Exchanges are inherently invested in identifying and eliminating market manipulation. One of the major goals for an exchange is to ensure ‘fair play’ in their markets.
Providing an environment in which all participants uphold market rules results in more liquidity, better spreads and more activity for the exchange. Exchanges that successfully cultivate such environments are more attractive to law-abiding traders than exchanges that do not.
Additionally, letting market manipulation continue within an exchange can be costly. A Journal of Financial Economics study of an emerging market highlights the costs of market manipulation directly.
Asim Ijaz Khwajaa of Harvard University and Atif Mianb of the University of Chicago examined data from the Securities and Exchange Commission Pakistan (SECP). They found that annual rates of return were 50 to 90 percentage points higher when brokers traded on their own behalf versus returns earned by outside investors. Neither market timing nor liquidity provision by brokers could explain this.
The authors found evidence of “pump and dump” price manipulation, which accounted for up to half of a broker’s earnings. Large rents such as this explain why emerging markets struggle to build volume.
Because of this, emerging markets often need to counteract market manipulation with good, highly visible market surveillance coupled with strong, well enforced regulations. These are powerful deterrents against “pump and dump” and other illegal practices. For example, when TurkDEX sought to establish a comprehensive trading system to detect abusive trading patterns at high-speed market rates, it installed complex event processing (CEP) software as its platform to speed the development and deployment of its surveillance applications.
There are many types of behavior that can be categorized as market manipulation and emerging markets need to be aware of the key types to monitor for, including:
• Insider trading: Trading on material data that is not known to all participants in the market. The classic example is illegally trading on merger and acquisition data that moves a stock price significantly.
• False or misleading transactions: Disingenuous trades deliberately intended to deceive other traders. “Wash trades,” for instance, occur when an unscrupulous investor simultaneously buys and sells a single instrument to increase its activity, potentially signaling that there is material news imminent. ”Painting the Tape,” trading between investors, also artificially increases the activity levels for an instrument.
• Price positioning: Altering the end-of-day price. ”Marking the Close,” when a trader makes the last trade of the day at a price significantly different from the current price, allows market-on-close orders to be executed at a price that is advantageous to the manipulator or accomplices. This can be especially damaging on an expiration Friday or an index rebalancing day. Another variant of price positioning is the abusive squeeze, whereby a person with significant control over the supply and demand of a product engages in behavior to corner the market with the aim of positioning the price of that product at a distorted level.
• Fictitious Devices: Buying or selling after erroneous news moves an instrument’s price. ”Pump and Dump” schemes attempt to boost the price of a stock through misleading statements so the perpetrators sell their positions at the peak of the hype cycle. This practice is popular in smaller exchanges and smaller stocks where the price can move quickly and dramatically on material news. ”Trash and Cash” circulates bad news about a stock, lowering the price so a trader can buy below fair market value.
A combination of several approaches is necessary to address market manipulation and increase market trust in 2012 and beyond. New technologies that can monitor all market activities in real time, including the options streams, can identify potentially abusive behavior and flag it for investigation. The challenge of identifying these behaviors across execution venues needs to be addressed both at the national and international level. Stephen Luparello, vice president of FINRA, has proposed several principles:
• Comprehensive surveillance. The regulatory structure should provide a holistic approach to regulation, where regulators can monitor and detect problematic activity across products (e.g., equity, debt and derivatives) and not just within each market and market segment.
• Fine-grain information. The structure should guarantee sufficient granularity and aggregation of audit trail data across markets and financial products so that regulators can readily identify activities -- such as direct market access, high frequency trading and algorithmic trading, among others -- and better design surveillance systems to detect market manipulation and other abusive strategies.
• Openness. The structure should ensure that audit trail data is transparent so that market participants’ trading activity is discernable to regulators. It must also prevent participants from masking their identity by using multiple identifiers or the identifiers of another broker-dealer.
Basically, knowledge is power. The more transparent and standardized we make market data, the more power everyone will have -- making it tougher for manipulators to survive and thrive.