Articles Posted in Insider trading

Facebook’s IPO, NASDAQ and the Illiquid Electronic Marketplace Revisited

By R Tamara de Silva

May 24, 2012

According to the news people, there is blame to be had all around after shares of the largest initial public offering in history, Facebook (FB), lost almost twenty percent of their value in the first three days of being publicly traded. However, the lasting lesson of FB’s IPO is that the financial world’s increasing reliance exclusively on electronic trading often leads to catastrophic problems during critical market events.

Discontent over FB’s IPO is heard from regulators and especially investors who saw the value of the their investment drop, to those who consider that the IPO was priced to perfection at 106 times its last 12 month’s earnings or at 5 times the value of the most valuable (according to market capitalization) company in the world, Apple. The possibility of investing in FB’s initial public offering, as in any other IPO, always bore the risk of buying an IPO at a price above its market price-that is the price it has in the publicly traded market. That said, very public examples of less than elegant IPOs are said, (whether in practice their impact is meaningful or not), to threaten the investing public’s appetite for prospective IPOs. Another concern with FB’s IPO is the possibility that FB, and its lead underwriters including Morgan Stanley, J.P. Morgan, and Goldman, Sachs & Co., failed to disclose material information involving new information about FB’s revenue prospects during the IPO roadshow to all but a handful of their large clients-not the public supposedly because their larger clients had paid for the seemingly “inside information.” Keep in mind that under the federal Securities laws, information about revenue, operations and prospects of a planned IPO are considered “material information” and must be divulged to the public in a very scripted manner. This has already resulted in a class action lawsuit filed for $15 billion in damages to the investing public. Another and more significant class action lawsuit was filed on the third day of FB becoming public, a lawsuit which picks up on the most important aspect of FB’s IPO – the failure of one of the world’s largest and its fastest electronic trading platforms-the NASDAQ.[1 ] Traders and investors who placed orders in FB on the day of its IPO were stuck in limbo as the electronic exchange that calls itself, “the power behind 1 in 10 of the world’s securities transactions” froze and stopped working. NASDAQ’s software issues constitute neither a reasonable failure nor an excusable one. Let the world take note that we will rue the end of the trading floor and open outcry as FB’s IPO demonstrates how we are hostage to electronic software that like all software will fail or have glitches and show us how worthless electronic markets are when they are completely illiquid and we are held hostage to them.

All market transactions involve a degree of risk. In the law as in the markets, there is a presumption, albeit rebuttable, that the greater the amount of information a market participant has, the better able the participant is to assume and understand the risk behind a transaction. Information is valuable in decision making until such time that too much information leads to diminishing returns because the amount of information incapacitates the decision-maker and prevents him from making a decision. Risk increases dramatically when a market participant’s information about price and order execution becomes nil. This is precisely what happened to the traders of close to 30 million shares of FB on the day of its IPO because of a software glitch at the NASDAQ.
What happened on the day of FB’s IPO to most of the traders of FB shares is a condition little understood-the state of high illiquidity along with a lack of transparency. Transparency refers to the degree of information that is available. In a perfectly transparent market all relevant information about a market transaction from the price, order size, order flow, trading volume, identity of the traders/counterparties, all bids and offers available, etc. would theoretically be discoverable.

Transparency’s value in the marketplace is best explained by its absence- a condition of opaqueness. Lack of transparency in the financial markets is called opaqueness. The environment that led to the past credit crisis was opaque. In the past mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth. The participants in instruments that led to that last crisis operated in a very opaque if not downright murky environment. The mortgage related securities being traded from brokers to banks and between banks were not pegged to the value of anything tangible and often marked by model to myth. One could make the case that they were not even derivatives because their value was effectively not derived from an underlying anything.[ 2]

Illiquid and opaque markets occurred during FB’s IPO. The opposite of illiquidity in the market is liquidity. Liquidity is the lifeblood of well functioning trading markets. In its simplest terms, liquidity is the ability of a market participant to trade at his or her price-that is to get in and out of the market at their chosen price. A history of the financial markets shows that liquidity requires a broad based collection of market makers to keep markets liquid. The more market participants the better. Without market makers, we see wide illiquid market spreads. These wide bid offer spreads in turn lead to market maker defection, to volume decreases and unfavorable trading markets for the public at large.

The regulated futures market, long a stepchild of the financial markets, with open outcry and electronic trading is the most liquid and transparent market in the world. It has been remarkably free from systemic financial crisis . . .with the exception of a certain salad oil scandal. All over the world at any given time, the value and the price of an S&P500 futures contract are known. What is more impressive is that during all major crises from the market crashes to presidential assassinations, the futures markets with open outcry have maintained their liquidity and their ability to absorb even the world’s crisis level order flow or volume-without a glitch.

But most people, even corporate governance committees at financial exchanges conflate volume for liquidity-they are completely distinct. Most of the trading volume now on the largest domestic trading exchanges is in the form of electronic trading or more precisely in the equity markets, it is in high frequency trading. High frequency trading is spreading from securities to other markets like futures, currencies, derivatives, and debt instruments and to the overseas exchanges. To put this in perspective, in 2003 high frequency trading accounted for only 5% of all trading volume while today it is well over 70%.

High frequency trading firms (“HFTs”) utilize a series of algorithms to take advantage of the computers’ speed and proximity to the marketplaces to get information about orders and price before every other market participant. Three types of institutions comprise the trading volume of HFTs and are what is meant by HFTs: 48% proprietary high frequency trading firms, 46% investment banks and 6% hedge funds. Investment banks often have dual roles in owning proprietary high frequency trading firms and directing investment bank trade to and from these firms.

The physical exchanges like NYSE, NASDAQ and CBOE lease out space to HFTs that allows them to place their supercomputers directly next to the supercomputers of the exchanges thereby giving the HFTs advantages of milliseconds and microseconds-to see price and order information (inside information) before anyone else that is not paying for co-location and does not have a supercomputer with algorithms at the physical exchange. Their proximity to the servers at the physical exchanges give them an insurmountable advantage which they utilize to “trade,” or effectively front-run everyone else’s orders. Any argument that we have a level playing field in terms of price and order information in the market today is simply false.

It should be said that for the majority of the time and in non-crisis conditions, HFT works and is the major revenue generator for the electronic equity exchanges. It is argued that HFTs, like their human counterparts, are market makers in that they provide price discovery. I am profoundly skeptical of the argument that HFTs are pure market makers as this term has historically been understood because they are not active market makers. HFTs are quintessentially passive, largely using their location and software advantage to detect volume and to see order flow before everyone else and to react to it. Their market making activities are essentially different from the floor trader and floor broker who will take an unqualified risk even in the most volatile times, HFTs make markets passively by reacting to other people’s activities that they are able to see happening before anyone else can. HFTs hold their market positions for milliseconds up to a few hours. Often HFTs fish for what order flow is out there by sending out false quotes to induce a reaction and therefore gauge the type of order flow that is out there in milliseconds before retracting its bids and offers-long before anyone would react to them…things non HFTs simply cannot do and what would on the trading floor be called the jailable offenses front-running and trading on inside information…but I digress.

The fact is most volume on equity exchanges like NASDAQ and NYSE are the result of electronic order flow and HFTs. However, these “traders” or algorithms are historically the very worst market-makers when crises occur because unlike their human counterparts, they largely bolt-withdrawing and canceling bids and offers en masse. Hence in times of crisis, in the marketplace dominated by HFTs, liquidity not just lessons, in the absence of human market makers, it largely disappears. What this means for all other traders and the public is that they cannot execute their orders or trade when a market crisis occurs.

This is what happened during the Flash crash of May 6, 2010 wherein the Dow dropped almost 1,000 points (the biggest intraday loss in history) losing nearly 10% of its value in seconds along with most of the 8,000 individual stocks and exchange traded funds, some of which traded 60% below their value of seconds prior before ultimately recovering. A September 30, 2010 report by the joint staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, that studied the causes of the Flash crash found that the presence of electronic trading and its interaction with HFTs during that crisis eroded liquidity, “the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets.”[3 ]

In the case of FB’s IPO, and according to sources including the trading database developer Nanex LLC, HFTs caused the NASDAQ to have to delay the opening of trading on FB because of “excessive quote cancellations,” adding that this is “ironic enough, it was mostly HFTs that benefited later when NASDAQ quotes stopped coming from the Securities Information Processor (SIP) which transmits quotes for everyone who doesn’t get the premium direct feeds.”[ 4] In other words, NASDAQ’s software could not handle the volume of bids, offers and cancellations from HFTs before FB’s opening.

At this point, it would not be logical for the exchanges to commission independent research and study into the true impact of HFT on price discovery, liquidity and volatility and what this means to their markets because the volume of trades generated by HFTs constitutes their major source of revenue. The exchanges now have a conflict of interest between their vital public functions of providing price discovery and liquidity and their bottom line.[5 ] Both the SEC and CFTC noted in their joint report into the Flash Crash of May 6 2010 that “high trading volume is not necessarily a reliable indicator of market liquidity”. As I stated above, liquidity erodes or disappears in a market crisis where there is a prevalence of HFTs because volume comprised of quotes and price information recorded in the milliseconds (1/1000th of a second) if not microseconds (1/millionth of a second and the current speed of many HFTs) that can be withdrawn and cancelled before ever being in danger of being executed is not only not known with certainty to be recorded, but it is “noise” in terms of its impact on price discovery and it is simply not executable liquidity.

There was a time just a few years ago when the largest exchanges in the United States were de facto public utilities. They provided the most crucial of all functions to the world, they established the price of all the metals, grain, oil and bonds the world needed to exist. Price discovery and the liquidity provided by their trading members to the world was a vital service to the world economy. The equity exchanges existed primarily to provide equity capital to businesses through the exchange in ownership of shares traded at the exchange. Now the exchanges are by and large public companies with elaborate corporate structures and well paid corporate boards whose concern has shifted away from assuring the most liquid and crisis-free markets in the world to layers of decisions made by committees all with the view to revenue and deliberately not thinking outside of the revenue generating box. This is not a problem in principle except in this case it will be because the exchanges in protecting their primary revenue source, the HFTs, will no longer function as they once did and the public will suffer. Future crises will likely result in crippling illiquidity that will harm the trading public and result in massive financial losses.@
R. Tamara de Silva
May 24, 2012 Chicago, Illinois
R. Tamara de Silva is an independent trader and lawyer
1. Case 12 cv 04054 Phillip Goldberg v. NASDAQ, OMX Group, Inc. and the NASDAQ Stock Market LLC-which I am attaching here: Goldberg v. Nasdaq .pdf

2. But if they were, their value was not discoverable, or perhaps not verifiable. The values of mortgage securities were not marked to market, they were not pegged to an underlying asset, and if they were, no reasonable allowance was made for unfavorable movements in the value of the underlying assets.


5. According to one credible source, one of the Chicago exchanges has established its own HFT that will likely compete with its customers and the investing public.

Insider Trading Charges Against Goldman’s Rajat Gupta By R Tamara de Silva October 26, 2011
Yesterday Rajat K. Gupta, a Senior Partner Emeritus and Managing Director of McKinsey & Co. and Board Member of Goldman Sachs Group, Inc., was indicted on criminal charges of insider trading.[ 1] Mr. Gupta is alleged to have provided Raj Rajaratnam, the founder of one of the largest hedge funds in history, Galleon Group inside information from which Rajaratnam profited[2 ]. Mr. Gupta will likely be prosecuted by the same U.S. Attorney, Preet Bharara, who obtained a conviction and eleven year sentence (the longest sentence ever dealt on the charge of insider trading) against Raj Rajaratnam.

Mr. Gupta’s arrest comes on the heels of what has been an over four year investigation of alleged insider trading on Wall Street. The principal focus of the government’s investigation has been on whether information was passed along by analysts and consultants of companies that provide “expert network” analysis to hedge funds and mutual funds. Expert network companies arranged for meetings and calls with executives from hundreds of companies and then shared this information with traders at hedge funds and mutual funds.

The activities of expert network firms came to be discovered by the Securities and Exchange Commission (“SEC”) by analysis of the performance results of hedge funds and mutual funds. Funds that performed much better than other funds were scrutinized and essentially targeted for wiretap and surveillance. Historically the SEC has found inside trades by looking at the ticker tape (in addition to volume and unusual options activity) before and after the release of inside information.[ 3]

Even a superficial definition of terms is necessary. Insider trading is a legal term that encompasses both legal and illegal conduct. Legal insider trading occurs when corporate insiders, defined as officers, directors, and employees, buy and sell stock in their own companies. There are times when corporate insiders are prohibited from buying or selling stocks or making options plays in their own companies. Illegal insider trading generally encompasses “the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”[ 4 ]

Illegal insider trading also encompasses the “tipping” of information obtained by virtue of a tipper’s fiduciary duty, employment of relationship of trust and confidence to any third party “tippee,” who trades in the markets using or influenced by this information.

There is a significant amount of ambiguity and fluidity in the definition of who is an “insider,” who may become a “constructive insider,” what trading “on the basis of” information means, and what information, classified as property is truly “inside information.” Some of the terms used in the SEC’s Rule 10b-5[ 5], which governs insider trading, are determined in their breach as much as in their observance. Many terms in Rule 10b-5 are subject to the roving interpretations of the judiciary based upon the unique fact patterns of the cases for insider trading that reach trial. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Efforts to more precisely describe what is and what is not insider trading have been opposed by the SEC for fear that proscribing the precise conduct of Rule 10b-5 too precisely would narrow the powers of the SEC.

Congress and the SEC have extended the prohibition against trading on unequal and inside information to include of certain types of “outside” information-information about takeovers pursued by third parties-wherein there is no insider or fiduciary relationship [6 ].

In the case of Gupta, if the alleged conduct is proven to be true and the prosecution has actual proof of the information alleged exchanged in Mr. Gupta’s indictment, then it fits within the unambiguous gambit of Rule 10b-5. This would be the archetypical case of insider trading. The indictment (11 CR 907), alleges among other charges, two clear examples of insider trading:

1) In September 2008, the indictment alleges that 16-20 seconds after leaving a board meeting at Goldman wherein it was discussed that Warren Buffet would buy $5 billion of preferred shares in Goldman (at the time an extremely valuable infusion to Goldman especially given its exposure to AIG), Mr. Gupta called Rajaratnam. Rajaratnam and Galleon Tech Funds began purchasing Goldman stock immediately, which it turned around and sold after the announcement became public for a profit of $840,000 and avoided a loss of several millions of dollars;
2) On January 29, 2009, the day before Proctor and Gamble was to report its quarterly earnings, Mr. Gupta exited a board meeting at P&G wherein the earnings were revealed to be coming out below the guidance P&G had given to analysts, and conveyed this inarguably inside information to Rajaratnam. Rajaratnam immediately began shorting approximately 180,000 shares of P&G.

As in the case of Mr. Gupta, what is described in his indictment is the disclosure by an insider (board member) of unambiguous inside information. However, if the evidence of Mr. Gupta’s were not based upon actual wiretap recordings (if the prosecution had no recordings of Mr. Gupta actually conveying this information) but merely on the alleged hearsay conversations between a convicted Rajaratnam, while trying to get a reduced sentence, then the case itself becomes extremely tenuous and the evidence ambiguous.

In other cases, the problem becomes defining what is inside information and what is excellent hard won research-a problem exacerbated by the ambiguities in the definitions of the building block terms that go into what constitutes Rule 10b-5’s definition of “inside information.” Being privy to a board meeting to discuss earnings before they are released to the public or learning about a merger through a confidential email or conversation easily constitutes inside information. An insider’s disclosure of clearly inside information would violate the fiduciary duties that corporate board member and managers, as agents, owe to their principals-the ultimate principal being the shareholders.

However, hiring researchers to park next to a Federal Express shipping station and daily tally the number of shipments loaded on the trucks over time to forecast seasonal shipping performance, is by way of an example, gumshoe research that may be proprietary and hard won, but is it ever inside information? What if a hedge fund routinely employed these tactics and achieved results far superior to other funds. Assuming there are 8,000 hedge funds in the United States each trying to out guess the performance of public companies and taking a bet on whisper numbers, no one in theory has an edge aside from inside information. Unless, certain funds simply had superior information through the most aggressive research. A fund that outperformed its competitors enough would likely draw attention from the SEC, but would this fund’s use of research be inside information? To some degree the work of expert networks illustrates the problems with a roving and malleable definition of insider trading. Mr. Gupta’s indictment, taking the alleged facts as true, does not.@

R. Tamara de Silva October 26, 2011 Chicago, Illinois Footnotes:
1. The topic of insider is large and discussed thoroughly and much more substantively in my upcoming book on the United States Criminal Justice System.
2. Copy of the indictment can be retrieved here: 3. The exchanges are called self-regulatory organizations (SROs) and have historically been the best regulators and watchdogs of unusual and potentially illegal market activity.
4. 5. 17 C.F.R. § 240.10b-5, promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934.
6. United States v. O’Hagan, 521 U.S. 642 (1997)