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.