Category Archives: Securities regulation

high-frequency trading vs. computer-driven trading: the Trillium fine

September 15, 2010 By in Current Market Thoughts, Industry Analysis, Investment firms, Securities regulation Tags: , , , , , , , , Leave a comment

In the aftermath of the “flash crash” of a few months ago, regulatory authorities have been, almost frantically, looking for a cause.  My guess is they won’t be successful.  If there is a single culprit, I think he’s highly unlikely to come forward himself.  (Would you, if you thought you would be made a scapegoat and driven from the business?  Neither would I.)  And the complexity of Wall Street–almost any business, for that matter–comes from taking relatively simple ideas and repeating them over and over again, sometimes with subtle variations.  The result is an end product that’s difficult to unravel by anyone not immersed every day in that line of work.

But the search for an answer has apparently turned up non-related market abuses.  One of the is is the case of Trillium, a small brokerage house and some of its proprietary traders just disciplined by FINRA (the Financial INdustry Regulatory Authority).

to step back a minute

High-frequency trading (admittedly not an area I’m very familiar with, so leave comments if you want) seems to me to come in two flavors:

arbitrage This is the computer-driven search for pricing discrepancies that provide risk-free or low-risk trading opportunities.  These can be as simple as quirks in the bid-asked spreads of different market makers in the same security.  Or they can be differences in the prices of derivatives linked to the same underlying security, or closely-related securities.  Or they can be differences in the prices of a given theoretical financial attribute as contained in different securities or derivatives.

This activity isn’t particularly new.  Harry Markowitz started the ball rolling in the early 1950s.

order execution A large money management institution deals in very large position sizes.  It has two basic choices in controlling its buying and selling.  It can deal in the traditional way, by developing a staff of highly-skilled (and highly compensated) professional human traders, or it can use computers.  I’ve only worked in firms that took the former strategy, so I can’t say from experience how the latter works.

There are two (maybe three) problems with using human traders:  the buying and selling process can be slow, and the firm’s intentions can easily leak into the market through the counterparty before the transaction is completed.

Firms using computers break large orders down into many small ones which they hope to execute quickly with a number of different counterparties and on various trading platforms.  So they hope to get the trading done before information about their intentions has spread, and therefore with limited market impact.  As I mentioned above, I have no idea whether this works well or not.

The third issue, which I haven’t seen discussed anywhere, is who pays for the trading.  A traditional buy-side trading staff can easily cost several million dollars a year, money that is paid by the management company out of its management fees.  My guess is that high speed automated trading systems get poorer executions but are much less expensive to run.  If so, the management company saves the traders’ salaries and the clients pay the economic cost of trading through higher buy prices and lower sell prices.   On the other hand, if the blitzkrieg approach gets better executions, everybody (except the displaced traders) wins.

returning to Trillium

According to the FINRA documents linked above, what Trillium did was this:

Let’s say the best (highest) bid for stock ABC was $50 and the best (lowest) offer for ABC was $50.25.

Trillium traders would decide they wanted to sell ABC.  They would place a limit order to sell just inside the best offer, say, at $50.24.  They would then rapidly place a bunch of orders to buy ABC at different prices just below the best bid.  These orders were “often in substantial size relative to a stock’s over all legitimate pending order volume.”

The Trillium traders never intended to buy ABC.  What they wanted to do was use the false impression of rapidly building buy volume to trick day traders into thinking a powerful upward movement was about to start.  They wanted short-term traders to rush in to buy the stock to ride the impending uptrend.  Of course, the first shares to be bought would be the ones Trillium had pre-placed in the market through their limit order.

As soon as the limit order was executed, the Trillium traders cancelled their phony buy orders.

This is a boiler room operator’s ploy that’s as old as the hills.  It’s the kind of market manipulation the syndicates of the 1920s-1930s did, though on a far larger scale than Trillium.  And it’s one of the abuses that Depression-era reform of the securities markets was intended to stamp out.

is this high-frequency trading?

What does this have to do with high-frequency trading, though?  Nothing that I can see.

Yes, the Trillium traders probably used computers to enter their orders, both real and fake.  And they worked this scam over 46,000 times during the three months FINRA cited in its disciplinary action.  That’s about once every 30 seconds while Wall Street was open for business.  Otherwise, what’s the connection?

More interesting, what would cause the Huffington Post, or the Financial Times, or Fortune to say there’s one?  I don’t know.  The Fortune Street Sweep blog does have a clue, though.   In its post on Trillium, it quotes FINRA’s Thomas Gira, who’s identified on the FINRA website as executive vp of the Market Regulation Department as saying (as I read it) that Trillium’s is a high-frequency trading abuse.

Maybe there is a dark side to high-frequency trading, but I don’t see Trillium as a case in point.  I don’t get why FINRA would say it is, other than the agency must be under pressure to do something.

New SEC rules allow shareholders to nominate company directors

August 26, 2010 By in Current Market Thoughts, securities markets, Securities regulation Tags: , , , , , , , , Leave a comment

new rules on electing company directors

The SEC wasted no time in acting on the authority it got under the recently enacted Dodd-Frank (or Frank-Dodd) Wall Street Reform and Consumer Protection Act to determine shareholder ability to add materials to proxy materials of publicly traded companies.

Yesterday it set new rules that permit shareholders to place their nominees on the ballot for election to the board of directors, providing:

–the shareholder owns at least 3% of the company’s shares,

–it has been a 3% holder for three consecutive years,

–it doesn’t hold the stock as part of an effort to change control of the firm, and

–it has no side agreement to support the existing management.

A qualifying shareholder can submit nominations for up to 25% of the board.

The new rules will go into effect in about two months.

the “system” this replaces

Any shareholder could submit names to a corporation and ask that they be considered for inclusion on the proxy ballot.  But the firm had no obligation even to consider these requests, which I would imagine went directly into File 13.  A shareholder wanting change could raise his objections at the annual meeting–a futile undertaking, since management would already have obtained enough proxies to control any vote.  The only other alternative for an unhappy shareholder has been to wage a proxy fight, that is, to contact other shareholders directly and ask for their votes–a very expensive process.

Until July 2009, a proxy fight was an even more futile process than it sounds, since a brokerage firm could vote all the shares it held for clients in “street name” (basically, all of them) for the directors the broker desired, provided he had received no instructions from the shares’ owners.  Effective with voting at meetings after January 1, 2010, brokers must either vote the shares they hold for customers in accordance with their instructions, or–without instructions–not vote them at all.  Since a company’s management control the flow of investment banking business, guess who brokers tended to vote those silent shares for?

are new rules needed?

Yes, in my opinion.  Think about the recent GM bankruptcy.  Through 35 years of almost continual loss of market share, a complacent board defended stunningly incompetent management.  Both were in denial to the very end.  Both rebuffed all outside attempts to change a corporate culture of failure.

two observations–my opinions–about boards and individual shareholders

1.  In theory, shareholders elect the board of directors to supervise the operation of  company.  Directors set strategy and hire the management that carries out the board’s wishes.  In practice, the opposite is the case.  Typically, management in effect controls the board both by influencing its composition and by regulating the amount and completeness of information that it supplies to board members.  Many board members are managers or former managers of the company.  “Independent” directors may come from politics or academia and have little experience in, or even knowledge about, the industry the company is in.  All are paid for serving on the board and are indemnified by insurance against lawsuit damages for any action they may take.

It’s easy to pick a company and check.  Google the board members.  Ask yourself what industry background the independent directors have.  What’s their “day job” and how much of their time does that take?  How many other boards are they on?

2.  Oddly–to me, anyway–individual shareholders tend to be intensely loyal to management and the sitting board.  The invariably support management/board recommendations, even when company performance is poor and when proposals they are asked to vote on seem to very clearly run against shareholders’ interests.  I’ve never gotten why.  Maybe it has to do with the just-abolished practice of brokers voting clients’ stock for them.

much ado about nothing?

The consensus seems to be that the teeth have been pulled from the new voting rules by provisions two and three above, concerning change of control and three-year ownership requirement.  And you might argue that even if someone gets control of a quarter of the board, they’ll still be a frustrated minority that isn’t able to crack an “old boy” board.

maybe not

1.  25% of the board is more than it seems to be at first glance.  Suppose a large pension fund (the obvious large, benign holders of corporate stock) ended up with such representation on the board of a given firm.  I think this would say two things:  a) the company is receptive to change, and b) if you can ally with the pension fund, half the work of being able to force change through control of the board is already done.  Arguably, the first step in becoming open to change, the one taken by the pension fund, is harder, so maybe well over half the work is done.

2.  The new rules may change legal leverage in unusual ways.  I can imagine that if a few leading pension funds begin to place directors on corporate boards, they may establish a new standard for good stewardship of pensioners’ assets.  Other funds may  follow suit, if for no other reason than fear of negligence lawsuits if they don’t.

Also, when a board is a closed club that speaks with one voice and provides no information about its deliberations to the public, members may feel there are no penalties for acting as a rubber stamp for management.  If board minutes contain well-reasoned dissenting comments, or if a new board member is willing to make deliberations public–even to campaign against sitting board members in the next election–that may change.

Pressure on sitting board members to take an active part in the management of the company can come in two ways, I think.  One is possible public embarrassment, or loss of a board seat, for members who simply collect a check from the firm (for big companies, payments to directors can be hundreds of thousands of dollars) and do nothing.  Another is perhaps the greater worry that clear evidence of board members’ negligence will invalidate the liability coverage that they think protects them from the consequences of their actions.

investment implications

I think the first few proposals of alternate director candidates will be crucial in setting the tone for what will follow.  It should be interesting to watch.  It may well be that either the proposal itself, or the election of new board members, will be a signal for a period of stock outperformance.

state of New Jersey–the latest strange SEC decision

August 20, 2010 By in Current Market Thoughts, securities markets, Securities regulation Tags: , , , , , Leave a comment

New Jersey is an odd state.  On the one hand, this small but densely populated region contains a famous research university, Princeton.  It generates much of the pharmaceutical research done in the US.  It contains bedroom communities for New York City and Philadelphia, as well as miles and miles of rolling beaches, and the hills, lakes and horse farms in the western part of the state.

On the other hand, its reputation in the minds of many Americans is determined by the HBO series The Sopranos, about an organized crime family operating in NJ; the reality show Jersey Shore, whose “stars” are, ironically, New Yorkers; and a short–but heavily used–stretch of the New Jersey Turnpike that seemingly threads its way through every oil refinery, chemical plant and natural gas storage area in the Northeast. Local politicians have also done their bit to define the state’s character, as they have sued for the right to remain in office, or to run for reelection, while in their jail cells.

New Jersey has been in the financial news recently for another signal achievement–it’s the first state ever cited by the SEC for securities fraud (San Diego, CA has the dubious distinction of being the first government entity to be the subject of an SEC securities fraud action).  The charges, which New Jersey settled in an administrative proceeding this week, are basically that while Jim McGreevey and Jon Corzine were governors, the state continually deceived potential investors in its municipal bonds.  In bond offering documents and in other official state records, New Jersey either misstated or failed to disclose the increasing underfunding of state workers’ pension plans–caused in part by the fact that the state was “balancing” the budget by no longer making contributions to them.

You might think that this is the strange part.  It isn’t.  The really strange part is that in the cease-and-desist order linked in the paragraph above, no individuals are cited for this misconduct–not the governors who knew what was going on, nor the state treasurers who prepared the fraudulent financials, nor the investment bankers whose due diligence was non-existent.  In this regard, Mr. Corzine’s name in particular jumps out to me, not necessarily because his actions were any worse than the others’ but because his long career at Goldman Sachs, including serving as its CEO, make it very difficult to believe he wasn’t completely aware of the relevant securities laws and of the gravity of what New Jersey was doing.

The rationale for the SEC’s inaction–cooperation from New Jersey, which has promised to mend its ways.

The fact that this is not a court proceeding means there’s no judge to evaluate the SEC’s decision.  But it seems to me that this enforcement action–particularly in an apparently simple and straightforward case–reinforces critics (including judges, in court cases) who say that the SEC is a relatively toothless regulator, more interested in fast settlements than in adequate ones.