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Monday, May 21, 2007

The Wall Street Shell Game – Wanna Play?

Recently, The Wall Street Journal buried a story about a settlement reached between the SEC and Morgan Stanley. The SEC found that after retail investors in their Private Wealth Management unit placed an order to buy a stock, Morgan Stanley would quote them a marked-up price, usually no more than a penny more than the stock’s actual price. According to the article, Morgan Stanley would do this on a massive scale and profit handsomely.

But that gain is likely only one of three profit centers Morgan Stanley and other major Wall Street brokerages are making off the backs of high net worth retail investor clients. The real profits exist on a much darker and sinister level. It’s known in the industry as getting a “threefer,” and the ease at which the scheme is carried out is a result of the erosion of the specialist floor broker at the New York Stock Exchange and the rise of aptly-named “dark pools.”

The easiest way to understand the “threefer” is to consider this scenario:

A major Wall Street brokerage accepts a sell order from a retail investor for 10,000 shares of a thinly traded stock. Revenue stream number one comes from the fee the retail investor must pay the brokerage to sell the stock. The brokerage then enters into what is known as “the dark pool,” where the hedge fund sharks swim. Avoiding any stock exchange or floor trader, the brokerage and the hedge fund negotiate a trade. The brokerage then marks up the stock price representing revenue stream number two and the penny markup represented in the WSJ article.

The hedge fund now sells 9,000 shares and keeps 1,000 in its own portfolio. So, the hedge fund turns back to the brokerage to execute the order via the brokerage’s pipeline to a major exchange. The hedge fund pays a fee for the pipeline to the brokerage, which completes the “threefer,” but the illicit profits don’t end there.

Why would a hedge fund make profitless trades and pay a major Wall Street brokerage for the trouble? Well, when the hedge fund buys the stock, it will be executed through a program in 1,000-share increments usually reducing the stock’s price by a few cents. Once the trade is complete, the hedge fund will ride the stock back up using the 1,000 shares it kept, sometimes increasing its stake if the arbitrage gains are significant enough. The scheme is virtually risk free and equates to a license to print money.

Worse yet, the above scenario occurs all day everyday in plain sight and is a major reason hedge funds can produce outsized returns. High net worth investors are most susceptible because their buy and sell orders are large enough to affect stock prices.

Every investor, whether institutional or retail, is entitled to the “best execution” of his or her buy/sell orders, meaning the best possible price. Institutional investors buy and selling huge positions so they are less likely to be taken advantage of because they’ll check the data.

How can a retail investor do the same? Morgan Stanley and all brokerages are actually required to disclose where a trade was executed. The rule requiring them to do so is SEC 606. The disclosure comes in the form of the confirmation document your brokerage will send to you, usually buried somewhere in the ninth or tenth item. You might see four letter acronyms representing the other market participant. Ask your broker for details on these mysterious four letter words.

If they won’t tell you or do come clean and the four letter acronyms represent a hedge fund or other firm with a proprietary trading desk, you’ve probably fallen victim to Wall Street’s secret little shell game.

So what’s the harm here? The rich-guy investor only paid a penny a share more. No harm no foul, right? Think again. The stock market is based on the principle that a stock price is the reflection of the way the market views it at a particular time. The Wall Street shell game creates a manufactured price. If there’s no guarantee that a stock is priced at market value, then the market will lose confidence, which is bad for investors big and small.


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