Capital market regulations and laws are in place to ensure financial markets operate in a fair, orderly, and informationally-efficient manner for investment purposes, liquidity management, intergenerational transfers and risk management. That is why regulators come down hard on market manipulators who disrupt or abuse markets to their advantage, usually at the expense of legitimate participants.
Almost 50 years ago, a US Supreme Court judge famously wrote in his judgement that while pornography is hard to define, he will definitely know it when he sees it. Financial market manipulation faces a similar but less racy ordeal.
Recent populist events on a Reddit trading forum have gotten people so excited that even those on opposite sides of the US political divide are aligned on their views about market manipulation, investment pools that pump (and eventually dump) stocks, and basic investor fairness.
Categories of manipulation
Most dictionaries define manipulate as “to control or influence something or someone to your advantage, often unfairly or dishonestly”. This definition serves our purpose in the financial trading and capital markets context. I will go further and define three categories of financial market manipulation, which have also been used in academic literature1.
- Information-based: this is when private information, be it true or false, can lead to profitable opportunities for the “insider”. They are often illegal due to insider trading rules.
- Action-based: the manipulator’s actions affect the perceived value of the stock to his or her advantage.
- Trade-based (or informationless trading): profits generated simply from buying or selling activities, which could be accompanied by some misleading “stories” to buoy the position.
The distinction between the three categories is blurry and could sometimes confuse people. Yet, they are useful to illustrate my key points. Additionally, various exchange rules and financial regulations have outlawed the first two – more blatant – forms of manipulation, usually drawing on the term “fraud” in many civil and criminal complaints.
The third category is a little more nebulous but all-encompassing.
As an example of information-based manipulation, the multi-billionaire founder of Galleon hedge fund in New York, which also had offices in Asia, was convicted in 2011 of fraud and conspiracy in one of the biggest insider trading cases in Wall Street’s history. He allegedly traded on private information and tips provided by an insider, who had privileged information about a listed financial services company; the news was not yet available or released in the public domain.
In comparison to his net worth, the founder netted a modest profit of US$800,000 for this information-related trade. But the crime cost him 11 years in jail and a whopping $150 million in fines.
I refer to this as the “Martha Stewart stupid trade”. This was when Stewart, the multi-millionaire TV personality, upon receiving an insider-related trading tip just prior to negative news about a biotech firm being publicly released, dumped her shares in the firm simply to avoid a paltry loss of $45,673. She was estimated to be worth $650 million before this trading scandal hit the news in the early 2000s. She ended up spending five months in prison.
When a manipulator’s actions affect the perceived value of the stock to his or her advantage, it is categorised as action-based manipulation. It can happen in many ways. For example, when an investor, by reputation, market power or signaling, disguises buy trades as an attempt to perform a takeover bid of a company, thus driving up the stock price. At some point during the rally, the manipulator withdraws the takeover bid, takes the profits and walks away. This is sometimes referred to as “greenmail”. A famous case of greenmail is James Goldsmith’s takeover attempt of Goodyear Tire and Rubber Company in the mid-1980s.
Another form of potential action-based manipulation could be a cohort of well-known personalities or influencers forming a private pool and subscribing to the pre-initial public offering venture funding rounds of a company, making it publicly known that they are, thus causing the IPO price to be elevated well above the stock’s “fair value” or the offer price without their participation. This is due to what is referred to as association bias or pro hominem fallacy in behavioural finance literature.
Corners and squeezes
Trade-based manipulation can be illustrated by market corners and squeezes. A corner is when a manipulator, or a group of them acting in concert, controls a substantial supply of an underlying security or commodity through a series of buy trades and driving up the price.
Trading or investment pools involve a group of traders buying shares – in tandem, willfully, or otherwise – and trading frequently by buying and selling among themselves (or “wash” sales) – to create positive price pressure on the stock, perhaps even by injecting savoury news stories about it along the way. This form of abusive trading was prevalent in the 1920s, and sometimes referred to as the “pump and dump” strategy.
A short squeeze happens when short sellers are forced to return the security when it is called, presumably by those cornering the security and hence its price.
On the lighter side, such a profitable manipulation strategy was made famous in the 1983 fictional comedy Trading Places, where the market for frozen orange juice concentrate was cornered and squeezed by unsavoury movie characters using orange juice futures.
Apart from regulatory enforcement for violation of securities laws, a market corner and squeeze on a security can be avoided by forcing settlement in cash as opposed to securities, issuing more shares of the security, or placing position limits on traders. That said, position limits can be easily circumvented by the manipulator, either by trading in the corresponding derivatives, or when a group of traders – say, a very large group of retail investors on an internet forum – form an implicit or complicit investment trading pool to artificially bid up the price of a stock. They avoid the position limit constraint because their individual holdings are below it.
History is replete with colourful stories of corners and squeezes. These include the tin market corner of 1981-1982 allegedly conducted by a sovereign-linked entity, the cornering of the silver market from 1979-1980 by the Hunt brothers, and the Treasury market corner and squeeze of May 1991 where Salomon Brothers and its colluders, mostly the firm’s clients, cornered close to 95% of a particular Treasury auction, which collectively was in violation of the 35% position limit. The subsequent price run-up put tremendous stress on businesses that needed Treasurys for the conduct of their day-to-day operations, including collateral financing, general obligations and asset-liability management, as well as short sellers who had to cover their positions with hard-to-find Treasurys, which were artificially inflated in price.
Why is Reddit redlining?
In the recent financial insurrection by millennials, there were accusations that certain hedge funds were manipulating a particular set of stocks by short selling them. Yet few involved in the business of determining the fundamental value of a stock would dispute the fact that at least one of those stocks would soon go the way of other dinosaur companies of old.
The belief that Wall Street was constantly short-changing these investors led to the appearance of a form of retail-level pump (and eventually dump?) on a Reddit trading forum. Trades were then executed en masse via online platforms such as Robinhood.
If it turns out that there indeed was collusion, gurus and/or deceit involved in driving prices up so as to punish Wall Street – as opposed to reflecting beliefs on the stock’s fundamental value – there could be a civil or criminal case made against these “hot hand” traders for violating the very fundamental tenet and mission of financial regulators – which is to maintain a fair and orderly market. In which case, it becomes a form of trade-based manipulation.
On the flip side, I find it curious that certain well-known hedge funds came to the rescue of one of the players caught on the short-selling side of the trade. Usually, the top hedge funds fire portfolio managers who end up in such a situation, arguing it should have been better risk managed. Maybe there indeed is more than meets the eye in some of these cases, as the millennials claim?
In any case, and in the spirit of maintaining fair and orderly markets for all investors, no subset of traders should be in the business of punishing a counterparty using regulated capital markets. Nor should hedge funds be manipulating the market to their advantage while trading.
That said, short selling is a perfectly legitimate activity as it keeps prices efficient. Or put another way, no one wishes to overpay for a stock – one could if there are short-sale restrictions on it.
Lastly, trading platforms should not be unilaterally suspending trading activity or restricting a subset of traders from trading a particular stock. In the case of exchanges, trading suspensions are rules-based. For example, an exchange would typically execute a market-wide trading halt if a severe market-wide price decline occurs. There is also the stock-level limit up/limit down rule, which leads to a trading pause in the stock to address any excessive volatility it is facing.
My hunch is, regulators will be kept busy the next few weeks trying to uncover what exactly happened on both sides of the financial divide. And if necessary, bring guilty parties to task for any trade-based manipulation, be it on the long or short side. It may also result in the introduction of new rules and regulations to ensure fair and orderly capital markets in the presence of electronically well-networked angry millennials.
* Joseph Cherian is practice professor of finance at the National University of Singapore Business School. (With thanks to millennial Jivesh Tolani for providing key insights on how social news aggregator discussion platforms work.)
1 For references, please see Market Manipulation and Corporate Finance: A New Perspective, by Joseph Cherian, Arkadev Chatterjea and Robert Jarrow, Financial Management, Summer 1993, 200-209 and Market Manipulation, by Joseph Cherian and Robert Jarrow, Handbooks in Operations Research and Management Science, 1995, v.9, Chapter 20, 611-630.