MARTIN MAYER
LEARNINGLAB
Excerpts from Martin Mayers book "Stealing The Market",
BasicBooks, HarperCollins, 1992, chapter 5
'Sure Things' Pp. 85-108.
Early Characteristics of Abusive Program Trading
The theory of index arbitrage holds that participants in the
markets who are fast on their feet can take advantage of discrepancies
that open up between the price of the futures contract and the prices
of the underlying stocks...
A brief history regarding the S&P index contract traded at the
CME
in the late 1980's..."Orders to buy and sell individual stocks would
move the S&P contract price. No doubt, it could happen: Indeed, there is
considerable evidence that it did happen on December 19, 1986, a
"triple-witching day" on which option contracts, futures contracts,
and options on futures expired. On that day, Solomon Brothers
purchased index futures contracts for its own account in Chicago
shortly before placing a one billion dollar order for stocks in the
S&P basket, transforming a market that was down about ten Dow
points to a market that closed up more than sixteen points."
"Only very large orders in New York could produce such movements,
however. Enought stocks to make a hundred contracts would cost
some millions of dollars ($5 million in the early 1980's, $15
million in the late 1980's), and a hundred contracts were almost
certainly not enough to move the Chicago price. The Merc on a
normal day traded fifty thousand or more S&P contracts. But the
tail might wag the dog-five hundred contracts, which almost certainly
would move the price (sometimes by quite a lot, as locals in the
pits added their demand to the trend), could be bought in Chicago
on margin of only two and a half a million dollars."
..."As there was so much index arbitrage by market insiders,
'riskless principal trading' between the markets did stand
out. Because the two markets-NYSE and CME-were regulated by different
government agencies, there was no single authority that could
investigate intermarket trading and police it."
..."In April 1988, six months after the great crash that had been
exacerbated by intermarket trading, the staff of the NYSE proposed
a rule that would at least limit the use of information on customer
intentions in one market to give brokers a sure-thing bet
for their own accounts in the other:
["When a member or person associated with a member or member
organization is in possession of material non-public market
information concerning one or more baskets of stock, the
execution of which affects the value of an index, trading
in the futures on tha index before information concerning
the execution of the stock basket(s) has been made publicly
available, to take advantage of the non-public information,
MAY violate just and equitable priciples of trade."]
..."The rule was interesting in what it left out. There was no
prohibition here: The rule would not touch the most common source
of such cheating, the leakage of information to other participants
in the market in return for allocated commissions, "soft dollars,"
or reciprocal leaks."
Richard Heckman of Prudential-Bache rhetorically asked members
of the House Subcommittee on Telecommunications and Finance in a
hearing in May 1988...
["Large institutions with computer access
to the floors of the futures exchanges and the NYSE, have every
abiliity to manipulate stock prices and futures prices and can
front run their own program trades."]
Robert A Kante, professional arbitrageur and former specialist
at the American Stock Exchange gave the Senate Banking Committee
the populist perspective...
["Individual investors and other market
participants are continuously entering into transactions with
parties who possess material non-public market information, the
result being a transfer of untold sums of dollars from one group
to another. Eventually, if not stopped, public confidence in
our markets will erode and the individual investor will be
forced out of the market. In addition, professional traders and
on-floor market-makers, who have been taking the 'other side' of
the front-runners trades, eventually will be unable to compete
and will exit the market. Unless a series of corrective measures
are implemented, this abusive trading practice will ultimately
destroy the liquidity, depth and integrity of our markets."]
A formula for basic Program Trading that
serves no
legitimate purpose but to realize profits from abusive trading
practices is as follows..."Issues concerning 'self-frontrunning'
(brokerage houses playing for their own account ala proprietary
strategies) that exploit intermarket opportunities begins with
the acquisition of a large number of S&P 500 contracts, on
insider margin of 1 percent. Not much cash is required, because
as the price runs up the purchaser can finance his future purchases
with the quickly credited profits on his earlier purchases, as
momentum following locals assist in pushing up the price of the
contracts.
Once the futures contract leg is in place, the house begins
purchasing the stocks itself. This does take a large capital
investment, reduced once again by the likelihood that other
bidders will come into the market to help. AS this stage of the
strategy ends, the house has large positions in the underlying
stocks as well as its large positions in the index futures, and
the market is rising smartly.
Even before completing its stock-purchasing program, the self-
frontrunning house begins selling the futures contracts at a
profit, and keeps selling, in effect taking a net short position,
At this point, the house begins to dump the stocks acquired not
concerned with subsequent potential losses, because of the greater
profit potential of the short position taken in the stock futures."
Benny The Trader
John A Mendelson, then senior vice president and head of the
market analysis group at Dean Witter, laid out the scenario in
one of his periodic papers about his friend Benny The Trader,
who had moved from New York to Chicago because 'this is where the
action is'. Benny's card identified his new corporate name as
'Personalized Markets, Inc.,' and his advertising slogan was
'Markets any way you like them'.
Benny had been a pioneer of
index arbitrage, and had previously explained to his buddy John
the mechanics of the basis, the gap between the price
of the futures contract and the calculated price of the basket of
real stocks that was necessary to make index arbitrage profitable:
..."It occurred to me that, although I was making a fortune, there
was still a greater one to be made. The program guys needed
leadership. The robots needed a general to grab the ring in their
nose and jerk them around. I decided Benny the Trader and a few
of his Chicago friends would become the generals...
"You would be surprised at how many clients we have in only six
months. We never ask questions about their motives and we never
do anything that is in violation the securities laws. WE also
charge $150,000 a day for our service. You want the market to
open up 10, then turn down 20 points, and close flat? No problem.
All we do is move the basis and the $100 billion behind us [the
amount of money estimated to be in index funds as of December
1986, when Mendelso wrote this piece] does the rest...All we do
is move the basis and the rest automatic."
"Benny, you are manipulating the market! My friend, the great
Benny the Trader, is a crook." "No, no, we only move the
nearby future, that is all. Why is that illegal? The rest is
a reflex action. You call it manipulation, but we like to say
we are providing creative leadership for the billions and
billions in the hands of robots. We say jump and they jump.
The program guys say your wish is our command...you must have
noticed that every intraday movement either up or down started
in Chicago."
Another Tactic
..."One tactic that remained unpoliced at that time and fairly
common is a triple play using all three markets. A trader buys
calls on the options exhange and then aggressively buys stocks
in New York, meanwhile selling a futures contract in Chicago to
hedge the risk of loss on the newly acquired stocks. The profits
made on the rising stocks are devoured by the losses on the
declining futures, by the call options rise dramatically in value,
and can be cashed in before reversing the other transactions.
The beauty of this operation is that once the purchases and the
hedges are in place, the trader does not care whether the stocks
and futures go up or down, however, this portfolio strategy does
not work so well when stocks are declining."
