insider trading and ETF stripping

insider trading

Over the past couple of months there has been a constant drip, drip, drip of news conferences by the SEC on the topic of its ongoing investigation of insider trading.   Most have been to announce arrests of hedge fund-related professionals accused of this white-collar crime.  The “timed release” nature of the news flow has several objectives that I can see:

–it unsettles as yet uncaught lawbreakers, perhaps causing them to make foolish mistakes that will make their apprehension easier,

–it discourages anyone tempted to trade on confidential company information,

–it burnishes the reputation of the SEC as guardian of the securities markets, and, of course,

–it keeps unflattering stories, such as the one that the agency’s own financial statements have chronically failed to meet minimum government standards, off the front page.

ETF stripping

One the of the latest SEC announcements involves something new to me–ETF stripping. What is it?

The securities exchanges and their regulators maintain continual computer surveillance of public market trading, both of securities and derivatives.  They look for unusual patterns in volume or price movement that may indicate insider trading.   For example, three days before a merger announcement, trading in near-term call options of the target firm spikes to 5x normal volume; or the day before a surprisingly bad earnings report, puts for the stock of the company in question do the same thing.  Such deviations from the norm ring alarm bells and prompt the regulators to investigate who was trading and why.

According to the SEC, one way traders on inside information have been able to outwit this surveillance has been by buying shares in a sector ETF that contains their target stock, and shorting all the other names the ETF contains.  They end up owning only the name they want to.  But they don’t show up on the regulators’ screens as owning the target stock at all.  Instead, they’re seen as holding an index security (the ETF) and a bunch of short positions.

my thoughts

I have several thoughts:

–Most traditional investors can’t short stocks.  For those who can, there’s a very good chance that clients would notice and question the synthetic construction of a long position through ETF stripping.  So the SEC is talking about hedge funds here.

–Hedge funds would presumably piece the trading out to several brokers so that no one counterparty sees the entire picture.

–ETF stripping would be particularly hard to find if it were done by the trading desks of brokers, particularly those who act as intermediaries for ETFs and are constantly buying and selling both ETFs and their component securities.  Trading costs would be the lowest for such brokers, as well.

–There’s no reason to go to the trouble of ETF stripping other than to try to evade regulatory scrutiny.  So the practice seems to me to be a two-edged sword.  On the one hand, the chances of being detected are lessened.  On the other hand, the ETF stripper is like the burglar caught in the bank after hours with safe-cracking tools.  If caught, he can’t claim he’s there by accident.

–I can’t imagine the SEC figured this out by itself.  Instead, I presume the agency learned about ETF stripping through an arrested inside trader who offered information in exchange for a lesser sentence.

It will be interesting as this story develops to see how widespread the practice has been.