For those of you who do not yet grasp what has occurred, here is a piece I wrote last summer:
The Scandal of Day Trading: Chat Site and Broker-dealer Abuses
The most popular arena in which to day trade equities listed on the New York Stock Exchange, the American Stock Exchange and the Nasdaq National Market is that of the Internet chat site, a real-time "room" where traders, generally under the leadership of one or more equities analysts, known as "moderators," can gather together to exchange views on the direction of specific stocks and the market in general. In theory, and in fact, it is possible for a site to excel and lead full-time, committed day traders to great profit in the markets. That is the potential. The reality in the field of day trading has been that the interests of "members," fee-paying subscribers, have been utterly disregarded by many sites, in the quest for vast riches generated from the trading endeavors of others. Three of the most common abuses are outlined below.
First, and most obvious, is moderator trading. There are sites run by moderators who not only perform the function of stock market analysis, but also enjoy the right to trade on their own account. This is a clear and blatant conflict of interest. One cannot expect objectivity from anyone who has a personal financial stake in a supposedly impartial equities recommendation. For this very reason, all of the major Wall Street investment banks, firms such as Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers are quick to maintain that their analysis and trading departments are strictly segregated, and do not communicate. [The "analysis department" providing upgrades, downgrades and initiation recommendations and the "trading department" day trading (presumably not the upgrades or downgrades from the analysis department) for their own account each and every day, in addition to fulfilling their roles as specialists and market makers.] Whether this laudable objective is truly honored is another question. Many day trading advisory sites, however, do not stoop to providing even this thin pretence. They "call" stocks and trade them for their own account.. This is obvious and reprehensible, yet the practice continues to be widespread. At the extreme end of the spectrum, moderators front-run their calls, buying and selling in advance of their own recommendations, trading against their own respective memberships. A stock market advisory site with integrity will not allow its moderators to hold any equity or derivative position in the stock market at any time, let alone day trade.
Secondly, some chat sites, in the spirit of self-aggrandizement, have installed "fakes" in their trading rooms. These are impostors, fictional members created and directed by the administrators of these sites, who fulfill the role of cheerleading through constant and incredible claims of impossible stock market success. Whether this clear fraud should go unpunished is a question for the relevant authorities; whether it is immoral to mislead true traders and investors in such fraudulent fashion is beyond question. A member of a stock market advisory site with integrity must be able to expect that all members are true traders and investors, and not phantasmic spirits descending on them with fantastic, preposterous claims.
Finally, and most obscene of all, is an infinitely deceitful and illegal form of payment-for-order-flow. This practice is widely misunderstood. When an investor or trader places an order to buy or sell a stock, with for instance his/her on-line broker, that order may be routed to a specific market-maker ("MM"), or dealer in that stock, who then pays the broker a fee, or "cut" for sending the order in his/her direction. What this means is that an order is not necessarily sent to the MM who can obtain the best possible price execution; it is often sent to who will pay a client's broker, often resulting in a worse price execution than might have otherwise been achieved through good-faith order handling. This is a clear conflict of interest, and perfectly legal. I have spoken with a staff member of the Senate Permanent Subcommittee on Investigations, Committee on Governmental Affairs, who held this to be an odious practice he would like to see eliminated. Yet it remains. It is legal because it is disclosed. Most traditional brokerage houses and on-line discount brokers accept payment-for-order-flow kickbacks, and every client is required to sign a statement asserting a full understanding and acknowledgement of the existence of these agreements before an account may be activated. The fact is, payment-for-order-flow is a gross breach of the broker-client relationship, and should be illegal. Like front-running and other forms of insider trading in the early part of this century, it is a now-legal practice that has no place in our markets.
Now, when payments of this nature are not disclosed in writing, and acknowledged to exist by a client, they become completely illegal, a criminal act on both the part of the Internet site and the broker-dealer. Many chat sites contain advertising for brokers. Many of them have executed illegal agreements in which they have been paid by brokers on a continuing percentage basis for each trade executed by their members. This has led to massive and utterly illegal churning by a large number of sites, in an effort to generate commission revenue. For example, Trading Site X agrees with Broker Y that for each trade placed by a member introduced to Broker Y by Site X, Broker Y will pay Site X, for example, $6 per trade. The client is not made aware of this agreement, and continues to trade at Trading Site X because he or she believes the site to be operating in his/her best interest, attempting in good faith to issue stock recommendations free from any external bias. However, any site with this kind of agreement has a best interest only to encourage each and every member to place as many trades as possible, and pay as much as possible in commissions, regardless of the financial consequences to members in terms of capital gain or loss.
Here is how this process generally works:
1. A day trader joins a chat site, where he/she may be asked to provide privileged information about which broker he/she currently uses;
2. The site recommends one or more brokers, with whom the site has made illegal payment-for-order-flow agreements;
3. The trader becomes a client of the recommended broker;
4. The broker reports to the chat site the account has been opened;
5. The brokerage and/or chat site may "train" the trader in the hopes he/she does not go bankrupt too soon;
6. The site issues countless buy and sell advisories, in an effort to rack up as high a trading volume of its members for commissions as possible;
7. For providing this commission revenue stream, the broker pays the chat site a percentage of all commissions (often as high as 30%);
Both the broker and the chat site are far more interested in commissions than any potential market success of their client/member.
Please see the following table for a clear indication of how a trading site-brokerage firm payment-for-order-flow arrangement such as this would work, under a typical agreement, where a trading site would receive contingent percentage broker-dealer compensation for each trade placed by its members. In the following example it is assumed a membership of 200, membership access fees of $350, $6 per trade payment-for-order-flow compensation, and an average member/client trade volume of twenty tickets daily (10 round trips, a quite conservative estimate):
TRADING AND INVESTMENT SITE MEMBERSHIP VS. ILLEGAL PAYMENT-FOR-ORDER-FLOW REVENUE COMPARISON
Total Membership Trade Volume (200 Members; 20 tickets per member, daily) Membership Access Fee Revenues ($350.00 monthly) Illegal Payment-for-order-flow Revenues ($6.00/trade)
Daily 4,000 $3,100.00 $24,000.00
Monthly(assumes 22 trading days) 88,000 $70,000.00 $528,000.00
Yearly 1,056,000 $840,000.00 $6,336,000.00
In this, a typical breakdown of a trading site-brokerage firm payment-for-order-flow arrangement, payment-for-order-flow revenues are on an order of nearly eight times as high as direct membership access revenues. For this reason, many sites charge no fees whatsoever. Nevertheless, they are most certainly not "free." All sites with these kinds of agreements have an overriding interest that their members trade to an enormous volume of tickets, rather than limit themselves to a small number of trades which are high in risk/reward, which after all is the ultimate goal in day trading: high returns with minimal commissions. This is clearly not the goal of brokers and chat sites that have these agreements, however. Their goal is commission revenues.
It is estimated that the pool of full-time committed day traders is in the vicinity of 10,000 at present, and rapidly climbing. To put these figures in perspective, we estimate well over $300 million in illegal, illegitimate payments are directed to on-line chat sites every year, and this figure may very well be on a magnitude of two to three times higher. A large number of day traders we have interviewed have stated that, had they been informed of payment-for-order-flow, they would have passed on over fully 50-85% of the trades they placed while members of chat sites.
Each member of a site with an arrangement similar to that in the preceding example is in effect an unwitting employee of both his/her broker-dealer and his/her trading advisory site. A stock market advisory site with integrity should under no circumstance nor at any time be associated in any way with any brokerage firm.
This criminal behavior on the part of chat sites and broker-dealers is rampant. A majority of these sites in their very own disclaimer statements make false claims, stating that they are "not investment advisors." Anyone who accepts fees for stock market commentary, in whatever format, is legally considered to be an investment advisor, and said to be giving investment advice. (For further information, please refer to the Investment Advisor's Act of 1940, Title 15, Chapter2D, Subchapter II, Section 80b-2.) It is time some transparency and integrity were injected into the field of day trading. |
