Wanted: A Better Ringmaster
Today, the Securities and Exchange Commission manages Wall Street's three-ring circus with a whip and a gun. It cracks the whip to get traders to pay attention to its rules and, occasionally, it shoots a few right between the eyes. In April the SEC aimed such a shot at a gaggle of NYSE specialists who made almost $20 million by trading ahead of their clients. And two months ago, the agency struck again by indicting a day-trading executive and four former stockbrokers who took bribes to let the day traders eavesdrop on the brokers' squawk boxes.
According to the SEC, a rogue day-trading executive, John Amore, paid brokers at Merrill Lynch, Citigroup and Lehman Brothers to leave their phones off the hook right next to a squawk box that broadcast big trades to the brokers before the transactions were executed. Amore's firm, A.B. Watley, allegedly made $600,000 by taking positions in front of these trades and profiting after the trades moved the market. The Watley firm 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: a Citigroup broker, Ralph Casbarro in Bayside, N.Y., 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 Corp. stock. Over the next three minutes, Watley day traders shorted 36,000 Noble shares -- selling borrowed shares with the almost certain promise of replacing them soon thereafter with less expensive ones and pocketing the difference -- at $28.63. In the next two minutes, Citigroup executed the sell order. As Noble shares dropped, Watley traders covered their shorts- buying 36,000 shares at $28.10-and pocketing a $19,000 profit.
In Wall Street, there are three rings of market information. The Inner Ring (for example, traders at major investment banks, hedge funds, and mutual fund complexes) is closest to trading decisions as they are made, and its members have the best information about the immediate future. The Middle Ring consists of intermediaries, such as analysts, brokers and the omnipresent NYSE specialists-15 of whom were charged in April with making $19 million by front-running. The Outer Ring is everybody else -- the ultimate buyers and sellers, for whom the market is a black box.
Market regulation tries to enforce fairness by keeping walls between the members of the three rings and the information possessed in the inner and middle rings. Watley profited illegally by tunneling through one of these walls. Casbarro and his peers gave privileged access to the information in the middle ring. Through his illegal payments, Amore pretended to be in the outer ring while gaining access to the middle one.
Regardless of whether Amore's scam is isolated or more widespread, it raises a broader question of fairness. Who should know what, and when? 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 inner-ring sellers of Noble Corp. 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 answer?
What the SEC needs is a ringmaster to impose order on the market from the moment its participants create material information. Its Regulation Fair Disclosure (FD) requires the managers of public companies 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?
Some shrug: Trading is a rough business; let the buyer beware. They would suggest that there is no reason that willing buyers or sellers should be protected from their ignorance of an upcoming trade. But there are already many protections for investors, ranging from the insider-trading laws to financial reporting requirements, which were put in place in the wake of abuses which cost investors money. The resulting loss of confidence diminished market liquidity and threatened the long-term survival of the markets.
Reg FD came about in 2000, after the SEC received 6,000 comment letters from individual investors who felt that securities analysts attending posh outings sponsored by management received market-moving information before they did. The SEC decided that Reg FD's cost to companies was far lower than the benefits of market liquidity that would result from plugging a leak in the dam holding in investor confidence.
Regulators must address practical questions if they are to head off further investor-confidence-shaking incidents like the Squawk Box probe and the NYSE specialist front-running indictments. Among them: How big should a trade be before disclosure is required? How soon before execution should such a transaction be disclosed?
An answer to the first question is to apply the materiality standard used for Reg FD. If the trade is considered potentially large enough to move the price more than, say, 1.5%, it should be disclosed. Regulators could set materiality thresholds by analyzing stock-price movements resulting from trades, based on the transaction's size as a percent of average daily trading volume. As for the timing of disclosure, it would be best to apply the Reg FD standard prohibiting selective disclosure by broadcasting the squawk box to all investors at the same time, not just the brokers in the trading room.
Those in the inner ring would no doubt resist the added transaction costs they would incur. However, over the longer term, stock prices would adjust to the idea that big investors will no longer be able to earn that little bit extra, due simply to the market-moving power of their fat wallets. Investors with the power to move markets owe a duty to smaller investors-and themselves -- to keep a level playing field.
If this helps preserve small investors' confidence in the market, the large ones ultimately will benefit from the added market liquidity. And until their information advantages evaporate, the stock market will remain a weighing machine whose scales slope steeply toward those privileged members of the inner ring.
Published in the October 10, 2005 Barron's