq and the Bulletin Board, says it has never gathered information about short interest in Bulletin Board stocks. But it does publish monthly the accumulated short interest on all Nasdaq stocks — important information to investors, who can use it to gauge bearish sentiment on a stock.
Penny-stock investors say the discrepancy isn't fair — and that it gives market makers on the Bulletin Board a huge advantage, since investors have no way of knowing just how high the short interest in a particular penny stock is.
"We are blind as to what is going on," says Ulshafer, a freelance Web designer and founder of an online investment club that trades only in Bulletin Board stocks. "Any information we could get about what the market makers are doing would be helpful. It would make it more fair for investors."
“[People] don't seem to understand what market-making is all about. There are certain people who are enamored of these stocks, and we are the only ones they can get mad at.”
Michael Dorsey
Knight Trading Group
general counsel
The information gap has led to some wild conspiracy theories in stock chat rooms. One of the more extreme accusations is that market makers pay "bashers" to write negative comments in message boards about companies they're shorting, to drive down the stock price. Since market makers take such extreme short positions, the theory goes, they need to drive share prices down so that shorting doesn't cost them their shirts.
On the surface that might make sense: The last thing any trader wants is to be short in a stock that's rising. When things get out of hand, the result can be a short squeeze — a situation in which the big short positions combine to send a rising stock price even further upward because everyone's trying to buy before the price rises more.
So the notion that market makers are paying people to drive stock prices down — which would be illegal — is at least rooted in logic. But there isn't a shred of evidence to prove this. The SEC says it's never found an instance of paid bashing by market makers, and officials with market-maker firms say the very suggestion is absurd. "I've read some of these messages...and [people] don't seem to understand what market-making is all about," says Michael Dorsey, general counsel for Knight, the nation's largest market-making firm. "There are certain people who are enamored of these stocks, and we are the only ones they can get mad at."
Indeed, while many penny-stock investors think there's something fishy if not downright illegal about market makers shorting stocks, the SEC says it's legit. In fact, SEC officials say shorting by market makers is often necessary to keep the markets operating smoothly. Why? Market makers are supposed to sell a stock when investors want to buy it. When there's a big buying demand, a market maker may have to go short and borrow shares in order to a produce a ready supply of stock. "I don't know how you can be a market maker without going short," says Knight's Dorsey.
The lesson in all of this? Penny-stock investors should be wary. There's a good chance the market makers in a particular stock may be betting its price is going to fall, but you'll never know. Still, you shouldn't believe everything you read on message boards. Sometimes, the truth really isn't out there.
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