Friday, 12 August 2011
When we think of market manipulators, names like Bernie Madoff and Mike Milken come to mind. Or perhaps it’s Michael Douglas’ character Gordon Gekko from the 1987 classic Wall Street.
These guys profited from exploiting investors, causing major losses in the process.
All three of these men went to jail for their crimes, even the fictional Gordon Gekko. But there is blatant market manipulation taking place right now that is sure to go unpunished. The worst part is that it is happening in plain sight.
What Is Market Manipulation?
Market manipulation can come in many forms.
Inside information, one of the more common forms, can be used to get an edge over investors and take advantage of their elation or panic once the information becomes public.
Insiders can be corporate executives, their close friends and family, or anyone who obtains non-public information before it’s available to the public.
An example would be an employee of the National Agricultural Statistics Service (NASS) who gains knowledge of a crop report for oranges that shows far fewer were harvested this past season. If there were fewer oranges produced, prices would be sure to rise. If that person buys thousands of OJ futures ahead of the report, he is almost sure to profit. This is a form of insider trading, punishable by law.
Another form of market manipulation is the exploitation of technology.
Take the Small Order Execution System, aka the SOES. Whenever investors use the SOES to exploit traders or manipulate prices, they may or may not be breaking the law. It is a fine line that has been walked for many years. The “SOES Bandits” gained popularity back in the late ’80s and ’90s when firms like Datek Securities allowed active traders to take advantage of a weakness in the SOES.
Some call High Frequency Trading (HFT) traders the SOES Bandits of the new millennium. While we can’t blame extreme volatility on all HFT traders, I know there are some who are taking advantage of the system and causing investors to get undesirable results in their trades.
No… the real manipulators are different animals entirely.
The Real Market Manipulators
Believe it or not, the HFT traders don’t worry me. In fact, those folks who use inside information to profit don’t bother me either (although they should be punished), but they generally don’t have the power to create massive swings in global stock markets.
The big concerns I have are coming from sources you wouldn’t expect and no one talks about… clearing houses, exchanges and even the very regulators that are supposed to protect us from manipulation, the SEC.
Clearing Houses
A clearing house is basically a financial institution that provides settlement and clearing services, and houses customer accounts and assets. This means that a clearing house matches and reconciles trades between two parties. So if you buy a stock and some other random person sells that stock to you, a clearing house ensures that the trade is properly allocated and the assets are placed in the proper account.
Firms like Goldman Sachs, JPMorgan, Pershing and Penson clear billions of dollars’ worth of transactions per day and handle billions of dollars of clients’ money.
On Monday afternoon, the hedge fund that I co-manage received a scary notice from Penson Financial stating that they were increasing margin requirements on short options over 400%.
Here is their letter:
Unrealistic Margin Requirements
To put it simply, a trade that cost us $20,000 in margin, would now cost $80,000. If we didn’t have the money to cover it, they would force us to close the position, even at a loss! That’s scary… and barefaced manipulation!
Imagine how you would feel if you bought a house with $20,000 as your down payment, moved in, and then a month later your mortgage company sent a letter forcing you to come up with an additional $60,000 in a day or it was selling your home. This is exactly what was happening to tens of thousands of people this Monday.
And guess what… It drove volatility even higher!
Penson is the largest independent provider of clearing and settlement services around the world. It clears trades for many of the brokerage firms, ones that you might do business with. It may have had a hand in creating the volatility Monday and Tuesday: they forced tens of thousands of investors and hedge funds to trade violently to cover new margin requirements.
When you force that many people into panic, you create a lot of risk. Two days later Penson reduced their unreasonable request under pressure from customers…
Exchanges are doing this as well. The Chicago Mercantile Exchange (CME) recently hiked gold margins for the second time this year. They have increased silver margins seven times already in 2011, which may be another reason silver prices are lagging.
The SEC and Other Regulators
The worst manipulation of price in my mind is the short-sale ban. France, Belgium, Italy and Spain all have banned short selling on their exchanges today. Short selling is natural, it allows for markets to find their true value, and can be an important tool for traders trying to keep their heads above water in a bear market.
The most foolish thing a regulator can do is ban short selling. Abnormal pressures and overflows will happen when you stop the markets from flowing freely. Like water, traders find the path of least resistance and bust through with a force 10 times more powerful than first thought.
The more these guys try to manipulate and control the markets, the more violent those markets will become. The potential effects are magnified because the global markets are so connected to each other.
On Sept. 19, 2008, the SEC banned short selling on 800 financial stocks for two weeks. By Oct. 2, the S&P 500 plummeted 13%. As soon as the ban was lifted, stocks dropped another 24%. Did their plan really help?
There is no doubt that negative global issues alive and well. But I believe we should let the markets perform and quit trying to control and manipulate them. Not only would they be more efficient, but investors would have more confidence. It’s hard to play and trust the game when the rules are always changing.
The media wants you to believe that Madoff ruins the game, but he only breaks the rules. Perhaps we are looking for criminals in the wrong place.
Editor’s Note: There is no doubt runaway regulations and a government gone wild have pulled the economy to a virtual halt… but that’s OK. It has led us to a class of people we call “Recession Millionaires.”
These people were not rich before the markets stumbled… just the opposite. They made their wealth because the economy crashed. To read our latest special report and see how they did it, follow the link.
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Other Related Topics: Clearing Houses , Insider Selling , Jared Levy , Market Manipulation , Option Strategies Weekly , Safe Investments
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