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Study Confirms Bank Prop Desks Sell Ahead Of Own Research Analyst Downgrades, Finds Recurring Rule 2110-4 Violations
A recent article by the WSJ about the "Goldman huddle" sparked anger resulting from selective and advance disclosure by the firm to its choice clients about so-called trading recommendations. Yet a much more provocative study published in the October edition of the Journal Of Finance by Jennifer Juergens and Laura Lindsey titled "Getting Out Early: An Analysis of Market Making Activity at the Recommending Analyst's Firm" stands to create much more trouble for Wall Street firms if proven true, and is yet another stab at what little is left of the reputation of already disgraced regulators such as FINRA, who are now seemingly unable able to even police existing rules and regulations. Furthermore, the study is additional proof that bank prop trading needs to be, if not completely separated, than to be contained exclusively from not just client flow trading, but from internal research dissemination, and has to be much more closely regulated.
As a reminder, FINRA rule 2110-4 prohibits member firms from trading ahead of their own research analyst stock downgrades, upgrades and other calls:
Trading activity purposefully establishing, increasing, decreasing, or liquidating a position in a Nasdaq security, other exchange-listed security traded pursuant to unlisted trading privileges, or a derivative security based primarily upon a specific Nasdaq or other exchange-listed security, in anticipation of the issuance of a research report in that security is inconsistent with just and equitable principles of trade and is a violation of Rule 2110.
Nasdaq believes that such activity is conduct which is inconsistent with just and equitable principles of trade, and not in the best interests of the investors. Thus, this interpretation prohibits a member from purposefully establishing, creating or changing the firm's inventory position in a Nasdaq-listed security, other exchange-listed security traded pursuant to unlisted trading privileges, or a derivative security related to the underlying equity security, in anticipation of the issuance of a research report regarding such security by the member firm.
Yet the JOF finds that firms regularly break this rule, and that bank prop trading mysteriously increases with increased sell activity in the days ahead of a downgrade by a firm's own research analyst, questioning the validity and utility of any Chinese Walls, and just how much embedded in restricted information flow Wall Street prop trading is.
From the paper's conclusion:
We do not find corresponding increases in affiliated sell volume on the downgrade days themselves, though sell volume is significantly and positively related to affiliated downgrades before the actual revision date. We find evidence that a portion of the disproportionate sell volume prior to the downgrade date is institutional volume, and at least some of the volume comes from clients of the firm. A provocative finding is the relation between the presence of proprietary trading and associated revenue measures with predowngrade sell volume, which is suggestive of Rule 2110-4 violations.
It would appear that the entire regulatory overhaul in 2002 and 2003 has been completely discredited and all the work Eliot Spitzer had put in to enforce Chinese Walls between research departments and other bank divisions has been undone.
As for all those claims that research analysts comp is in no way related to any given upgrade or downgrade? Turns out those are bogus too.
An implication of our findings is the revenue generated from research production through the market making channel, specifically as it relates to upgrade and downgrade events. At minimum, the increase in volume is associated with an increase in trading commissions. The firm may also generate trading profits. In dollar terms, the effects are nonnegligible. For example, if we assume trading commissions of $0.05 per share (Stoll (2003)) up to $0.91 per share (obtained from conversations with full-service brokerage firms) and multiply by a rough estimate of abnormal shares traded on the release day (106,115), the average abnormal commission revenue for a typical bulge-bracket investment bank ranges from $5,305 to $96,565 for each recommendation change. Multiplying by 1,741 revisions, the average among the 12 largest firms over the year of our sample, yields abnormal commissions feasibly ranging from $9.2 million to $168.1 million per firm-year from the event day alone.
And this, of course, ignores the capital benefits from unwinding positions in stocks that within 48 hours may plunge as a result of analyst actions.
The bottom line according to the paper authors:
Though prior research finds that analyst activity garners attention for the issuing firms more broadly, we document a dramatic effect on trading activity for the issuing brokerage firms around both upgrades and downgrades. Our paper is the first to document increased trading at the recommending firm prior to the release of an analyst report, strongly suggesting that one of the ways brokerage firms recover costs is through enabling advanced trading, and that the advanced trading comes to the market maker of the recommending firm. This effect has real and significant monetary implications for these firms, as both trading commissions and execution fees from spreads are generated from increased trading volume. While market making volume is not a measure directly applicable to securities exchanges with other structures, it is likely that proprietary trading, relationships with institutional clients, and client reaction to analyst information releases would be similar across exchanges. Our results are consistent with analyst recommendations still having value to investors in a postregulatory environment, though some investors appear to receive more valuable information than others.
No surprise that "informational asymmetry" rears its ugly head once again, this time blatantly in violation of what even backward looking FINRA has stated it deems an unlawful activity. And pundits wonder why retail investors are increasingly growing more skeptical of a Wall Street whose tentacles have exploded to include not just D.C. but regulatory "capture" as well. Maybe instead of talking about what a great job it is doing, the SEC and FINRA can at least enforce their already adopted rules and regulations. Although why should they? For turning their head they afford Wall Street to make billions a year on this malfeasance alone (let alone on all the other issues we have discussed), and guarantee themselves cushy jobs that pay roughly 30 pieces of silver a year for all those years in which regulators themselves betrayed and abused investor confidence over and over.
Full paper below.
h/t Sergio
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I'm shocked!!..shocked I tell you!!!!
im glad the chinese wall has worked so well
Worked about as well as the real Chinese Wall.
I'd pay for Spitzers hooker if he would come back.
If Spitzer were willing to consider CCE imports rather than relying on Jersey girls I would be more than happy to make some arrangements for him.
Haha! Spitzer for head of SEC and FINRA. We should bait him good and proper though:
"Elliot, if you can nail these bastards to the wall, we'll give you 3 free "pardons" when you next slip up with ladies of the night"
Oh, to be the perfect human being just like you.
One can only dream. Sigh...
Once again, FINRA and the SEC have failed miserably.
Mary Schapiro must go now President Obama. Get somebody in there who will go after Goldman et. al. and get the facts straight.
Greetings deadhead,
I know you know this but I'll put it out there just the same:
GS owns the whitehouse. The mighty O will be sittin this one out.
Best of luck to all ;>
"MARK IT ZERO, DUDE"
i hear you spek.... however, his base absolutely hates the cheat st establishment and so far have been giving him a pass on this matter in favor of health care, crap and trade, michelle's latest fashion nuggets, etc...... that could turn quickly
Very good points, deadhead.
Always enjoy your comments here on the ZH.
"MARK IT ZERO, DUDE"
that would be refreshing for a change
maybe with criminal prosecutions and a fine larger than the actual value of the crime
Amen Bro, you said it very well. And you know what else? Read this article here, they found paper trails of massive wrongdoing by wall street and the SEC will not reveal who dunno it, even though they know who did it: http://www.rollingstone.com/politics/story/30481512/wall_streets_naked_s...
If one is actually shocked by any of this then they haven't being paying attention.
Regardless, of chinese walls, one should always assume research is published for the purpose of corporate finance business. Specifically when it comes to upgrades.
Tyler, i can only speculate about how badly the SEC and FINRA are starting to loathe your lunatic rants.
I wouldn't put any trust in any sell side analyst.
I see that WFC upgraded BAC today......I was kind of surprised as I thought all the banks had already upgraded each other to "super duper, if you buy these banks you will become a millionaire" status.
If they are such an overweight, why are their current p/e ratios based on the rosiest of wild ass guesses out to 2011, 2012? clearly, the business model has changed and will change even more to the banks' detriment.
the capital ratios are a joke. there is still a ton of tarp money in the capital accts. the fasb 157 is a gimmick as we all know. cre is carried at par for pete's sake. siv sludge is scheduled to come back on the balance sheet in 3 months. credit contraction, nuff said.
yeah, I know the fed is propping via liquidity but this situation is the ultimate house of cards. we are so phucking stupid cuz we just let history repeat itself.
Everybody's doing it so whats the problem, a majority of investors just want their piece of the pie. The same happens when you buy a report and have hours before the market to trade. I think the little guy accepted this before but today it happens to the 10th power now. More Squid anyone
The politically appointed head of the SEC is doing precisely what she was appointed to do.
Avoid discovering any actual malfeasance by staying ignorant of the problems (not very hard to do) move the curious and outraged to the side and let the motorcade of reinflated bank (and corporate) profits sail on by.
Mission accomplished.
Thank goodness we won't have to see Mary walk around lower Manhattan in a flight suit.
Mizz Shapiro going on tour with Le Maitre Maxi.
http://www.fogmachines.net/buy-le-maitre-maxi-fogger.shtml
LOL
Unfortunately it's standard equipment these days for any political appointee handling the nations money or regulating same.
Great stuff...
Probably one of the most fraudulent examples of front-running from my days of supporting the trading desks at one of the top 5 trading firms during 96-2001 was the annual front-running of the Russell Rebalance. And I'm not talking about issuing buy / sell lists after the prop desks were fully invested. Essentially, a day or 2 before the actual rebalance, the desk would get portfolio lists from mutual fund and pension funds looking to properly rebalance their portfolios. Based on the $$$ amounts involved, the desk would either increase or decrease exposure accordingly. In 2001, a pension fund came to the table 2 days before the rebalance with a HUGE buy order. Our institutional desk "guaranteed" the close on the rebalance day. Meanwhile, for the next day and half, our prop desk bid up the buy portfolio over 12% and "sold" (actually it was simply a cross) it to the pension fund at the close on the rebalance day. Fwiw...pension fund managers were considered the "mark" by our desks...
I am sure Marla would like to hear from you. Make sure you check out the guide before you communicate.
Cheers.
I learned during the portion of my career in law enforcement that the purpose of organizations like FINRA and the SEC is to provide continuing professional education credits in how to manipulate financial markets for the greatest profit and fun while providing the necessary illusion that there are actually police on the job who support the concept of the rule of law from the perspective of law enforcement. This perspective of "prudential regulation" is especially troubling not only to persons who support the concept and practice of the rule of law, but to those who are made sacrificial lambs of the process in the pursuit of fostering and perpetuating the illusion of regulatory enforcement.
A big thank you to The Journal Of Finance and Jennifer Juergens and Laura Lindsey for their work.
+1...well spoken Miles.
Right on, and just to add to this, these so-called "regulatory" agencies will not only not prosecute the big Fed-owning banks, but are actually there to protect their monopoly on all criminal and illegal activities in the financial markets. The biggest reason they even prosecute anyone is because they are encroaching on the monopoly turf of these bastards or perhaps some big bank ended up holding the bag on account of illegal activity by that entity. The system operates EXACTLY like a mafia organization. Whoever expects these regulatory agencies to regulate anything is dreaming.
Word, GG and Miles. The SEC "prosecution" of Bank of America is a perfect example of what you're talking about.
This is so easy to resolve with today's technology....
Firstly the exchanges have to be de-fragmented so that they are easily regulated by electronic monitoring....
One needs to understand that exchanges of old are solely for a day gone by....
To be completely replaced by direct access electronic software....
What does the software do ? Very simple....When someone enters a buy on their PC....they are a first come first served time stamp on the number of units indicated....
That's all....That's all an exchange really is today....
And secondly shares outstanding are finite....Therefore Short sales are very simple....they are limited by the outstanding number and electronically tagged....
Any IB accounts would be so easy to see....on a fully electronic exchange whereby all securities of all asset classes have to discover their price....thus very easy to regulate....
But here again....there needs to be complete separation of conflicting businesses....
IBs should be providing public companies for the exchange by boilerplate entry....nothing more....
An IB cannot be allowed to be in conflict with clients....thus no security ownership will be allowed....ie no hedge funds or prop desks within the same or related firms....
A regular bank cannot hold public securities....it has to be in the business of making regular loans on a know your customer local basis....
PCs have taken the place of market makers and specialists....
Govt. policy should point towards trying to promote as much individual participation as possible while insuring against conflicting practices by the IBs and Banks....
Also factual securities information must be wiki based....
Opinionated biases are not allowed....
If one seeks opinions....this would be per name for those in the business of opinions....and their track records should be public information....
I know its old news but this story takes me back to the SEC's own insider trading episode. The capture is so deep it reminds me of the guy who smoked so much weed he forgot it was illegal. They told the IG that daytrading on insider info was a "passion" for cripes sakes! From the IG's report:
We found that the Enforcement attorneys we investigated routinely discussed stocks and investment strategies in e-mails and in public. They maintained separate folders entitled, "Stocks," in their SEC e-mail accounts and, on most days, sent e-mails from those accounts about stocks and their own stock transactions. We discovered that one of the Enforcement attorneys traded often, and even testified that the financial markets were her main hobby and passion. We found that this attorney spent much of her work day e-mailing her co-workers about various stocks. We also found that these Enforcement attorneys shared many of the same investments and had regular weekly lunch meetings where they often discussed the stock market, their own securities transactions, and their SEC work and investigative cases.
I'm sure there's GA meetings around, but that does explain 1)why GA meetings are needed and 2) no one has time to do their jobs CAUSE THEIR TRADING! (AND TRYING TO GET THE BEST INFO TO DO SO!)....I'm telling you, polygraphs are in order TO WORK IN GOVERNMENT.
"Our paper offers a number of new imperical findings ..."
HAHAHAHAHA
NEW?!?!
Reports like this are precisely the stuff that should be presented to congressional committees. You can forget about introducing new regulations when the SEC and FINRA can't even enforce the basic ones that are in place.
FINRA has no reason to even exist, because it simply fails in its self-regulatory functions.
The SEC needs to be revamped from top to bottom, with the primary goals of enforcement and investor protection-- to which it has woefully lost its way. Given Mary Shapiro's past experience (heading FINRA during the peak of finanical institution malfeasance), I can't imagine a worse person to head the SEC.
Or the best choice to head the SEC if your on the side of continuing the embezzlement of the American taxpayer.
You are correct, sir!
Great post!
Finra must be sensing their demise- they now tout their "mission" repeatedly on Bloomberg radio all day long.
They do not provide a phone number for whistle-blowers, just a deadend website.
They need a "study" to find that out? LOL!
Damn, I think the SEC and FINRA should be reassigned to drug enforcement. That way I don't have to worry about smoking a few blunts on the lap of ole Abe at the Lincoln memorial. Then put the DEA after Wall Street complete with their tools of total asset seizure and mandatory minimum sentences.
What will it take to make everyone realize that the current financial system is a cancer killing the worlds economy?
It would seem that word is getting around. Volumes are getting lower even with the HFT boost. The beast is being starved.
Why is it virtually impossible for people to say the word ENFORCEMENT?
I'll donate $1 to charity for every time I here the words; "Enforce the current Regulations" or "Enforce the Regulations currently on the books", or "Enforce the Regulations" in the TV MSM.
At the end of the day, I'll still have that same dollar in my pocket.
First Call: Prop Desk
Second Call: SAC
Third Call: Next biggest prime broker customers
Fourth Call: Friends
Fifth Call: Customers, after lunch break
a lot of this is not new. however, this a recent article from October 2009. what's new is the way in which they release information. it is not by e-mail or text and is not done verbally. it is done meerly by unusual volume activity as a "tip-off" to firms on who's downgrade is ahead.
Superb article. Well done to Tyler and the 2 Journal of Finance authors Jennifer Juergens and Laura Lindsey. Investigative reporting at its finest.