The Spread of Insider Trading
- by Martin Hutchinson
- August 17, 2009
"I don't see how you young chaps are going to make any money at all," said Sir Kenneth Keith to me in 1978 when told that insider trading was about to be made illegal in the United Kingdom, as it already was in the United States. How wrong my esteemed merchant bank chairman was. Far from its ban condemning "young chaps" to a life of penury, insider trading as broadly defined has become central to the profitability of the major investment banking organizations. All entirely legally, too.
Insider trading is defined by Random House as "the illegal buying and selling of securities based on privileged information." That definition rather begs the question: if nobody makes insider trading illegal, then according to Random House, it doesn't exist! It also raises the question of what information is "privileged." In the original Securities Exchange Act of 1934, insider trading was forbidden only if carried out by directors or 10% owners of a company. However, Securities and Exchange Commission (SEC) activity since 1934 has broadened the definition greatly to include such people as printers, newspaper columnists and in one case, that of the Equity Funding Corp. analyst Ray Dirks, an analyst who discovered on his own that a company's activities were fraudulent.
Before its statutory prohibition, insider trading was frowned upon by common law. In 1909, the U.S. Supreme Court declared that a director who bought a company's shares immediately before their price jumped on favorable information was committing fraud against the other shareholders. In 1912, the British Marconi scandal nearly brought down the Liberal government when it was revealed that three Cabinet ministers, one of them the future Prime Minister David Lloyd George, had profited from advance knowledge of contracts being negotiated with the Marconi company. They got off on the technicality that they had bought the shares of the U.S. Marconi subsidiary, not itself a party to the contracts.
Traditionally, insider trading in moderation was tolerated. Both merchant bankers and senior corporate management naturally had access to inside information, and it was equally natural that they should trade on it. It was regarded as one of the perks of the job, like good lunches. Brokers also were privy to the details of new issues, and so naturally made money for themselves from this knowledge. Little distinction was drawn between inside knowledge of corporate activities and that of funds flows, which could be used to trade upon equally profitably.
The U.S. prohibition on insider trading arose in the 1930s from revulsion at the practices of the 1920s bull market, and a mistaken belief that they had in some way been responsible for the subsequent economic misery. In Britain in the 1970s, there was a general trend towards greater regulation, and a revulsion against the "old boy network" of the traditional City. Thus in political circles it was felt that moving to an SEC-type regulatory system would magically improve the quality of London's markets.
Hence in both cases, insider trading was prohibited and in the United States, since the SEC had little else to do, prosecuted with some vigor. Traditional mores of corporate finance were violated by the 1966 Texas Gulf Sulphur case, in which Thomas W. Lamont, a senior partner at Morgan Stanley, was prosecuted for trading half an hour AFTER the public announcement of a minerals find had gone out across the wires.
When insider trading was prohibited, in both the United States and Britain, the definition of insider information was restricted to knowledge of corporate activities. It was presumably felt that knowledge of market funds flows was part of the stock in trade of brokers, jobbers (in Britain) and specialists (in the U.S.). Thus it would be both unfair and impracticable to prosecute trading based on this knowledge. Only the practice of "front running" was prohibited, by which a broker traded in front of a large institutional order. Even that practice, so obviously contrary to the interests of the client, remained in reality a frequent source of trader profits.
Philosophically, that loophole made no sense. Presumably the objection to insider trading based on corporate information was that it was unfair to less well-informed investors. However, knowledge of market funds flows is equally "privileged" – available only to a few people, those whose houses represent a large market share of trading in the instrument concerned.
With the proliferation of markets and the spread of computer based trading after 1980, the advantages of inside information about funds flows have multiplied. Computers are able to react in milliseconds, and take advantage almost instantaneously of new information about funds flows. Trading with such inside information, repeated in thousands of transactions daily, is a major advantage for houses which control a substantial percentage of the order volume. It has thus contributed greatly to the expansion and oligopolization of Wall Street. Through insider trading, it is more than twice as profitable to know 20% of a market's order flow as to know 10%.
As more and more instruments, including derivatives, have come to be actively traded, trading has become an ever more important part of Wall Street's income. Each individual trading profit may be quite small, but dominance of most markets by a few firms has allowed them to extract a toll on the entire volume of business in equities, bonds and most derivatives. In the purest economic sense, Wall Street has been able to extract an ever-increasing rent from the market.
In recent years, much of the share volume on the New York Stock Exchange has been generated by high-frequency traders (HFT) – computers which trade stocks instantaneously based on algorithms and information about money flows and are located physically inside the Exchange building to minimize communication times. The financial consultancy TABB Group has estimated that the total revenues from such trading amount to $21 billion annually. Although there are around 100 high-frequency trading houses, one institution, Goldman Sachs, has been estimated to have a 20% market share, and so presumably derives about $4 billion in annual revenues from this business. Most of that revenue must drop to Goldman's bottom line as net income, since the trading is done by computers, with no human traders involved.
According to a paper, "Toxic equity trading order flow on Wall Street," by the brokerage Themis Trading, there are a number of different types of HFT. Liquidity-rebate traders take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, providing liquidity to the market. When they spot a large order, they fill parts of it, then reoffer the shares at the same price, collecting the exchange fee for providing liquidity to the market.
Predatory algorithmic traders take advantage of the institutional computers that chop up large orders into many small ones. They make the institutional trader that wants to buy bid up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the "predatory algo" shorts the stock at the higher price it has reached, making the institution pay up for its shares.
Automated market makers "ping" stocks to identify large reserve book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer's limits. They use this to buy shares elsewhere and on-sell them to the institution.
Program traders buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By this, they trigger sharp market moves.
Finally, flash traders expose an order to only one exchange. They execute it only if it can be carried out on that exchange without going through the "best price" procedure intended to give sellers on all exchanges a chance at best price execution. The SEC has now promised to ban this technique.
This toxic trading has caused volume to explode, especially in NYSE listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as previously.
When you think about the examples of HFT listed above, they all constitute insider trading, in the sense of taking advantage of privileged information not available to the market as a whole. The HFT computers are located in a privileged position (for which the NYSE is said to charge $300,000 annually) so they get order information before outsiders. They use simple but proprietary programs to trade at superior prices, making money in the same way as the old illegal "front runners." If the SEC was prepared to prosecute Thomas Lamont for trading on information that had already reached the wire services half an hour previously, there can be no defense of trading on information only a few milliseconds old.
Most important, HFTs by extracting rents from the market cause it to be more volatile and unpredictable for outside investors, consistently worsening the prices at which their orders are filled and taking volume away from the NYSE specialists who theoretically make the market. By making HFT an integral part of their operations, such traders are using their privileged position to extract rents from the public just as surely as was David Lloyd George in profiting from his insider knowledge of the Marconi contracts.
The remedy is not prosecution; the market would be hugely damaged by jailing a high percentage of senior staff at all the major Wall Street houses, even if a jury could be convinced that market flow knowledge was "insider information" in the Securities Exchange Act sense. Particular HFT practices could be banned, but the algorithm designers would simply get to work designing new ones.
Instead the government should impose a "Tobin tax" by which a small amount, maybe 0.1 cents per share, would be levied on each stock transaction, with equivalent levies on other instruments. This would incommode only modestly retail and conventional institutional traders, seeking to invest long-term or even to profit from short-term moves in market sentiment. It would, however, impose a heavy cost on the algorithmic HFTs, putting the most egregious practices out of business and sharing the profitability of the remainder with the U.S. public, which has done so much to ensure Wall Street's survival in the last year.
I am generally opposed to taxation, but government must be financed somehow and a tax that reduces the rent seeking of Wall Street must be among the most economically beneficial that could be devised. Wall Street will squawk, but should be reminded that the alternative is for its traders and top management to share the fate of Thomas W. Lamont.
The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com
Views are as of August 17, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania
40997
Disclaimer
The opinions expressed are those of the author and do not necessarily reflect those of www.PrudentBear.com. This is not a recommendation to buy or sell any security, commodity or contract.
The Bear's Lair 
The Spread of Insider Trading
"I don't see how you young chaps are going to make any money at all," said Sir Kenneth Keith to me in 1978 when told that insider trading was about to be made illegal in the United Kingdom, as it already was in the United States. How wrong my esteemed merchant bank chairman was. Far from its ban condemning "young chaps" to a life of penury, insider trading as broadly defined has become central to the profitability of the major investment banking organizations. All entirely legally, too.
Insider trading is defined by Random House as "the illegal buying and selling of securities based on privileged information." That definition rather begs the question: if nobody makes insider trading illegal, then according to Random House, it doesn't exist! It also raises the question of what information is "privileged." In the original Securities Exchange Act of 1934, insider trading was forbidden only if carried out by directors or 10% owners of a company. However, Securities and Exchange Commission (SEC) activity since 1934 has broadened the definition greatly to include such people as printers, newspaper columnists and in one case, that of the Equity Funding Corp. analyst Ray Dirks, an analyst who discovered on his own that a company's activities were fraudulent.
Before its statutory prohibition, insider trading was frowned upon by common law. In 1909, the U.S. Supreme Court declared that a director who bought a company's shares immediately before their price jumped on favorable information was committing fraud against the other shareholders. In 1912, the British Marconi scandal nearly brought down the Liberal government when it was revealed that three Cabinet ministers, one of them the future Prime Minister David Lloyd George, had profited from advance knowledge of contracts being negotiated with the Marconi company. They got off on the technicality that they had bought the shares of the U.S. Marconi subsidiary, not itself a party to the contracts.
Traditionally, insider trading in moderation was tolerated. Both merchant bankers and senior corporate management naturally had access to inside information, and it was equally natural that they should trade on it. It was regarded as one of the perks of the job, like good lunches. Brokers also were privy to the details of new issues, and so naturally made money for themselves from this knowledge. Little distinction was drawn between inside knowledge of corporate activities and that of funds flows, which could be used to trade upon equally profitably.
The U.S. prohibition on insider trading arose in the 1930s from revulsion at the practices of the 1920s bull market, and a mistaken belief that they had in some way been responsible for the subsequent economic misery. In Britain in the 1970s, there was a general trend towards greater regulation, and a revulsion against the "old boy network" of the traditional City. Thus in political circles it was felt that moving to an SEC-type regulatory system would magically improve the quality of London's markets.
Hence in both cases, insider trading was prohibited and in the United States, since the SEC had little else to do, prosecuted with some vigor. Traditional mores of corporate finance were violated by the 1966 Texas Gulf Sulphur case, in which Thomas W. Lamont, a senior partner at Morgan Stanley, was prosecuted for trading half an hour AFTER the public announcement of a minerals find had gone out across the wires.
When insider trading was prohibited, in both the United States and Britain, the definition of insider information was restricted to knowledge of corporate activities. It was presumably felt that knowledge of market funds flows was part of the stock in trade of brokers, jobbers (in Britain) and specialists (in the U.S.). Thus it would be both unfair and impracticable to prosecute trading based on this knowledge. Only the practice of "front running" was prohibited, by which a broker traded in front of a large institutional order. Even that practice, so obviously contrary to the interests of the client, remained in reality a frequent source of trader profits.
Philosophically, that loophole made no sense. Presumably the objection to insider trading based on corporate information was that it was unfair to less well-informed investors. However, knowledge of market funds flows is equally "privileged" – available only to a few people, those whose houses represent a large market share of trading in the instrument concerned.
With the proliferation of markets and the spread of computer based trading after 1980, the advantages of inside information about funds flows have multiplied. Computers are able to react in milliseconds, and take advantage almost instantaneously of new information about funds flows. Trading with such inside information, repeated in thousands of transactions daily, is a major advantage for houses which control a substantial percentage of the order volume. It has thus contributed greatly to the expansion and oligopolization of Wall Street. Through insider trading, it is more than twice as profitable to know 20% of a market's order flow as to know 10%.
As more and more instruments, including derivatives, have come to be actively traded, trading has become an ever more important part of Wall Street's income. Each individual trading profit may be quite small, but dominance of most markets by a few firms has allowed them to extract a toll on the entire volume of business in equities, bonds and most derivatives. In the purest economic sense, Wall Street has been able to extract an ever-increasing rent from the market.
In recent years, much of the share volume on the New York Stock Exchange has been generated by high-frequency traders (HFT) – computers which trade stocks instantaneously based on algorithms and information about money flows and are located physically inside the Exchange building to minimize communication times. The financial consultancy TABB Group has estimated that the total revenues from such trading amount to $21 billion annually. Although there are around 100 high-frequency trading houses, one institution, Goldman Sachs, has been estimated to have a 20% market share, and so presumably derives about $4 billion in annual revenues from this business. Most of that revenue must drop to Goldman's bottom line as net income, since the trading is done by computers, with no human traders involved.
According to a paper, "Toxic equity trading order flow on Wall Street," by the brokerage Themis Trading, there are a number of different types of HFT. Liquidity-rebate traders take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, providing liquidity to the market. When they spot a large order, they fill parts of it, then reoffer the shares at the same price, collecting the exchange fee for providing liquidity to the market.
Predatory algorithmic traders take advantage of the institutional computers that chop up large orders into many small ones. They make the institutional trader that wants to buy bid up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the "predatory algo" shorts the stock at the higher price it has reached, making the institution pay up for its shares.
Automated market makers "ping" stocks to identify large reserve book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer's limits. They use this to buy shares elsewhere and on-sell them to the institution.
Program traders buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By this, they trigger sharp market moves.
Finally, flash traders expose an order to only one exchange. They execute it only if it can be carried out on that exchange without going through the "best price" procedure intended to give sellers on all exchanges a chance at best price execution. The SEC has now promised to ban this technique.
This toxic trading has caused volume to explode, especially in NYSE listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as previously.
When you think about the examples of HFT listed above, they all constitute insider trading, in the sense of taking advantage of privileged information not available to the market as a whole. The HFT computers are located in a privileged position (for which the NYSE is said to charge $300,000 annually) so they get order information before outsiders. They use simple but proprietary programs to trade at superior prices, making money in the same way as the old illegal "front runners." If the SEC was prepared to prosecute Thomas Lamont for trading on information that had already reached the wire services half an hour previously, there can be no defense of trading on information only a few milliseconds old.
Most important, HFTs by extracting rents from the market cause it to be more volatile and unpredictable for outside investors, consistently worsening the prices at which their orders are filled and taking volume away from the NYSE specialists who theoretically make the market. By making HFT an integral part of their operations, such traders are using their privileged position to extract rents from the public just as surely as was David Lloyd George in profiting from his insider knowledge of the Marconi contracts.
The remedy is not prosecution; the market would be hugely damaged by jailing a high percentage of senior staff at all the major Wall Street houses, even if a jury could be convinced that market flow knowledge was "insider information" in the Securities Exchange Act sense. Particular HFT practices could be banned, but the algorithm designers would simply get to work designing new ones.
Instead the government should impose a "Tobin tax" by which a small amount, maybe 0.1 cents per share, would be levied on each stock transaction, with equivalent levies on other instruments. This would incommode only modestly retail and conventional institutional traders, seeking to invest long-term or even to profit from short-term moves in market sentiment. It would, however, impose a heavy cost on the algorithmic HFTs, putting the most egregious practices out of business and sharing the profitability of the remainder with the U.S. public, which has done so much to ensure Wall Street's survival in the last year.
I am generally opposed to taxation, but government must be financed somehow and a tax that reduces the rent seeking of Wall Street must be among the most economically beneficial that could be devised. Wall Street will squawk, but should be reminded that the alternative is for its traders and top management to share the fate of Thomas W. Lamont.
The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com
Views are as of August 17, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania
40997
Disclaimer
The opinions expressed are those of the author and do not necessarily reflect those of www.PrudentBear.com. This is not a recommendation to buy or sell any security, commodity or contract.