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.''