If you are or aspire to be a financial regulator, you have spent much of this week assuring everyone that you were diligently looking into predatory high-frequency trading long before Michael Lewis ever dreamed of writing a book about it, who is Michael Lewis, never heard of him. Unless you're Eric Schneiderman, who managed to actually front-run Lewis's book, or the Securities and Exchange Commission, who ... ohhhhhh, the SEC. If the FBI says "we've been thinking about market structure," that is news. The SEC gets no points for just announcing that it's thinking about market structure. It has had decades to think about market structure. It has more or less created the market structure. "We also have some thoughts about how to fix what we've broken, which we'll reveal at the proper time": Not an inspiring announcement.
Schneiderman and the FBI have the luxury of thinking, but the SEC has to act. And ... what's this?
The Securities and Exchange Commission today charged the owner of a Holmdel, N.J.-based brokerage firm with manipulative trading of publicly traded stocks through an illegal practice known as “layering” or “spoofing.”
The SEC also charged the owner and others for registration violations. Two firms and five individuals agreed to pay a combined total of nearly $3 million to settle the case.
"Layering" and "spoofing"! Sure sounds like predatory trading to me. And I guess it is, I don't know, there's a lot of this:
Dondero’s trading in the stock of First Capital, Inc. (FCAP) from 9:34:24 to 9:54:09 on May 8, 2009, illustrates his pattern of layering. At 9:34:25, Dondero placed an order to buy 100 shares of FCAP at $16.20 per share. Prior to Dondero placing his order, the inside bid was $14.01 and the inside ask was $17.00. Dondero’s buy order raised the National Best Bid (“NBB”) from $14.01 to $16.20. At 9:34:29, Dondero placed an order to sell 2,000 shares of FCAP at $16.21 per share. This order did not change the National Best Offer (“NBO”) because Dondero used an order type that allowed him to not display his order to other market participants; thus, the NBO remained at $17.00.
At 9:34:31, Dondero placed two orders to buy a total of 1,000 shares of FCAP at $16.20. He immediately cancelled these orders and placed another order at 9:34:35 to buy 100 shares of FCAP for $15.10. The NBB at this point was still $16.20, established by Dondero’s open orders. At 9:36:49, Dondero again placed two orders to buy a total of 1,000 shares of FCAP at $16.20 and then immediately cancelled those orders.
... look, it goes on from there, it's page 7 of the SEC order, go read it if you're into this sort of thing; it doesn't get more interesting. Joseph Dondero ("a co-owner of Visionary Trading LLC") ended up selling 1,700 shares for an average price of $16.06, well above the inside bid before he traded, though also well below the ask. He covered his short the next day at a $2,919 profit.
How bad is this? On the one hand, I don't get hugely upset about people who use their wiles to buy stock inside the bid/offer spread. On the other hand, this thing -- posting buy orders to move the price up, because you really want to sell -- is traditionally frowned upon as a deceptive practice. Because it is deceptive, of course, though that is neither necessary nor sufficient for a practice to be frowned upon as a deceptive practice. But this is a traditionally disfavored one.
On the third hand, notice the trick on which Dondero's scheme hinged: He wanted to sell above the bid, so he posted a small displayed buy order well above the previous best bid ($16.20 versus $14.01), and he posted a large secret sell order well below the previous best offer ($16.21 versus $17.00). The result was to move the National Best Bid and Offer from $14.01/$17.00 to $16.20/$17.00, making it look like the price was going up -- instead of to $16.20/$16.21, the actual state of the market, which is a more ambiguous move. One might just argue that market rules that allow some limit orders to be displayed, and others posted by the same traders to be secret, rather invite this sort of abuse. Lots of people do argue that! And who approved those rules? (The SEC did, sorry for the rhetorical question.)
Dondero's trading seems to have been faster than I would find comfortable, though slower that the millisecond speeds used by high-frequency trading algorithms. (The SEC: "At 9:36:56 ... At 9:36:57 ... At 9:36:59 ... At 9:37:00 ... At 9:37:01 ...." ) And FCAP is not a great high-frequency trading target: It traded an average of 3,409 shares per day in May 2009, making Dondero's 20 minutes of trading half an average day's volume. High-frequency traders tend to like to trade oh I don't know frequently; a stock that trades only a couple of times a day is not really suited for the speedy predators. I suspect that the people on the other side of Dondero's trades were small-time day traders just like him.
Because Dondero's outfit, Visionary Trading LLC, doesn't seem to have been an elite high-frequency trading operation. Dondero's previous brush with fame came when he was accused of manipulating a CNBC stock-picking contest, inspiring this memorable no-comment:
Reached on the afternoon of June 13 at a local horse-racing track, he said, "I'd be happy to talk after CNBC comes out with something, but until then I have no comment."
Perhaps his algorithms were minding the shop while he stepped out to play the ponies on a Wednesday afternoon? On Thursday, they switched, and the algorithms went to the track.
The nice thing about this case is that it's a reasonably easy-to-understand case of a guy ripping off small investors in human-scale time increments. Dondero tricked the market, and the small dumb investors on the other side of his orders got burned. And the SEC caught him. Actual high-frequency trading, meanwhile, moves at speeds that the SEC has trouble monitoring, has problems that stem largely from SEC-approved market-structure rules, and is probably good for small dumb investors. Dondero is an inaccurate metaphor for the larger problems in the equity markets, but you can see why he'd be an appealing one for regulators.
I've never really grasped spoofing because it seems to rely on people being dumb and trading for non-economic reasons. I think of market manipulation as pushing up the price so you can sell to a price-insensitive buyer; for spoofing to work, you need the public equity markets to be that price-insensitive buyer.
Why does the small dumb investor get burned? In the end, whoever bought at 16.21 (or whatever average price of 16.06) bought well below the initial offer price of $17. Liquidity providing! If the small investor is trading momentum based on mid price and rushes to front run the possible big bidder of 16.2, well, his bad. If he just wanted to buy, he bought below the initial $17.
The first thing Brad [Katsuyama] noticed as he read the SEC report on the flash crash was its old-fashioned sense of time. "I did a search of the report for the word 'minute,'" said Brad. "I got eighty-seven hits. I then searched for 'second' and got sixty-three hits. I then searched for 'millisecond' and got four hits -- none of them actually relevant. Finally, I searched for 'microsecond' and got zero hits." He read the report once and never looked at it again.
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