More Equal Than Others

more_equal_matrix

Every time he is channel surfing and comes across The Godfather, my husband, James, watches it. It doesn’t matter whether the film is one minute or one hour in, he stops and watches the rest of the movie. He never tires of it. He is happy to watch The Godfather every day of the week, if that is how often it pops up on the television. In high school, I had a similar relationship with Animal Farm (and some other books). It is a good thing that I didn’t mind reading Animal Farm, because it was a book we studied, at great length, in school. It has been many years since I read the book, but the commandments stick with me. For those that have not read Animal Farm, in a nutshell, animals on a farm rise up against the humans and come up with seven commandments. The commandments include declarations like “No animal shall drink alcohol” and “No animal shall kill any other animal”. However, as time goes by, some animals are sucked in by the intoxicating nature of power and the commandments are amended – “No animal shall drink… to excess” and “No animal shall kind any other animal… without cause”. This week, when Jim Ulvog wrote to me about UBS in the news, I was reminded of the commandment that was, initially, “All animals are equal” but morphed into “All animals are equal… but some are more equal than others”.

Last year, when writing about high frequency trading, I mentioned dark pools. Watching the news, the stock market that gets the most coverage is the New York Stock Exchange (NYSE). However, there are 16 national securities exchanges and then there are a further 45 so-called dark pools. Dark pools are not easily accessible to the public and are run by private brokerages. UBS ran one such brokerage and the SEC charged this brokerage with telling its customers that they were all equal while behaving as though some customers were more equal than others. In doing this, they not only violated their customers’ trust, they also, allegedly, violated securities law.

Dark pools are so-called because they give anonymity to the traders who use them. Like an extreme version of poker, in dark pools, the identities of the traders and the size of their orders are kept secret until the orders are filled. In this way, dark pools give traders the freedom to trade without other parties being privy to what they are doing. However (according to the SEC’s charges), with UBS, it turns out that UBS was operating its dark pool at an additionally shady level and giving some of its clients flashlights. For example, to its market makers and high-frequency traders, it gave the option, called PrimaryPegPlus (PPP), of being able to bid in fractions of a cent, despite this practice being illegal. So these PPP customers were able to jump ahead of customers bidding in, legal, whole penny prices. Furthermore, UBS did not disclose this and other practices to all its customers. So the uninformed customers were trading in this dark pool, thinking that they were equal to the other members of the dark pool, while, in reality this was not the case. It is as though UBS held a road race that a bunch of people entered but then UBS picked out a few cool kids and, secretly, gave them rocket-propelled shoes.

Trading in the various securities markets is complicated enough as it is, with some players being more experienced and sophisticated than others. We have high-frequency traders who use complex tools, large volume and nano-second speeds, tools that the ordinary man on the street generally does not have access to. To add to all of this complexity, if you have the markets advertising themselves as one thing, but selling something completely different, something that gives clandestine, unfair advantage to a group of clients over another, that just doesn’t sound right. It didn’t sound right to the SEC either – they fined UBS $14.5 million (even though UBS neither admitted nor denied guilt when paying the fine). Maybe that’s because the Animal Farm commandments are, right or wrong, just the way things are?

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