Invisible Hand interview bombshell: Market Ticker’s Karl Denninger reveals brokerage scam skimming pennies on stock trades

May 9, 2010
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Market Ticker‘s Karl Denninger dropped a bomb on The Invisible Hand this Saturday, revealing that during the 6-minute crash and rebound on May 6, 2010, brokerages were illegally shutting down trades with the New York Stock Exchange and going to other exchanges for trades instead, but giving their customers the NYSE-quoted price for shares (The NBBO or “National Best Bid and Offer”) and then pocketing the difference. He openly questions whether this has been going on for the last 5-10 years without anybody ever noticing. Here’s a sample from our interview with him, which will be included in the upcoming edition of The Invisible Hand podcast, Episode 7, to be released very soon. (UPDATE:HERE IT IS).

Also included below is a transcript of this portion of the interview.

YOUTUBE LINK

Transcript:

Now, there were a number of things that were done during the crash that made it considerably worse. And one of them is that the New York Stock Exchange, when they started to get overwhelmed with sell orders, implemented a system that they have always had in place, that basically, what they did was that they slowed everything down. They went into what they call “slow mode.”

And they do this because, on the stock exchange there’s a specialist that’s in charge of every stock that trades on the floor. And that specialist’s job is to maintain an orderly market. He normally makes a small amount of money for every trade that transacts. And it’s a cushy job if you can get it. The problem is, everyone says, “Oh, that’s just skimming off of our transactions.” Well it is. But the job that he does, and his position in life, is, at times like this, to provide a buyer where there is no buyer, and to provide a seller where there is no seller. So his job is to maintain order for the stock that he is a specialist for.

Normally, during normal operations every day, most of these trades are matched by computer, and the guy kind of stands there and, you know, he pays attention to what’s going on, but he’s not directly involved in the execution. The computer handles it for him. He’s the one that owns the computer, but the computer’s doing it on his behalf.

When they go into slow mode, this changes. The specialist will actually look at the orders to see if they make rational sense. Because, at times when things are extremely volatile, not everything does make sense. And so they will actually look at these orders before they match them and pass them through. This results in a delay sometimes of between 30 and 60 seconds. And it’s intentional. In other words, if I put out a market order to sell – in other words, I’ll take any price. There are 1000 shares of IBM, and there’s nobody willing to buy at any price, then those shares of IBM are going to sell for a penny. Well, that’s ridiculous is they were selling for $100 30 seconds before.

So what the slow mode does is it allows the order to sit there on the New York Stock Exchange for a short period of time, be advertised and be visible to market participants, and say, you know, “This guy wants to sell. What is the best bid we can give him? Now that’s a protective measure, and I would argue it’s a good thing. But here’s what happened on Thursday.

Stocks like Accenture, several tens of thousands of shares literally sold for a penny. Proctor & Gamble sold well below any reasonable quote. These quotes were not being disseminated by the New York Stock Exchange. They were on other markets, electronic exchanges that these stocks trade in, in parallel with the New York Stock Exchange during the trading day.

The problem with what happened is that, according to the SEC, you as an investor are entitled to what’s called “National Best Bid and Offer” [NBBO]. And what that means is that when you go to sell a stock, you are entitled to receive the highest bid on any exchange that is operating, and on which quotes are advertised for that security. If you sell, you are entitled to receive the highest price. If you buy, you are entitled to receive the lowest price.

Now, the problem is, that in this instance, the computers went around the New York Stock Exchange because it was intentionally disseminating trades at a slower pace. It was not down. There is an exception in the SEC rules if there’s a communication disruption. For example, let’s say that there was a fire, and the New York Stock Exchange wasn’t able to … you know, all the phone lines and fiber optic cables burned up, and they could not disseminate information, then they’re allowed to go around that particular exchange that is not disseminating quotes. But in this particular case, that didn’t happen.

Now there are some people that are in the industry that have argued with me about this, that what they did was perfectly legal. I disagree. The fact that you have to wait 30 seconds or 60 seconds to get a fill back doesn’t change the fact that the New York Stock Exchange was not down. It was operating. The specialists were on the floor. They were handling orders. Everything was running exactly the way it was designed and supposed to run, and these computer systems and these brokerages went around these quotes anyway. And as a result, what you saw was a drop in the Dow that wasn’t real.

The problem here is that if you were one of the people who got hosed by this, I would argue that you are entitled to your fill, that NBBO, and if the brokerage ends up having to eat that, then that’s too bad. And I mean, you know, NASDAQ broke a bunch of trades. There are other exchanges that are talking about breaking trades. I think that’s the wrong sort of thing to allow. I don’t think it should be permitted. They claim these were clearly erroneous. There was nothing erroneous about them. These people matched orders that they had absolutely no right to give you. And you know, as far as I’m concerned they should be forced to make them good.

Now, I recognize that this would bankrupt some brokerages and probably some large banks. I don’t care. You know, the reality is that, as an investor, these rules exist for your protection. If they’re not going to be enforced, then, you know, I don’t see any reason why anyone should be in a market where the rules only count when they work against you.

The other thing it draws into question for me is, during normal market times, there is no reasonable way for you as an investor to know if you are actually getting National Best Bid or Offer. Things happen too fast. If you sell 1000 shares of GE, and it fills at $16.52, how do you know at that particular instant in time if $16.52 was the best bid. You know, you’re entitled as the seller to get the highest price, OK? That’s advertised. How do you know that there wasn’t $16.55, you know, on some other exchange that you did not see? And you didn’t get $16.55. You got $16.52. But your brokerage got the $16.55, and gave you the $16.52, and pocketed the $.03.

You don’t know that. The rule is supposed to prevent that from happening, OK? That’s what NBBO is there for, is to prevent brokerages from skimming like this. The radical dislocation we saw on Thursday put out into the open air the fact that it happened, that the computers went around the Best Bid and Offer. And people got hosed, alright?

The question that it leaves open for me is, has this been happening on a routine basis? That the pennies that have been skimmed off of people over the last, you know, 5, 10 years, they’re pennies, and people haven’t caught it? This just brought it out in the open. You now, you really can’t hide Accenture is quoting $33 on the New York Stock Exchange, and trades for a penny on some electronic network.

We don’t know, but it leaves the question open whether or not this kind of game has been going on all along. And, you know, is it one of those dirty secrets that nobody knows about in our stock markets and our exchanges? I don’t know the answer to that question, but I’m very suspicious having seen what I saw on Thursday. Because I can’t imagine, you know … If the systems are supposed to prevent this from happening, if the computer networks are supposed to be coded, you know, so that this does not occur, then why would they not work on Thursday when they work every other day? I mean, I have to draw the assumption that there’s something systematically wrong here. You know, I can’t prove it, but I’m suspicious. You know, my antennae’s up on this.

For the full interview, go here.

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