Kim Snider
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February 14, 2007

Front Running - The Next Wall Street Scandal?

The SEC has launched a widespread investigation into front-running by major Wall Street firms, including Merrill Lynch, Morgan Stanley, UBS and Deutsche Bank. From the New York Times:

 

The inquiry, these people said, seems aimed at determining how pervasive insider trading, or the illegal use of market-moving nonpublic information, may be on Wall Street. Knowledge about a large trade, like the sale of a big block of stock by the mutual fund giant Fidelity, would tell a trader which way the stock would move.

 

Trading ahead of client orders, or front-running, has long been an issue on Wall Street. Large mutual fund companies have often complained in the past that Wall Street brokerage firms were front-running their trades, using information about the funds’ plans to buy or sell to make a risk-free bet on a stock’s direction.

 

But the latest S.E.C. investigation appears to have a new twist: Rather than examine whether a bank is trading ahead of its own client by using knowledge of the customer’s trade, the scope of the investigation will allow regulators to see if banks tip their valued customers who then go trade at another bank, making the paper trail harder to detect.

 

At this point, the SEC is in fact-finding mode. If they find evidence of insider trading, they will start a formal investigation.

 

Here is why this matters to you. Let's say brokerage firm XYZ gets an order to sell a major portion of Fidelity's holdings in some stock. The article uses DELL or IBM just as an example. When Fido sells, because the quantity is so big, the price of that stock is going to go down. That is known as market impact cost.

 

Now let's assume a big hedge fund is told in advance about the impending sale of shares. Knowing what is going to happen, the hedge fund gets to make a risk-free bet. But in doing so, they drive the price down too, before the mutual fund sells their shares. So they aren't just profiting on the knowledge, they are taking money out of the pockets of the mutual fund owners by, in effect, increasing market impact costs.

 

If true, and I have to say there is no hard evidence of that yet although it has been alleged for a long time, it is yet another case of brokerage firms making money at the expense of the little guy - you and I. The hedge fund makes a risk free return, the brokerage firm gets more business from the hedge fund, and you and I get screwed.

 

I have said it a million times. The reason I think you have to learn to manage your own money is Wall Street is one great big ball of conflict of interest. Everywhere you turn, there are systemic problems that cause the people who are supposed to be helping us to put their own financial interests ahead of ours.

 

I think we have enough to worry about - the possibility of financially disruptive events during our working lives and funding thirty years of retirement. Every penny that gets siphoned off to enrich Wall Street is less for you and me. The best way to make sure you make all the money off of your money is to bypass the financial services industry and take care of your money yourself.

 

That's what I think. How about you? Leave your thoughts and comments below.

 

SOURCE:

 

1. Jenny Anderson. "SEC Is Looking At Stock Trading" New York Times 6 February 2007.

http://snipurl.com/frontrunning

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.

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