Goldman, Interactive Undermined by Insider Trading on Options By Edgar Ortega and David Scheer http://www.bloomberg.com/apps/news?pid=20601087&sid=aB3t.CViRA3I&refer=home July 2 (Bloomberg) -- The U.S. regulatory crackdown on insider trading is missing widespread abuses in the $4 trillion options industry, undermining everyone from Goldman Sachs Group Inc., the world's biggest securities firm, to Citadel Investment Group LLC, the $14 billion hedge fund manager. Interactive Brokers Group Inc., which handles 20 percent of all U.S. options trades, lost as much as $25 million in the first quarter to investors who may have violated laws by using non-public information to trade. Market makers PEAK6 LLC and AGS Specialists LLC say insider trading is costing them at least 10 percent of annual earnings. ``Big deals today are pretty much known in advance and the options market reflects that,'' said Matthew Hulsizer, the co- founder of closely held PEAK6 in Chicago. ``When people come in and cheat, there's very little we can do as a market maker to avoid it. Things have gotten worse, not better.'' The record pace of mergers and acquisitions has made the business of matching orders for options more treacherous than ever. Well-timed bets on call options, the investment of choice for traders tipped off to deals before they're announced, preceded four of the five biggest U.S. takeovers this year, including TXU Corp., Alcan Inc., First Data Corp. and SLM Corp. Market makers are getting hurt because they're obliged, in return for reduced fees from exchanges, to create liquidity by quoting prices at which they'll buy and sell securities. The firms rely on statistical odds to make a small profit on the difference between the purchase and sale prices. When a trader buys an options contract knowing that the price of the underlying stock will rise, the market maker can't win. SEC Lawsuits While the U.S. Securities and Exchange Commission has filed at least 22 insider-trading lawsuits this year, including a case involving TXU options, market makers say the agency is just scratching the surface. Market makers account for 44 percent of the options contracts traded in the U.S., according to Chicago- based Options Clearing Corp., which guarantees all trades. In addition to Greenwich, Connecticut-based Interactive Brokers, the biggest market makers include Goldman, based in New York; Chicago's Citadel and PEAK6; and Susquehanna International Group LLP in the Philadelphia suburb of Bala Cynwyd, Pennsylvania. Spokesmen for Goldman, Citadel and Susquehanna declined to comment. ``There isn't a long list of market makers in options,'' said Andy Nybo, a senior analyst at Tabb Group, the Westborough, Massachusetts-based consultant. If some of the largest firms are sustaining losses, ``I would expect other market makers to see the same kind of activity.'' London Account The TXU case reveals how sophisticated an options-trading scheme can be. According to the SEC's lawsuit, Hafiz Naseem, an investment banker in New York at Credit Suisse Group, tipped off Pakistani financier Ajaz Rahim about the leveraged buyout of TXU in the weeks before the $32 billion deal was announced Feb. 26. The agency alleges that Rahim, who was based in Karachi, made about $5 million by buying call options in advance through a London account with Switzerland's UBS AG. Regulators claim Naseem leaked word of eight other transactions. Naseem has denied the charges. Rahim's lawyer has said he plans to contest the case against him. ``Whether it's a power kick or just outright greed and also ignorance of the existing regulatory apparatus, they feel they can game the system,'' Robert Marchman, head of market surveillance at the New York Stock Exchange, said about the recent wave of insider-trading cases. ``And that's where we come in. Just as the market has peaks and valleys, we are now in a peak in terms of activity.'' Blink of an Eye The 22 insider-trading cases that the SEC has initiated this year is more than the total filed during the 1990s and harkens back two decades to the days of Ivan Boesky, Martin Siegel and Dennis Levine. The NYSE last year referred 111 incidents of suspected insider trading to the SEC for further scrutiny, exceeding the 98 it sent to the agency in 2000, at the height of the bull market. Through June 22, the exchange had referred 57 such cases to the SEC, including the one involving TXU. Getting a complete picture of insider trading in options is impossible because the Options Regulatory Surveillance Authority, formed last year by the six U.S. options exchanges to police the market, won't provide data on its referrals. A decade ago, brokers working on the floors of exchanges who received a suspicious order were able to warn market makers to hedge their positions against losses, said Peter Bottini, a former trader at the Chicago Board Options Exchange who's now an executive vice president at online brokerage OptionsXpress Holdings Inc. Now, with the advent of electronic trading, thousands of contracts can change hands across the country in the blink of an eye. Dow Jones Takeover ``Between the anonymity of electronic trading and the fact that there's such large liquidity, it's very easy to trade relatively significant quantities of options,'' said Steve Sosnick, a risk manager at Interactive's market-making unit, Timber Hill. Hulsizer says PEAK6, which makes markets for options in more than 2,000 companies, was stuck with ``several millions of dollars'' in losses after selling calls on shares of Dow Jones & Co. before News Corp.'s $60-a-share offer for the newspaper publisher was disclosed on May 1. Those contracts obliged PEAK6 to sell shares in Dow Jones at below-market value after the stock surged 55 percent. The day before the bid from Rupert Murdoch's News Corp. became public, it cost 35 cents to buy calls with the right to purchase Dow Jones shares for $45 through September. That contract's price shot up 3,330 percent to $12 after the news broke. Illegal Profits ``That one hurt,'' said Hulsizer, who started PEAK6 in 1997 after working three years as a risk manager at Swiss Bank Corp. ``It was fishy, but it wasn't fishy enough that we over- hedged.'' While the SEC sued a Hong Kong couple on May 8 in connection with Dow Jones share purchases before Murdoch's offer, it hasn't disclosed any case against options buyers. Just because regulators haven't filed a case based on a referral from an exchange doesn't mean none will be brought or that that they're turning a blind eye, said Walter Ricciardi, a deputy enforcement director at the SEC. ``Sometimes we rush in if there's money about to move overseas or somewhere,'' Ricciardi said in a June 22 interview in which he declined to discuss specific cases. ``But we have a system of due process. We issue subpoenas, we collect documents, we take testimony and we make a recommendation that goes up through the staff levels. It takes time, unless there's an emergency.''
-page 2- Oyster Bar The largest case of insider trading in options announced this year snared current and former employees at UBS, Morgan Stanley and Bear Stearns Cos. and a trader who handled orders for four hedge funds. Regulators claim that the scheme, hatched at the Oyster Bar in New York's Grand Central Station, produced more than $15 million in illegal profits over five years. New York-based AGS Specialists lost money on well-timed trades prior to at least four takeovers this year, including Deutsche Boerse AG's planned purchase of International Securities Exchange Holdings Inc., said founder Andrew Schwarz. While it's possible that some of those orders were legitimate, it's getting harder to make the distinction. ``To police insider trading has become impossible because there are so many hedge funds out there, seeking the kind of information that will give them an edge,'' said Schwartz. He estimates that 29-year-old AGS, which makes markets in options at the American Stock Exchange for 500 companies, loses more than 15 percent of its earnings to suspicious trades prior to takeovers. Lists of Targets To protect themselves, PEAK6 and AGS maintain lists of potential takeover targets and watch for trades in those options. Market makers also adjust buy and sell prices to compensate for potential losses after realizing they have entered a suspicious trade. ``It's definitely harmful to the quality of markets that we see in options, if insider trading becomes more frequent,'' said Bottini, the former CBOE trader now at OptionsXpress. ``Our customers want to see that liquidity, so we would want the regulators to be aggressive to protect market makers from getting taken advantage of in any situation that gets leaked out.'' Regulators are racing to catch up with the growth of derivatives trading. The NYSE is developing an electronic archive of investigations that can help regulators at options and stock exchanges spot suspicious trading patterns. The Big Board started using an automated system last month to quickly cross-reference trade reports with information on lawyers, investment bankers, accountants and corporate executives who worked on specific deals, Marchman said. Waiting for Years Yet even if the crooks are caught, market makers may have to wait years to recoup their losses. PEAK6 still hasn't recovered $3 million from an account that investors used to buy call options in InVision Technologies Inc. before it was acquired by General Electric Co. in 2004, Hulsizer said. Marc Brown, a managing partner at market maker Equitec/Brown LLC, said he's waiting for regulators to take action on a frozen account with $650,000 in profits made last October from GlaxoSmithKline Plc's purchase of CNS Inc. ``I've never been involved in cases where I've gotten any money back,'' said Brown, who has paired off buyers and sellers at the CBOE for 20 years. ``But I've certainly been involved in situations where it was very obvious to me that I was trading against someone with insider knowledge.''
"...A decade ago, brokers working on the floors of exchanges who received a suspicious order were able to warn market makers to hedge their positions against losses, said Peter Bottini, a former trader at the Chicago Board Options Exchange who's now an executive vice president at online brokerage OptionsXpress Holdings Inc. Now, with the advent of electronic trading, thousands of contracts can change hands across the country in the blink of an eye...." I don't get it. Sounds like IB and others were taking, at least some, of the other side of these option trades. Trading against customers, and they got smoked by these insiders? IOW why weren't they just laying off risk with conversions, etc. And only taking the spread as profit, like good little market makers? I'm sure it's much more complicated than that, and I certainly don't understand the complexities of option market making, but cummon, how'd they get hit with such big losses? Can anybody explain how this might have happened? How did they end up with such a large one-sided risk?
You are so correct. This is exactly what happened. Actually, in the news article there is a hidden contradiction. First it claims brokers make their money off the bid/ask spread. But then those brokers sue some clients who make a lot of money, alleging they are insiders. This is proof that they are taking the other side. It is also a scaring fact that these brokers can sue anyone and accuse him of being an insider even if he is not, just because they lost money taking the other side. They have the power to freeze accounts just by flagging them for possible insider trading activity. Then, they have an army of lawyers and the client must pay thousands to deal with the complicated legal issues. These days, all brokers trade against their customers in synergy and this is a sad fact of this industry. They do that one way or the other. There are many ways, through offshore funds, etc. Ron
As far as I know no market maker is perfectly hedge especally for deep OTM calls. So when a take over happens they are going to lose. I know several MM's on the PHLX or the AMEX back in the day who lost their years on one takeove.
But regardless if they are trading the deep OTM options; why arent they establishing a delta neutral position to lock in those small gains? I had the impression that they'll buy/sell (make the market) above or below their theoritical pricing model - so if they have a theoritical price of .80; they'll make the market at .70 x .90; then establish a delta neutral position via trading the underlying (or other options).....lock in that 10 cents at expiration? Does the problem arise from volitility? The takeover will have volitility skyrocket, thus making their prior theo value worthless - so they essentially have no hedge, and more or less over leveraged on the losing side of the trade?
This is why you cannot selective enforce securities laws. It is common knowledge the SEC only chases down ma and pa in these matters. Then, they wave the scalps in front of the other Indians. I watched Naked Shorting about destroy a Specialist firm on the AMEX, and the AMEX said nothing was wrong. More on that later. However, this is like one of those flesh eating diseases. It will destroy the capital markets from the inside. Enact the laws, enforce them. Use suitable fines as a way to fund the agencies, giving them the tools to do what they need to do. And start over. The agencies are rotten.
I might be wrong about this but their theoretical models might not take into account a stock gapping up 20%.
Now that i think about it....Their model may take that into account, but that would essentially be a 3rd standard deviation move; so, thinking in terms of probabilities, it is highly unlikely to happen....but in reality (if its true insider information) it actually has a 100% probability of occuring. I'm not sure, i'm already confused....It reminds me of a quote i heard a few years back though...."everyone goes into the options market to leverage their risk, but there are not enough players who are willing to take on that risk"
You're making it too complicated, as you guys always do. MM's are bookies with models developed either in their heads, or on paper. If you had a local book who would take your sports bet, when you knew a guy was going to throw a game, how well would he do? That's precisely why the Vegas book lays off both sides and is happy w/ the vig. He knows there is a wise guy out there who will bury him. Remember, the ones you read about are one out of a hundred. Aguirre said that in his hearings. The SEC had one major insider bust in 20 years. Aguirre was after Mack/Pequot, and the SEC stopped him. So Art nails Microsofts earnings after talking to an employee. They never mentioned how bad the mm's got nailed. If the SEC had done it's job, Samberg wouldn't have even tried that trade. as it was, according to Aguirre's testimony, he almost got nailed until Aguirre was shut down. This is all according to Aguirre's sworn testimony.