One Year Later: It's even worse for small investors
Sep 14th 2009 11:00AM
Updated Dec 4th 2009 3:23PM
A quick read of the anti-Wall Street classic Where Are the Customer's Yachts? tells you pretty much everything you need to know about how brokerages and other Wall Street sharks view customers. But the crash provided cover for developments that are clearly anti-retail investor and have been largely ignored by the authorities charged with enforcing fairness on stock markets. Let us count the ways.
High frequency trading, dark pools, and flash orders have allowed big hedge funds and trading houses to see large buy and sell orders before other participants, making it easy for them to steal profits from retail customers placing trades in the same securities. To tap into this data, hedge funds and large brokerage houses built complex computer algorithms to convert early warnings on trade requests into rapid-fire buy and sell orders.
This behavior has been going on for years, but in the booming pre-crash stock market, this inherent advantage was never questioned. A slew of hedge funds basically built their businesses around making small profits through seeing prices before anyone else. How much has this cost individual investors? Likely billions of dollars each year. And this has become a major issue because the proportion of high-speed trading in the markets has grown to represent a significant chunk of total U.S. trading -- over 50 percent, by some estimates, according to ZeroHedge. According to economist and New York Times pundit Paul Krugman, high frequency trading adds no economic value to the market and, instead, rewards bad behavior.
The market crash has also hastened the decline of so-called sell-side research. This is research sponsored by large brokerage companies and made available to all customers. This research is also widely available through many retail stock brokerages. Sell-side research formerly was profitable. Investors would pay for a bundle of trading executions and sell-side research in a mechanism called soft dollars. Soft dollars are no longer allowed at many funds, and investors increasingly frown on this opaque way of paying for what are now considered commodity trading services.
As a result, brokerages have had to find new ways to justify the cost of keeping analysts on staff, which is why Goldman Sachs (GS) started the practice of "huddling" with its best customers and giving them stock tips that are not shared with the entire customer base, according to the Wall Street Journal. Now that doesn't sound very fair, does it?
Investment banks that trade their own money have also instituted situations where their own proprietary traders, who essentially manage internal hedge funds for these banks, sit next to traders who are supposed to get the best deal for outside customers. How can this hurt retail investors? Among those outside customers are the retail brokerages that often group piecemeal retail trades into block orders. So if the large investment banks are watching these retail orders coming in and are able to trade in front of them -- a practice called front-running -- then the retail investor gets an inferior price for their trades.
Then there is the inexplicable inability of the Securities Exchange Commission to pursue investigations into any bank or financial institution of any real size. Since the inception of the credit crisis and the resulting collapse of three major financial institutions (including the bankruptcy of Lehman Bros.) , the SEC has yet to take any major enforcement action against any large investment bank. The SEC has an annual budget in excess of $900 million yet it routinely claims it does not have the money to pursue enforcement.
In light of the Bernie Madoff Case, where the SEC ignored red flag after red flag, and even stiff-armed a sophisticated investor who presented clear evidence of a pyramid scheme, it's now an open question whether the SEC is able to provide even a modicum of enforcement. Time Magazine even asked if Madoff investors could sue the SEC for failing to detect what in hindsight was an enormous elephant dancing in the corner offices of the agency. With no cop on duty, that means no penalty, and no reason for the bad guys to fear. No wonder, then, that the little guy has never had it worse on Wall Street.