Guest Post: A Primer on How Wall Street Bilks Taxpayers, and How to Stop It

September 5th, 2010 by Al Lewis (alewis)
The bank dealers that dominate trading in U.S. Treasury bonds routinely use information from customers about their impending transactions to illegally profit by trading ahead of them. Although this allegation is based on my experience trading Treasuries for J.P. Morgan for a dozen years, front-running should be equally common in any market with the same conflicts of interest and lack of regulation and oversight, such as those for many derivatives. This is one reason banks oppose moving derivatives trading from dealers to exchanges—-it would significantly reduce their opportunities to front-run.
 
How banks front-run
 
Banks, in their roles of dealer, adviser, and underwriter, regularly receive advance notice of their customers’ transactions. When these trades are large enough to move the market, even temporarily, a bank can profit by buying the designated securities for its own account and then selling them to its customer a short time later at a higher price. For example, if J.P. Morgan learns that an underwriting client needs to purchase a billion dollars of ten-year Treasuries (perhaps to unwind an interest-rate hedge) when Morgan prices its bond issue, the bank’s traders can aggressively buy ten-year Treasuries for the hour or two leading up to the pricing. If such buying pushes the ten-year’s price one-eighth of a point above Morgan’s average purchase price—reducing its yield from 3.50% to 3.485%, say—-the bank makes $1.25 million on reselling the Treasuries to its client.
 
Derivatives markets are even more prone to front-running since dealers know of a higher percentage of customer trades beforehand and less transparent pricing makes detection harder. This is consistent with what I observed of Morgan’s interest-rate-swap desk. (Note that front-running does not require a proprietary trading desk so the Volcker Rule would not prevent it.)
 
Why banks front-run
 
Dealers make money from the bid-offer spread on trades with customers and by positioning securities correctly. But dealing spreads in mature, standardized markets such as Treasuries are very small, especially when trading with knowledgeable counterparties (that is why banks concoct new “products” and seek out unsophisticated customers). Nor can dealers consistently predict the longer-term movement of securities prices. Skilled front-running, however, has a very high success rate. It accounts for, conservatively, well over a hundred million dollars of Treasury dealer profits annually and many times that for derivatives dealers.
 
How to stop front-running
 
Front-running has been prosecuted many times on stock and commodity exchanges but never in dealer markets for bonds or derivatives. The threat of punishment would reduce front-running, but moving trading from dealers to anonymous, electronic exchanges, directly accessible by customers, would be a better way to lower issuers’ and investors’ transaction costs. More importantly, the loss of dealing spreads and chances to front-run would remove banks’ incentives to create and peddle unsuitable financial instruments.
 
I have posted a more complete description of front-running in the Treasury market, as well as an account of my attempts to interest regulators in it and a sample front-run transaction, at http://www.ustreasurymarket.com/. Please e-mail “comments” at ustreasurymarket.com if you would like to discuss this issue. 
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One Response to “Guest Post: A Primer on How Wall Street Bilks Taxpayers, and How to Stop It”

  1. thinkoobfan Says:

    If you had this up before the financial reform package you’d have a winner. This is the best explanation of Wall Street ripoffs I’ve ever seen but I think ti’s too late now.

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