Interpositioning and the latest insider trading scandal

The latest scandal conviction to be tossed relates to NYSE specialists improperly interpositioning themselves into customer trades (WSJ, HT Law Blog). The WSJ quotes Judge Denny Chin's opinion:

The government was required to prove that customers expected one thing and got something different. Without evidence of what the customers expected, no rational juror could conclude that the interpositioning trades had a tendency to deceive or the power to mislead. A juror would be able to reach that conclusion only by speculating -- impermissibly -- as to what customers expected.

I wonder if this might relate to another brewing scandal: brokerage firms making money by advance knowledge of trades by big customers. Here's how Fortune's Shawn Tully describes what's happening:

Say a fund company, call it Big Dog, wants to buy a million shares of Intel. A Big Dog trader calls a broker at a Wall Street firm - call it Megabux. The broker enters the order into the Megabux trading system. A dozen Megabux "sales traders" get the info on their computer screens. Their job is to find sellers for the shares. But first they call their top hedge fund clients, giving them the chance to buy some Intel before Big Dog pushes up the price. To cover their tracks, the hedge funds don't buy the Intel shares through Megabux, but they reward their benefactor with a lot of other big trades and by paying higher commissions than the mutual funds do.

Is this illegal? A couple of weeks ago the NYT quoted me:

The information is going to the bank as an agent, and the bank is only supposed to use the information for the mutual fund’s benefit. If it uses it for someone else’s benefit, you might have a concern.

Note that I said you might have a concern. But even as to the brokerage firm's trade or leak based on advance knowledge of the mutual fund trade, the question raised by Judge Chin's opinion is whether the mutual fund sufficiently knew of the practice that it was tacitly approving of it.

Fortune's Tully says:

Why would mutual funds put up with such abuse? "They need access to Wall Street's research and clearing services and to IPO allocations," says [former Instinet CEO Doug] Atkin, so they have to keep trading with the big brokers.

Tully also notes that the funds could trade on fully anonymous electronic systems. So when they decide to trade through the brokerage firms – particularly now – what are their expectations? Do they know that they're "paying" for the firm's other services and favors with advance knowledge of the trades? 

Tully suggests the Megabux broker might also pass the information to his firm's proprietary trading desk. Instead of buying before Big Dog (i.e., interpositioning) it bets that Big Dog buys the Intel (or a tech fund that holds it) so it can profit on Big Dog's next order. He adds:

The practice is hard to trace and may or may not be illegal. But it still hurts investors in Big Dog's funds by forcing Big Dog to pay prices that are inflated by the leaks.

Possibly. But is this speculation trading on material inside information? There are a lot of facts here that need to be unraveled, and perhaps the SEC should be looking into them. The danger is that all of this is going to disappear into the black hole of a criminal investigation and trial. After all, there's the whiff of "insider trading," which ramps up the feverish public demand that regulators and prosecutors "do something."

But a criminal trial is not the way to find out the institutional background necessary for a worthwhile regulatory fix.  It's a long and expensive process, replete with procedural roadblocks. The whole thing could end the way the NYSE specialist cases did – ten out of 15 cases aborted or lost, with this negative result in the Finnerty case.

It is worth keeping in mind that the public harm from this conduct is not large, and is offset to some extent by information flowing more quickly into the market. The private harm to the mutual fund companies is another thing, but susceptible to market forces, particularly including the fund's ability to move its trades to the anonymous venue or to brokers who can offer better assurances against misuse of information. 

Finally, it might be that the mutual fund companies need the perks the brokers are giving them but that regulation prevents them from paying directly. In that case, maybe that regulation needs to be fixed. It wouldn't be the first time that regulation has had the perverse effect of moving basically legitimate activity that is subject to abuse underground so that the abuses can't be effectively detected or prevented.