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January 1, 2002

Big Brother Is Watching: The regulators are snooping more than ever for evidence of market manipula

By Pat S. Conti and William M. Mann

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  • Big Brother Is Watching: The regulators are snooping more than ever for evidence of market manipula
  • Page 2

You are a market maker in WONC. The inside market is 10 to 10.50 You place an open customer order to purchase 75,000 shares at the market price into POSIT, the crossing system that matches buyers and sellers at the mid-point of the NBBO periodically throughout the trading day.

You then enter an Instinet order to sell 100 shares of WONC at 10.25. Your Instinet order changes the inside market to 10 to 10.25 and lowers the NBBO midpoint from 10.25 to 10.125 (Alternatively, you move your quotation to 10 to 10.25, with the same result.) Minutes later, POSIT crosses and, voila, your customer's 75,000-share order is executed at 10.125.

When you placed your Instinet order in the opposite direction of your customer's order (or moved your inside quote), were you engaged in bona fide market making activities or were you engaged in market manipulation?

The staff of NASD Regulation, Inc. is asking this question with increased frequency. Armed with sophisticated market surveillance tools and the benefit of 20/20 hindsight, the NASDR pours over Nasdaq trading data searching for indications of market manipulation, or other fraudulent activities that harm the investing public or otherwise compromise market integrity.

Another Watchdog

Another potential watchdog in this effort is POSIT, whose technology is evidently capable of identifying suspicious trading patterns and quotation activities, and which may be obligated to report them to regulators.

Recent disciplinary actions indicate that, regardless of whose surveillance generates the lead, both the NASDR and the Securities and Exchange Commission have become increasingly active in this area. Earlier this year, the NASDR suspended and fined a trader $75,000 for entering Instinet limit orders to buy stock while placing orders to sell shares of the same stock through POSIT. The trader consented to findings that, on four occasions on the same day, he knew his Instinet orders would improve the NBBO yet cancelled those orders or let them expire after POSIT crossed.

Likewise, on November 5, 2001, the SEC filed four enforcement actions against six persons allegedly engaged in "spoofing," the use of electronic trading systems to post and promptly cancel so-called phantom quotes.'

In one case against a father and his two sons, the SEC alleged that, on at least 22 occasions, the father placed limit orders into an ECN to artificially affect the NBBO of a Nasdaq stock. He simultaneously sent flash-mail messages to his sons, who placed orders through accounts on the opposite side of the market.

Upon execution of those orders at improved prices, the father either cancelled his ECN orders or allowed them to be filled. In all four actions, the SEC seeks thousands of dollars in fines and permanent injunctions against future violations.

The recent SEC cases, which follow on the heels of actions brought last year, to date bring to six the number of SEC actions against spoofers. The NASDR has brought seven actions against persons engaged in similar conduct.

Complex Arrangement