Frontrunning and Finance: Left Foot Forward

This month, the Obama administration moved to regulate the so-called ‘invisible’ financial instruments that have come to rule the world of finance. Variations of the ‘shadow’ banking system — or, in the preferred language of financiers, market ‘risk management tools’ — have increasingly taken the spotlight during the current crises.

Jim Cramer, on one of those CNBC webcasts which he must have thought would never be seen by anyone who counts, appeared to admit in December to something illegal when he said, “A lot of times when I was short (stocks) at my hedge fund, I would create a level of activity beforehand that would drive the futures."

Might he have been referring to self-frontrunning, an egregious flim-flam that takes place on two separate exchanges almost simultaneously so that one regulatory eye can’t see what the other one sees? On one exchange, the hedge fund manager sells the index future, and on another, he executes a series of short sales in the stocks of which the index is composed. The net effect is to drive the future down to profitable levels. Or, in the case of Mr. Cramer, who goosed the futures after having shorted the stocks, to draw investors in to an arbitrage that he himself created.

It is strange and striking that a practice responsible for the lion’s share of the trading profits of the nation’s hedge funds and investment banks should remain a secret… even an open secret. But every morning on CNBC’s Squawk Box, commentators comfortably predict that the market will open up or down based on the movement of the futures. And nine times out of ten they are right.

This type of thing can go on ad infinitum: after having closed out the short position, one might readily go long the index future and likewise the composite stocks and make money on the upside as well. While not foolproof – a critical mass of fools could upend such plans in a jittery trading environment – one can achieve a comfortable margin of safety by working with other hedge funds to go long or short the identical stocks and futures in concert. The effect is momentum investing in the truest sense of the term. And lofty expectations are sure to be met because the law of one price will force the futures in line with the cash every time. Add computers and a little leverage, and your hedge fund will not only spectacularly outperform the market averages, but take on far less risk in the bargain.

Of course, Wall Street firms which execute trades for hedge funds often have an advantage over the funds because they have inside knowledge of the trading plans. And they can and often do trade in advance of these moves to the detriment of the hedge fund customers. Recently, a jury convicted three former stockbrokers at Bank of America, Merrill Lynch and Smith Barney for placing open telephone lines next to the internal speaker systems to eavesdrop on block orders by hedge funds and other institutional clients.

The hedge funds are run by bright people. They caught onto this scam quickly. And rather than miss out, they joined forces with the Wall Street firms themselves to combine their financial power in concerted transactions, which makes the markets even more volatile. Mighty orchestrations of computer-driven buy and sell orders then exploit the minute-to-minute differentials of the stocks and their derivatives. Those differentials add up to trillions of dollars.

Such bold moves trigger wild price swings and send skittish investors to the exits. But the solipsistic trading strategy is so wonderfully profitable to the insiders that any thought of calming the waters prompts snickers. Regulators don’t seem to care; they think these moves improve efficiency, seemingly without realizing that the traders create the conditions under which index arbitrage makes sense.

A variant of this practice played a major role in sinking the banks during the credit crisis that began last year. Hedge funds began by shorting the banks, and then forced them into the toilet by shorting the same mortgage pools that banks carried on their balance sheets.
Mark-to-market accounting created the impression that the banks were insolvent. This not only ensured that the short positions were profitable, but forced the Financial Accounting Standards Board to rush rule changes.

Years ago, when commodity firms first adopted it, marking to the market seemed like a good idea, as investors need to know not only the cost basis of an asset, but also what it would fetch in the marketplace. Today it’s clear that the market transactions may have less to do with an asset’s actual valuation in a normal trading environment than with its desired valuation in a manipulated one.

Having ruined the banks, these same swindlers turned on the insurance companies whose short interest skyrocketed in tandem with the crashing of their shares because their annuity products were backed by the same triple-A rated mortgage bonds that reposed on the banks’ balance sheets. Ironically, some firms, such as Lincoln National, ended up buying banks to qualify for bailout money so that they could continue in business.

The stakes to the economy may seem smaller when insurers — as opposed to banks — appear insolvent, but many alarmed customers were quick to move their business elsewhere at merely the whiff of insolvency. The consequences to both industries were such that for the first time in 16 years the finance and insurance sectors of the economy actually shrank by 16 percent. They now have to raise more equity just to keep their customers.

The transactions at the source of these woes were the result of what one financial writer termed “regulatory somnambulism,” in that it allowed for the elimination of the up-tick rule — which stipulated that short sales be entered at a price that is higher than the price of the previous trade — and of naked short selling, which can sink a flagship faster than a broadside beneath the water line.

Naked short selling is a vicious twist on the usual. Normal short selling occurs when investors borrow shares and sell them, hoping the stock will fall and they can buy back the shares at a lower price. Naked short selling artificially increases the supply of a security as one can sell them without first borrowing them and thereby might technically sell more shares than actually exist. This utterly speculative practice has no bearing on the efficiency of the markets, contrary to what its practitioners claim. Its only purpose is to flood the market with sell orders and drive down share prices.

In doing so, it contributes to an inaccurate picture of financial stringency that plays a major role in the price and allocation of credit and capital, which is central to the proper running of the world economy. It’s a true tail wagging the dog phenomenon that enriches well-placed gamblers at the expense of everyone else.

Tim Koranda is a former stockbroker who now works as a professional speechwriter. He can be reached at koranda@alum.mit.edu.