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Tim Quast
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September 22, 2005

NYSE & NASD Investigate Guaranteed VWAP

By Gregory Bresiger

The New York Stock Exchange's regulatory arm has been vigorously investigating institutional trading violations.

"The Big Board wants to prove to people that it is serious about regulation. They're getting tougher with their independent regulatory arm," an official of a floor brokerage firm told Traders.

The NYSE joined with the NASD recently to target upstairs desks. The pair sent notices to their members, reminding them of their obligations when handling large single-stock and blind-bid portfolio trades. The regulators are looking specifically at volume-weighted average price (VWAP) trades, but indicated their concerns covered other large trades as well.

When executing VWAP or other large trades, desks should not engage in "proprietary trading activity that compromises the customer's interest in favor of a member's proprietary trading interest," asserted the NASD.

The New York used similar language, pointing out that traders should not "advance the member's or member organization's own pecuniary interests at the customer's expense."

"The NYSE and NASD are both coming down hard on institutional transactions as they never have before," charged Bill Singer, a securities attorney. He said both NASD and NYSE officials believe that eventually only one regulator will be permitted. Each wants to prove that it would be the most effective regulator, he added.

"The New York is definitely trying to improve its image, especially in light of recent scandals with specialists and Merrill Lynch," said Benn Steil, a scholar who writes about markets for the Council on Foreign Relations.

"The New York understands that as a publicly held corporation, people will be watching it more closely and that it will have to compete with other markets. Having an effective regulatory operation will give it a better image," Steil said.

The NYSE/NASD notices come at a time when some of the largest firms on Wall Street are emphasizing proprietary trading to make up for declines in their traditional cash businesses and investment banking.

VWAP trades, those executed at a stock's average price for the day, are done on best-efforts or guaranteed basis. Blind-bid portfolio trades involve competitive bidding by brokers for entire baskets of securities.

Guaranteed VWAP trades are often executed on a portfolio basis and typically are conducted at the same desk as blind binds.

Both VWAP trades and blind bids often result in the broker, to allay its risk, taking offsetting positions in the cash or derivatives markets. It is this kind of hedging that has attracted the notice of regulators. They warn brokers-when hedging-not to "unreasonably" move the market or establish artificially high or low prices through manipulative trading or quoting.

The regulators also note that desks should inform their clients in writing if they intend to hedge their trades.

Indeed the SEC has taken notice of the regulatory actions of their counterparts in the UK.

The Financial Services Authority (FSA) earlier this year fined Morgan Grenfell, DeutscheBank's brokerage subsidiary, for failing to inform a client that it was engaging in pre-hedging.

This has been happening sometimes, regulators say, when program trades are executed without providing details to the client. Brokers, in these instances, are asked to bid blindly.

Using their own market insights, brokers will guess what is in the portfolio of the clients. Brokers then hedge their risk before the transaction.

But this hedging can move up the price of the stock, resulting in a higher price for the client.

Peter Chapman contributed to this story.