Tuesday, August 23, 2005

Squawking about the three rings

Reports about Squawk Box indictments bring to mind the three rings of market information introduced in e-Stocks. As long as the inner ring holds onto its information advantage, investors can’t rely on the fairness of the securities markets. One remedy: disclose market-moving trade information simultaneously to all market participants.

With today’s Wall Street Journal page one story, the Squawk Box saga is emerging from the shadows. What happened? A rogue day trading executive, John Amore, paid stock brokers at Merrill Lynch, Citigroup, and Lehman Brothers to leave their phones off the hook right next to a squawk box which broadcast big trades to the brokers before the trades were executed. Amore’s firm, A.B. Watley, allegedly made $600,000 by front running these trades.

Watley profited from the virtual certainty that a big trade would move the market in predictable ways. It made $19,000 in a few minutes in one such trade. Here’s how: according to the SEC, a Citigroup broker, Ralph Casbarro in Bayside, NY left his phone off the hook for Watley. At 9:52 a.m. on July 24, 2002, Watley overheard a Citigroup trader announcing an order to sell Noble (NE) stock. Over the next three minutes, Watley day traders shorted 36,000 Noble shares -- selling borrowed NE shares with the almost certain promise of replacing them soon thereafter with less expensive ones and pocketing the difference -- at $28.63 a share. Over the next two minutes, Citigroup executed the NE sell order. As NE shares dropped, Watley traders covered their short positions – buying 36,000 shares at $28.10 each – and pocketing a $19,000 profit.

Watley’s scam brings to mind the three rings of market information which include:

  • The Inner Ring (e.g., traders at major investment banks, hedge funds, and mutual fund complexes);
  • The Middle Ring (e.g., intermediaries between the inner ring and individual investors such as stock analysts, brokers like Casbarro and NYSE specialists – 15 of whom were charged in April with making $19 million by front-running); and
  • The Outer Ring (e.g., individual investors).

Market regulation tries to enforce fairness by keeping big walls between the information in the three rings. But Watley profited illegally by tunelling through one of these walls. Casbarro and his peers had simultaneous access to the information in the middle ring. Through his illegal payments, Amore pretended to be in the outer ring while in reality gaining access to the middle one.

Regardless of whether Amore’s scam is isolated or more widespread, it raises a broader question of market fairness. The real profit action is in the interaction between the inner ring, where decisions to buy or sell big blocks of stock are made, and the middle ring where they are executed. Why were the sellers of NE who placed their big order with Citigroup on July 24, 2002 so eager to dump their shares? Is it fair to those in the outer ring not to know the information that drove those big NE sellers to sell that day?

Those in the inner ring have huge information – and therefore trading – advantages over those in the outer ring. Regulation Fair Disclosure (FD) requires public company management to disclose market moving information simultaneously to all investors. As the Watley case demonstrates, big trades move markets, so why are those in the inner ring afforded a special privilege of not disclosing their trading intentions?

As long as these information advantages persist, the stock market will remain a weighing machine whose scales slope steeply towards those privileged members of the inner ring.

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