Posts tagged ‘SEC’

Insider Trading: Raj Rajaratnam vs. Pete Rose

Raj vs Pete Rose

A recent Wall Street Journal article written by Donald J. Boudreaux, a professor of Economics at George Mason University, makes the case that insider trading is actually healthy for the operations of the financial markets. The arrest of Galleon Group founder and hedge fund manager, Raj Rajaratnam, is a tragedy according to the article’s author. Specifically he says, “Insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.”

Oh really? Then I suppose Professor Boudreaux would be fine with all-time leading hitter and former Cincinnati Reds Manager betting on his own baseball team to win or lose.

Another disputed aspect of insider trading by Boudreaux is the inability to monitor the crime. “Insider trading is impossible to police and…parsing the difference between legal and illegal insider trading is futile—and a disservice to all investors.” Maybe heroin and cocaine should be legalized too, since we can’t completely police these crimes either? Seems to me the insider trading laws are pretty clear what insiders can and cannot do with material information. The digital world we live in today only empowers investigators more than ever to discover clear electronic footprint trails connecting trading and banking accounts. Certainly, there will be creative crooks like Bernie Madoff that can slyly succeed for a period of time, but those that grasp too far will eventually get caught.

Professor Boudreaux goes on to describe the scenario of an unscrupulous CEO at a hypothetical company (Acme Inc.) driving a company into bankruptcy. He argues employees, creditors, and investors would be better served by a CEO enriching himself with insider trading in the name of price efficiency. Capital productivity would be enhanced for creditors/investors thanks to information efficiency and employees could manage their job hunting effectively.

Sounds great Don, but in a legal insider trading world, don’t you think inefficient, unscrupulous behavior for siphoning information from executives might lead to distracting and wasteful corporate actions? If I’m an employee at ACME Inc. and I can make more money trading ACME stock, rather than being a productive employee making widgets, then it doesn’t take a genius to figure out where my 40 hour work week concentration will reside. Moreover, how is a sabotaging CEO, who is raking in millions by shorting his company’s stock ,supposed to be a good thing for stakeholders? I strongly disagree. Stakeholders will be jeopardized more by an unfocused, greed-absorbed workforce than by the current enforcement structure, which strives for an even playing field of information.

After forcefully arguing trading on insider information should not be prohibited, the professor hedges his stance by saying there are exceptions: “There are, of course, situations in which it is in the interest of both a company and the public for that company to delay the release of information.” For example, he describes a merger situation where early information leakage could “jeopardize the prospect of achieving greater efficiencies.” If according to Boudreaux, policing of insider information is impossible, then determining what he calls “proprietary” versus “non-proprietary” information is only going to stir up a worse hornet’s nest.

In the end, if price efficiency (see story on market efficiency) and cheaper cost of capital is Professor Boudreaux’s central aim, then perhaps disclosing inside information, rather than selfishly profiting from trading on inside information, is a more suitable approach. For Pete Rose, I recommend sticking to legalized sports betting in Las Vegas as a superior strategy.

Read Full Professor Boudreaux WSJ Article

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 26, 2009 at 2:00 am 1 comment

Surviving in a Post-Merger Financial World

The financial institution dominoes have fallen.

The financial institution dominoes have fallen.

Over the last two years we have experienced the worst financial crisis since the Great Depression. As a result, financial institutions have come under assault from all angles, including its customers, suppliers, and regulators. And as we have watched the walls cave in on the banking and brokerage industries, we have seen a tremendous amount of consolidation. Like it or not, we need to adapt to the new environment.

The accelerated change began in early 2008 with the collapse of Bear Stearns and negotiated merger with JP Morgan Chase. Since then we saw the largest investment banking failure (Lehman Brothers), and the largest banking failure in history (Washington Mutual). Other mergers included the marriage of Merrill Lynch and Bank of America, the combination of Wachovia into Wells Fargo, and most recently the blending of Smith Barney into Morgan Stanley. These changes don’t even take into account the disruption caused by the government control of Fannie Mae, Freddie Mac, and AIG.

So what does all this change mean for consumers and investors?

1)     Rise in Customer Complaints: Change is not always a good thing. Customer complaints rose 54% in 2008, and climbed 86% in the first three months of 2009 according to FINRA (Financial Industry Regulatory Authority), a nongovernmental regulator of securities companies. The main complaint is “breach of fiduciary duty,” which requires the advisor to act in the best interest of the client. Making the complaint stick can be difficult if the broker only must fulfill a “suitability” standard. To combat the suitability limitation, investors would be well served by investigating an independent Registered Investment Adviser (RIA) who has a fiduciary duty towards clients.

2)     Less Competition = Higher Prices: The surviving financial institutions are now in a stronger position with the power to raise prices. Pricing can surface in various forms, including higher brokerage commissions, administrative fees, management fees, ATM fees, late fees, 12b-1 fees and more. 

3)     Customer Service Weakens: The profit pool has shrunk as lending has slowed and the real estate gravy train has come to a screeching halt. By cutting expenses in non-revenue generating areas, such as customer service, the financial institutions are having a difficult time servicing all their client questions and concerns. There is still fierce competition for lucrative accounts, but if you are lower on the totem pole, don’t expect extravagant service. 

4)     Increased Regulation: Consumer pain experienced in the financial crisis will likely lead to heightened regulation. For example, the Obama administration is proposing a consumer protection agency, but it may be years before tangible benefits will be felt by consumers. Financial institutions are doing their best to remove themselves from direct oversight by paying back government loans. In the area of financial planning, proposals have been brought to Congress to raise standards and requirements, given the limited licensing requirements. Time will tell, but changes are coming.

Investing in a Post-Merger Financial World: Take control of your financial future by getting answers from your advisor and financial institution. Get a complete list of fees. Find out if they are an independent RIA with a “fiduciary duty” to act in the client’s best interest. Research the background of the advisor through FINRA’s BrokerCheck site ( and the SEC’s Investment Adviser Public Disclosure Web site ( Get referrals and shop around for the service you deserve. Survival in a post-merger world is difficult, but with the right plan you can be successful.

For disclosure purposes, Sidoxia Capital Management, LLC is an independent Registered Investment Advisor in California.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

August 7, 2009 at 4:00 am Leave a comment

High Frequency Trading: Buggy Whip Deja Vu

Slow Frequency Traders (SFT) Moving the Direction of the Buggy Whip

Slow Frequency Traders (SFT) Moving the Direction of the Buggy Whip

Innovation can be a thorn in the side of dying legacy industries. With the advent of the internal combustion engine from Swiss inventor Isaac de Riva (1807) and the subsequent introduction of Henry Ford’s affordable Model-T automobile (1908), the buggy whip industry came under assault and eventually disappeared. I’m sure the candle lobbyists weren’t too happy either when Thomas Edison first presented the light bulb (1879).

Legacy broker dealers and floor traders are suffering similar pains as those in the buggy whip industry did. New competitors are shrewdly exploiting technology in the field of High Frequency Trading (HFT) and as a result are gaining tremendous market share. Supercomputers and complex mathematical algorithms have now invaded the financial market exchanges, shrinking the profit pools of slow-moving, fat-cat broker dealers (a.k.a., Slow Frequency Traders – SFT) by simply trading faster and smarter than the legacy dealers and exchanges. As Dan Akroyd says to Eddie Murphy in the movie Trading Places, before making millions on the commodities trading floor, “It’s either kill, or be killed.” And right now it’s the traditional broker dealers and floor traders that are getting killed. According to a study by the Tabb Group, 73% of U.S. daily equity volume currently comes from high frequency traders (up from 30% in 2005). And despite only representing 2% of the relevant, actively trading financial institutions, the HFT industry generated an estimated $21 billion in profits last year.

Source: The Financial Times

Source: The Financial Times

HFT Controversy: So what’s the big controversy regarding HFT? Critics of these high speed traders (including Joe Saluzzi at Themis Trading) claim the fast traders are unfairly using the technology for selfish, greedy profit motives, and in the process are disadvantaging investors. Screams of “front-running,” effectively using the information obtained from fast computer processes to surreptitiously trade before poor, unassuming individual investors can react, is a foundational argument used by opponents. Also the detractors argue that the additional liquidity (traditionally considered a positive factor by academics) provided by the HFT-ers is “low-quality” liquidity because the fast trades are believed to suck valuable liquidity out of the system and contribute to heightened volatility. HFT participants are equated to aggressive ticket scalpers, who in the real world buy low priced tickets and later gouge legitimate buyers by reselling the original tickets at outrageously high prices.


  • On HFT Price Impact: If HFT is so damaging for individual investors, then why have price spreads narrowed so dramatically since the existence of this fast style of trading? The computerization and decimalization of trading has made trading more efficient – much like ATM machines and e-mail have made banking and document mailing more efficient. Investors can buy at lower prices and sell at higher prices – sounds like a beneficial trend to me.
  • On HFT Volatility: If HFT-ers are demonized for the market crash, then why isn’t anyone patting them on the back or buying them a drink for the ~+50% surge in the equity markets since March of this year? Maybe the investment banks that were levered 30x’s, or the $100s of billions in unregulated mortgage debt stand to shoulder more of the volatility blame?
  • On HFT Price Discovery: At the end of the day, if HFT partakers (robots) are actually manipulating prices,  then reasonable and greedy capitalists (humans) will stabilize prices by either scooping up irrationally low-priced stocks and/or selling short  illogically high priced securities.

On HFT Front-Running and Flash Orders: The New York Times recently ran an article describing a very specific one sided scenario where “flash orders” tipped off HFT traders to unfairly exploit a profitable trade in Broadcom (BRCM) stock. However, trades do not occur in a vacuum. Other scenarios could have easily been drawn up to show HFT-ers losing money on their computer-based strategy. “Quite possibly these flash orders are happening as an unintended consequence of an automated algorithmic trading program,” says Alex Green, Managing Partner at AMG Advisory Group, an institutional trading consulting firm.  Flash orders are used when trying to display an order for a small amount of time while waiting to be displayed in the National Best Bid Best Offer (the bid-ask quotes viewable to the  public). 

In addition, if front-running is indeed occurring, it is happening at prices between the bid-ask spread, thereby incentivizing other market makers to lower their offer price and raise their bid price (a positive development for investors). Any trading occurring outside the bounds of nationally displayed regulated price quotes constitutes illegal activity and can result in time behind bars.

Common Ground – Dark Pools: One area I believe I share common ground with the SFT-ers is on the issue of “dark pools.” In this murky realm, trading occurs in pools of anonymous buyers and sellers where no price quotes are displayed. These pools are bound by the same regulations as other exchanges, but due to their opaqueness are more difficult to police. According to a recent WSJ article, intensified scrutiny has fallen on these dark pools by the SEC because a large number flash orders are routed to them. Although flash orders may not in and of itself be a problem, there is more room for potential abuse in these dark pools.

Conclusion: When all is said and done, it is very clear to me that innovation through technology has translated into a huge gain for individual and institutional investors. It may take a PhD to write the code for a complex high frequency trading algorithm, however it doesn’t take a genius to figure out spreads have narrowed and liquidity has risen dramatically over the last decade – thanks in large part to HFT technological innovation. Certainly technology, globalization, along with the introduction of electronic communication networks (ECNs) like Direct Edge, flash orders, and dark pools have made trading complex. With a denser group of players and structures, it is important that SEC Chairman Mary Schapiro continue to regulate financial market exchanges with the aim of improved transparency and equality. As long as the trends of heightened liquidity and narrowed spreads continue, investors will benefit while the buggy whip lobbyists (legacy broker dealers and floor traders) will continue to scream.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

August 3, 2009 at 4:00 am 10 comments

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