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THE ONLY SURE WAY OF MAKING MONEY IS THROUGH INSIDER TRADING





by Justin Fox 

There’s a wonderful scene (one of many) in Michael Lewis’s new book, Flash Boys: A Wall Street Revolt, in which John Schwall, then the head of product management at RBC Capital Markets in New York, decides one day in 2011 to figure out how stock trading had evolved into a high-speed, unfair race he thought it had become.

Schwall goes into his backyard with a cigar, a chair, and an iPad, and Googles “front-running,” “Wall Street,” and “scandal.” Before long he learns that the current market landscape was to a large extent created by the Securities and Exchange Commission’s Regulation NMS, which took effect in 2007. Regulation NMS was an attempt to crack down on front-running — profiting from knowledge of customer orders to buy or sell ahead of them — by the “specialist” firms that then still controlled trading on the New York Stock Exchange. It definitely succeeded in throttling the specialists: the news this week that Goldman Sachs is hoping to find a buyer to pay $30 million for its specialist arm, which it bought for $6.5 billion just 14 years ago, is pretty conclusive evidence of that. But in the process the new rule also spawned a whole new industry of front-runners called high-frequency traders.

As Schwall looks further back into the past — he ends up spending several work days at his local public library on Staten Island — he discovers that this was just part of a long cycle going back to the 1800s:


The entire history of Wall Street was the story of scandals, it now seemed to him, linked together tail to trunk like circus elephants. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice.

When he got back to work and described his findings to his colleagues, Schwall’s conclusion was that “U.S. financial markets had always been either corrupt or about to be corrupted.”

That’s pretty much my sense, too. In the big picture, financial middlemen exist to enable the glories of capitalism, but day-to-day they’re mainly out to separate customers from their money. This is to some extent true of any business, of course (can I interest you in an HBR subscription?), but it’s especially stark when the product being sold is financial returns and every penny taken out by intermediaries makes that product worth a little bit less.

In olden times, the middleman’s take on Wall Street was set by cartels (the stock exchanges) and more or less endorsed by government. On May 1, 1974, though, the SEC ordered the end of fixed brokerage commissions, and since then regulators in the U.S. (and elsewhere) have kept pushing for more competition, lower transaction costs, and a smaller middleman’s take. This has certainly resulted in lower stock trading commissions and, in recent years, smaller “spreads” between the prices at which brokers offer to buy or sell stocks. But the middlemen have continued to make tons and tons of money, mainly by exploiting their informational advantages over their customers.

In the case of the high-frequency traders, those informational advantages start and end with speed. While the rest of the stock market world was still operating in terms of minutes and seconds, the HFTers (led by two Chicago-based firms, hedge-fund giant Citadel and upstart GETCO, now called KCG) found a whole new world of profit in the milliseconds and microseconds between when orders were placed and filled. Thanks to their early success, and the regulatory push that had broken the NYSE/Nasdaq duopoly into a scrum of competing exchanges, the HFTers were then able to get exchanges and brokers to craft all sorts of new ways for them to make money, some of them on the face of it pretty unsavory.

But the HFTers, at least some of them, are playing the same crucial role that NYSE specialists and Nasdaq market-makers did before them — ensuring that there’s a seller for every buyer and a buyer for every seller on the stock market. What’s never answered satisfactorily in Lewis’s book is whether they’re doing a worse or better job of this than their predecessors. Lewis certainly implies that things have gotten worse in the book, and has been even more explicit in his TV experiences, but he trots out only skimpy evidence and the occasional pithy quote in support of this view. My favorite of the latter:


“There used to be this guy called Vinny who worked on the floor of the stock exchange,” said one big investor who had observed the market for a long time. “After the markets closed Vinny would get into his Cadillac and drive out to his big house in Long Island. Now there is the guy called Vladimir who gets into his jet and flies to his estate in Aspen for the weekend. I used to worry a little about Vinny. Now I worry a lot about Vladimir.”

Don’t we all? Now, I’m not saying Lewis really owes us more than that. Nobody seems to have a good handle on the economic benefits and costs of high-frequency trading. Yes, it appears to have reduced spreads, but it has also introduced new, weird kinds of price volatility — most disturbingly the flash crashes that seem to have become a regular feature of modern stock markets. It certainly has to be healthy for this new regime to be challenged, both by the heroes of the book, a group of RBCers (Schwall among them) who leave to start their own, more transparent stock exchange, and by an author like Lewis.

Especially an author like Lewis. I’ve been meaning for a while now to buy and read two critical books on HFT published in 2012, Scott Patterson’s Dark Pools and Sal Arnuk and Joseph Saluzzi’s Broken Markets — both of which Lewis gushingly endorses. But I haven’t. I bought Flash Boys right after it was published, and read it in a day. It has already unleashed at least one epic and enlightening debate on CNBC, and will surely be sparking similar discussions for months and years to come. It shouldn’t be the last word, but it wasn’t intended to be (the book was clearly a bit of rush job, albeit it a brilliantly executed one).

In all these debates, though, it’s important to remember one thing. Yes, “the stock market is rigged,” as Lewis said on 60 Minutes. But it’s always been rigged, and that hasn’t prevented it from delivering pretty impressive returns to long-run investors. Yes, we should strive toward a market that’s rigged in the least expensive, most transparent, most efficient, most stable way possible. I don’t think we’ll ever get rid of the people (or computers) in the middle making money off the customers, though. And there may even be something to be said for letting them do it the old way, out in the open, with cartels and fixed fees and Cadillacs to drive home to Long Island.


My financial strategies are based on inside information, libertarian economics, and chaos theory. My objective is to identify the significant undiscounted aspects of economy and industries. This is where the true opportunities for investors lie and where business can get the jump on competitors. My approach is top down, emphasizing the major themes, which will influence business and financial markets.  Basil Venitis, [email protected], http://venitism.blogspot.com, @Venitis

The only sure way of making money is through Insider Trading.  That’s why all traders are insider traders, real or imagined.  The trick of the game is to differentiate a good tip from a malevolent rumor and from a stupid rumor.  That’s where experience comes in.  I, Basil Venitis, have been trading the markets for forty years, and I can smell the bullshit instantly. Insider trading is very healthy, because it helps the markets reach the equilibrium point soon.  All insider trading legislation is stupid.  You just cannot put all people in jail!  

The permanent political class enriches itself at the expense of the rest of us. Insider trading is illegal, yet it is routine among kleptocrats. Normal individuals cannot get in on IPOs at the asking price, but kleptocrats do so routinely. Kleptocrats also get many hot issues, bypassing all fair procedures of distribution.  By funneling hundreds of millions of dollars or euros to supporters, even more campaign donations are ensured. An entire class of investors now makes all of its profits based on influence and access to kleptocrats.

Kleptocrats have transformed politics to trade. They are traders who use their power, access, and privileged information to generate wealth. And at the same time well-connected financiers and corporate leaders have made a business of politics. They come together to form a kleptocratic caste.

Political intelligence consultants are hired guns who dig for closely held information to be used to trade stocks. Many work for hedge funds and securities firms, who just happen to be some of the biggest political campaign contributors.

Trading without inside information is a handicap!  Inside trading is the normal thing to do. Otherwise, the odds are stack against you, as almost everybody else is insider trader. Handicapped traders eventually lose all their money, throwing them in the black hole of ignorance.  Be an insider trader, or do not trade at all.  Technical analysis is ridiculous, and fundamental analysis is yesterday’s news.  Inside trading is the only way to trade!

Legislators do not understand that the objective of insider trading laws is counter-intuitive, to prevent people from using and markets from adjusting to the most accurate and timely information. The rules target non-public information, a legal, not economic concept. As a result, we are supposed to make today's trades based on yesterday's information. Unfortunately, keeping people ignorant is economic folly. We make more bad decisions, and markets take longer to adjust.

Insider trading laws imbalance markets by regulating only one-half of the trading equation. A good investor makes money by knowing when not to buy or sell as well as when to buy or sell. Many insider tips alert owners to hold their shares or not to buy other ones. The sooner people act on accurate information the sooner the market will reach the equilibrium price. Interfering with the adjustment process by prosecuting people for insider trading will take the market longer to adjust.

Individuals and companies are entitled to keep proprietary information and punish those who violate that trust. But the offense should be civil, not criminal. And the punishment should fit the charge. In no case is the government justified in using intrusive enforcement measures developed to combat violent crime. The government should stop punishing investors seeking to act on the most accurate and timely information. After all, that's what the financial markets are all about.

Insider trading creates an arcane distinction between non-public and public information.  It presumes that investors should possess equal information and never know more than anyone else. It punishes traders for seeking to gain information known to some people but not to everyone.  It inhibits people from acting on and markets from reacting to the latest information. Enforcing insider trading laws does more to advance prosecutors’ careers than protect investors’ portfolios.  Information will never be perfect or equal. 


Warren Buffett borrows to finance stocks that have low volatility, low price-to-book ratios, high profits, and high dividends.




This post first appeared on Venitism, please read the originial post: here

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