Federal regulators are close to finishing "five or six" investigations that are based on emerging forms of false trading that use high-speed electronic access to markets.
Investigators are keying their attention on trading techniques known as "layering" and "spoofing" of orders, according to an official at the Securities and Exchange Commission. The practices were described at the annual conference of the Financial Industry Regulatory Authority, which oversees brokers.
In layering, the trading firm or firms involved send out waves of false orders intended to give the impression that the market for shares of a particular security at that moment is deep. The technique may also use a large amount of "wash trades,” that have no economic effect, to achieve the appearance of market depth. The traders then take advantage of the market’s reaction to the layering of orders.
In spoofing, the trader or traders involved will send out an order with a corresponding cancellation, often at the opening or close of the market, in order to get a particular market reaction.
The regulators have not named the firms that are being investigated.
However, a September 2010 case involving Trillium Brokerage Services is a clear example.
In that case, Trillium, through nine proprietary traders, entered legitimate limit orders and numerous large "non bona fide" orders to create a false appearance of buying and selling pressure involving different stocks.
This was designed, FINRA contended, to lure other market participants to execute orders against the legitimate limit orders entered by Trillium’s traders.
Once their limit orders were filled, the Trillium traders would then immediately cancel the non-bona fide orders. This occurred in about 46,000 instances.
FINRA censured and fined Trillium $1 million and took action against the nine traders, Trillium’s Director of Trading and its Chief Compliance Officer.
The 11 individuals were suspended from the securities industry, had to pay $802,500 in fines and disgorge about $292,000.
More recently, FINRA expelled Genesis Securities, a broker-dealer based in New York City, from its membership in the industry as a regulated broker in a suspicious trading case.
The authority also barred its majority owner and chief executive William C. Yeh from associating with any FINRA member firm.
In the Genesis case, the firm gave master accounts to a variety of its customers, allowing them to operate as unregistered broker-dealers, according to FINRA’s enforcement action. The master account holders then recruited their own customers and opened separate accounts within the master accounts so that those customers could engage in high-volume day trading.
The subaccounts used a proprietary trading platform offered by Genesis that allowed direct access to different securities exchanges in the United States.
In addition to providing a trading system, Genesis tracked commissions, profit-and- losses, deposits and withdrawals for the subaccounts, and assisted the master accounts in establishing buying power and trade limits for the subaccounts.
Genesis received approximately $7.2 million in commissions from trading in the 17 master accounts from August 1, 2007 through August 31, 2010.
Genesis failed to monitor the day trading and whether each account had the required equity of $25,000 in it.
The firm and Yeh "did nothing to curtail suspicious and potentially manipulative trading through the master accounts and subaccounts at the firm, and they also conducted little or no background checks on the traders for the subaccounts.”
In such master account cases, the master account may be in Cyprus, the subaccounts can be spread throughout the world and 200 or 300 traders in China could be using an account set up in Panama.
None of the actual traders are registered and the broker-dealer may be in New York or Chicago.
The trading can be done by point-and-click traders or algorithms or a combination of both.
The approach can create a huge volume of orders, with a single firm accounting for 4% to 7% of Nasdaq activity, for instance. Large amounts of cancellations are also generated.
The organizational structure is such that you can see two people in office somewhere on the globe entering orders back and forth at the same price limits.
Master accounts and subaccounts are part of the basic fabric of capital markets, when opened for the right reasons.
But that becomes abusive, the regulators assert, if the accounts are opened to allow "unrelated parties" to trade "for their own accounts at their own risks.
Rolling up the subaccount activity into the master account and acting like it’s all one firm’s trading also can be "make believe" and changes, illegitimately, the rules that apply to the accounts.
Rules for filing appropriate Suspicious Activity Reports may be missed and, in some cases, the structure and activity has been used to fund terrorist organizations, according to one regulator.
