THE BEAR'S LAIR Tax is cure to 'insider' scourge
By Martin Hutchinson
"I don't see how you young chaps are going to make any money at all," said Sir
Kenneth Keith to me in 1978 when told that insider trading was about to be made
illegal in the United Kingdom, as it already was in the United States.
How wrong my esteemed merchant bank chairman was. Far from the ban condemning
"young chaps" to a life of penury, insider trading as broadly defined has
become central to the profitability of the major investment banking
organizations. All entirely legally, too.
Insider trading is defined by Random House as "the illegal buying and selling
of securities based on privileged information". That definition rather begs the
question: if nobody makes insider
trading illegal, then according to Random House, it doesn't exist! It also
raises the question of what information is "privileged". In the original
Securities Exchange Act of 1934, insider trading was forbidden only if carried
out by directors or 10% owners of a company. US Securities and Exchange
Commission (SEC) activity since 1934 has broadened the definition greatly to
include such people as printers, newspaper columnists and in one case, that of
the Equity Funding Corp analyst Ray Dirks, who discovered on his own that a
company's activities were fraudulent.
Before its statutory prohibition, insider trading was frowned upon by common
law. In 1909, the US Supreme Court declared that a director who bought a
company's shares immediately before their price jumped on favorable information
was committing fraud against the other shareholders. In 1912, the British
Marconi scandal nearly brought down the Liberal government when it was revealed
that three cabinet ministers, one of them the future prime minister David Lloyd
George, had profited from advance knowledge of contracts being negotiated with
the Marconi company. They got off on the technicality that they had bought the
shares of the US Marconi subsidiary, not itself a party to the contracts.
Traditionally, insider trading in moderation was tolerated. Merchant bankers
and senior corporate management naturally had access to inside information, and
it was equally natural that they should trade on it. It was regarded as one of
the perks of the job, like good lunches. Brokers also were privy to the details
of new issues, so naturally made money for themselves from this knowledge.
Little distinction was drawn between inside knowledge of corporate activities
and that of fund flows, which could be used to trade upon equally profitably.
The US prohibition on insider trading arose in the 1930s from revulsion at the
practices of the 1920s bull market, and a mistaken belief that they had in some
way been responsible for the subsequent economic misery. In Britain in the
1970s, there was a general trend towards greater regulation, and a revulsion
against the "old boy network" of the traditional City. Thus in political
circles, it was felt that moving to an SEC-type regulatory system would
magically improve the quality of London's markets.
Hence in both cases, insider trading was prohibited, and in the United States,
since the SEC had little else to do, prosecuted with some vigor. Traditional
mores of corporate finance were violated by the 1966 Texas Gulf Sulphur case,
in which Thomas W Lamont, a senior partner at Morgan Stanley, was prosecuted
for trading half an hour after the public announcement of a minerals
find had gone out across the wires.
When insider trading was prohibited in both the United States and Britain, the
definition of insider information was restricted to knowledge of corporate
activities. It was presumably felt that knowledge of market fund flows was part
of the stock in trade of brokers, jobbers (in Britain) and specialists (in the
US). Thus it would be both unfair and impracticable to prosecute trading based
on this knowledge.
Only the practice of "front running" was prohibited, by which a broker traded
in front of a large institutional order. Even that practice, so obviously
contrary to the interests of the client, remained in reality a frequent source
of trader profits.
Philosophically, that loophole made no sense. Presumably the objection to
insider trading based on corporate information was that it was unfair to less
well-informed investors. However, knowledge of market funds flows is equally
"privileged" - available only to a few people, those whose houses represent a
large market share of trading in the instrument concerned.
With the proliferation of markets and the spread of computer-based trading
after 1980, the advantages of inside information about fund flows have
multiplied. Computers are able to react in milliseconds and take advantage
almost instantaneously of new information about fund flows. Trading with such
inside information, repeated in thousands of transactions daily, is a major
advantage for houses which control a substantial percentage of the order
volume. It has thus contributed greatly to the expansion and oligopolization of
Wall Street. Through insider trading, it is more than twice as profitable to
know 20% of a market's order flow as to know 10%.
As more and more instruments, including derivatives, have come to be actively
traded, trading has become an ever-more important part of Wall Street's income.
Each individual trading profit may be quite small, but dominance of most
markets by a few firms has allowed them to extract a toll on the entire volume
of business in equities, bonds and most derivatives.
In the purest economic sense, Wall Street has been able to extract an
ever-increasing rent from the market.
In recent years, much of the share volume on the New York Stock Exchange has
been generated by high-frequency traders (HFT) - computers that trade stocks
instantaneously based on algorithms and information about money flows and are
located physically inside the exchange building to minimize communication
times. The financial consultancy TABB Group has estimated that the total
revenues from such trading amount to US$21 billion annually.
Although there are around 100 high-frequency trading houses, one institution,
Goldman Sachs, has been estimated to have a 20% market share, and so presumably
derives about $4 billion in annual revenues from this business. Most of that
revenue must drop to Goldman's bottom line as net income, since the trading is
done by computers, with no human traders involved.
According to a paper, "Toxic equity trading order flow on Wall Street," by the
brokerage Themis Trading, there are a number of different types of HFT.
Liquidity-rebate traders take advantage of volume rebates of about 0.25 cents
per share offered by exchanges to brokers who post orders, providing liquidity
to the market. When they spot a large order, they fill parts of it, then
reoffer the shares at the same price, collecting the exchange fee for providing
liquidity to the market.
Predatory algorithmic traders take advantage of the institutional computers
that chop up large orders into many small ones. They make the institutional
trader that wants to buy bid up the price of shares by fooling its computer,
placing small buy orders that they withdraw. Eventually the "predatory algo"
shorts the stock at the higher price it has reached, making the institution pay
up for its shares.
Automated market makers "ping" stocks to identify large reserve book orders by
issuing an order very quickly, then withdrawing it. By doing this, they obtain
information on a large buyer's limits. They use this to buy shares elsewhere
and on-sell them to the institution.
Program traders buy large numbers of stocks at the same time to fool
institutional computers into triggering large orders. By this, they trigger
sharp market moves.
Finally, flash traders expose an order to only one exchange. They execute it
only if it can be carried out on that exchange without going through the "best
price" procedure intended to give sellers on all exchanges a chance at best
price execution. The SEC has now promised to ban this technique.
This toxic trading has caused volume to explode, especially in NYSE listed
stocks. The number of quote changes has also exploded and short-term volatility
has shot up. NYSE specialists now account for only around 25% of trading
volume, instead of 80% as previously.
When you think about the examples of HFT listed above, they all constitute
insider trading, in the sense of taking advantage of privileged information not
available to the market as a whole. The HFT computers are located in a
privileged position (for which the NYSE is said to charge $300,000 annually) so
they get order information before outsiders. They use simple but proprietary
programs to trade at superior prices, making money in the same way as the old
illegal "front runners."
If the SEC was prepared to prosecute Thomas Lamont for trading on information
that had already reached the wire services half an hour previously, there can
be no defense of trading on information only a few milliseconds old.
Most important, HFTs, by extracting rents from the market, cause it to be more
volatile and unpredictable for outside investors, consistently worsening the
prices at which their orders are filled and taking volume away from the NYSE
specialists who theoretically make the market.
By making HFT an integral part of their operations, such traders are using
their privileged position to extract rents from the public just as surely as
was David Lloyd George in profiting from his insider knowledge of the Marconi
contracts.
The remedy is not prosecution; the market would be hugely damaged by jailing a
high percentage of senior staff at all the major Wall Street houses, even if a
jury could be convinced that market flow knowledge was "insider information" in
the Securities Exchange Act sense. Particular HFT practices could be banned,
but the algorithm designers would simply get to work designing new ones.
Instead, the government should impose a "Tobin tax" by which a small amount,
maybe 0.1 cents per share, would be levied on each stock transaction, with
equivalent levies on other instruments. This would incommode only modestly
retail and conventional institutional traders, seeking to invest long-term or
even to profit from short-term moves in market sentiment. It would, however,
impose a heavy cost on the algorithmic HFTs, putting the most egregious
practices out of business and sharing the profitability of the remainder with
the US public, which has done so much to ensure Wall Street's survival in the
last year.
I am generally opposed to taxation, but government must be financed somehow and
a tax that reduces the rent seeking of Wall Street must be among the most
economically beneficial that could be devised. Wall Street will squawk, but
should be reminded that the alternative is for its traders and top management
to share the fate of Thomas W Lamont.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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