Dark Pools

Recently Martin Wheatly, CEO of SFC, delivered a speech about regulating alternative trading venues, in particular dark pools and direct market access (DMA). Some major points are summarized below:

• Whatever term is used to describe them, be it dark pools or alternative trading venues, they are really just facilities that allow dealing activities outside traditional exchanges without prices being disclosed publicly.
• The proliferation of dark pools has been phenomenal during the last few years but the pace of development varies across the regions. According to US SEC, the number of active dark pools transacting in stocks that are tradedon major U.S. stock markets has increased from approximately 10 in 2002 to approximately 29 in 2009.
• In Asia, dark pools are still at an infancy stage. Some of the more prominent American and European firms have explored the prospects of setting up similar operations in the major markets in Asia, including Hong Kong. In Hong Kong, we have seen the number of dark pools, mainly brokers' internalisation pools, increased from just a handful several years ago to more than 10 currently.
• There have been discussions about the implication of dark pools for the integrity of the market. The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market. The dark pool is an institutional market. Regulators should carefully study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance.
• Another unintended consequence of dark pools is the fragmentation of pricing data, thus making it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors. The growth of dark pools calls for a review of the best execution policy.
• Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, it will affect the price discovery function currently performed by the exchange market.
• To bring about greater market transparency and fairness, US SEC has recently mooted three changes to enhance the transparency of dark pools: (a) dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5% of the volume of a particular stock, but the new plan would reduce the threshold to 0.25%;(b) the second change would require actionable indications of interests to be displayed in the public quotation system; and (c) the third proposal requires real time reporting from dark pools for their executed trades, making the dark pools' identity visible to the public.
• Dark pools can offer something exchanges cannot, e.g. a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with the exchanges, they are in fact offering a different type of service or servicing a different segment of the market.
• Along with the emergence of dark pools or alternative trading pools, we have also seen a rapid development of advanced trading tools, in particular algorithmic trading or DMA in general. DMA allows institutional investors to trade faster and to have direct control of their order execution. The increase in trading speed can amplify any unintentional errors in the execution process. DMA also enables institutional investors to send a large amount of order flow to the market within a very short period of time, which may have a systemic impact on the market. For example, the use of DMA facilitates the automatic generation of time-sensitive orders based on the changing market conditions. In the past, we have seen a number of occasions when DMA users sent large orders to the exchanges merely based on the pre-set algorithmic formula without giving sufficient consideration to the prevailing liquidity level in the market. As a result, the stock prices fluctuated wildly triggered by the arrival of these large orders. It is therefore important that brokers who provide DMA services ensure that there is sufficient pre-trade monitoring and control of orders using DMA.
• Broker-sponsored access has raised more challenges for us to monitor DMA orders. Some brokers have offered their institutional clients direct access to the market without going through the brokers' trading systems. This kind of DMA provides market participants unfiltered access to the market and makes it difficult for brokers to conduct any meaningful pre-trade monitoring. The term "naked access" can better describe this type of trading activity. Some regulators have been looking into this issue.

Greenmail

Every time after experiencing a financial crisis, many people would dream for recovering their capital losses by making some innovative investments. In 1999 they put their stakes at IT stocks, in 2009 they have faith on "green" investments.

SEC recently charged four individuals and two companies involved in perpetrating a US$30 million Ponzi scheme in which they persuaded more than 300 investors nationwide to participate in purported environmentally-friendly investment opportunities.

Wayde and Donna McKelvy, who were previously married and living in the Denver area, particularly targeted elderly investors or those approaching retirement age to finance such "green" initiatives of Pennsylvania-based Mantria Corporation as a supposed "carbon negative" housing community in rural Tennessee and a "biochar" charcoal substitute made from organic waste. The McKelvys promoted Mantria investment opportunities through their Denver-based company Speed of Wealth LLC. With the help of two other promoters who are Mantria executives — Troy Wragg and Amanda Knorr of Philadelphia — they convinced investors attending seminars or participating in Internet "webinars" to liquidate their traditional investments such as retirement plans and home equity to instead invest in Mantria.

The "green" representations were laced with bogus claims, and investors were falsely promised enormous returns on their investments ranging from 17% to "hundreds of percent" annually. In fact, Mantria's environmental initiatives have not generated any significant cash, and any returns paid to investors have been funded almost exclusively from other investors' contributions. They overstated the scope and success of Mantria's operations in several ways to solicit investors. For instance, they claimed that Mantria was the world's leading manufacturer and distributor of biochar and had multiple facilities producing it at a rate of 25 tons per day. In fact, Mantria has never sold any biochar and has just one facility engaged in testing biochar for possible future commercial production. Furthermore, Mantria's only source of revenue has been from its resale of vacant lots for its purported residential communities in rural Tennessee, but those did not generate cash with which to pay investor returns because Mantria provided 100% financing for almost all of its vacant lot sales to buyers using other investors' funds.

Speed of Wealth has frequently advertised its events through television, radio and print advertising as well as Internet marketing. At seminars and webinars sponsored by Speed of Wealth, Wayde McKelvy along with Wragg or Knorr generally conduct a two-part presentation in which they urge investors to liquidate all of their traditional investments, including individual retirement accounts, employer-sponsored 401(k) plans, mutual funds, stocks, bonds, and savings accounts. McKelvy also encourages investors to borrow as much as possible against home equity, parents' home equity, and business lines of credit. He then recommends that investors use all of their funds to invest in what he describes as the "consistent and safe" high-yield securities offered by Speed of Wealth and Mantria.

After Wragg or Knorr describe Mantria's purported operations and corresponding securities being offered, they market Speed of Wealth and Mantria securities with high-pressure tactics. They frequently offer short-term incentives and bonuses in various programs to induce investors to "pledge" their investments, or to induce those who have pledged to send in their money immediately. In seminars, webinars, and conference calls, Wayde McKelvy often calls upon past investors to provide "testimonials" about their receipt of high returns from past programs. McKelvy and Wragg also tout the safety and security of Mantria's securities based on collateral consisting of deeds of trust given to investors on Mantria's Tennessee rural land holdings. Wragg even tells potential investors that because of the valuable collateral, investors may make more money on their investments if Mantria defaults than if Mantria makes the promised payments. The promoters frequently allude to Mantria's imminent closing of sales worth hundreds of millions of dollars, initial public offerings of securities that are "sure to come" and "sure to be a very huge Wall Street hit", or upcoming investments by "Wall Street."

Mantria and Speed of Wealth used investor funds to pay returns to other investors in typical Ponzi scheme fashion. Mantria and Speed of Wealth also did not tell investors that they kept a significant amount of their funds to generously pay commissions of 12.5% to the McKelvys.

The word "greenmail" could be redefined now.

Insider Trading by Lawyers and Traders

Last week SEC charged a pair of lawyers for tipping inside information in exchange for kickbacks as well as six Wall Street traders and a proprietary trading firm involved in a US$20 million insider trading scheme.

SEC alleges that Arthur J. Cutillo, an attorney in the New York office of international law firm Ropes & Gray LLP, had access to confidential information about at least four major proposed corporate transactions in which his firm's clients participated. Through his friend and fellow attorney Jason Goldfarb, Cutillo tipped this inside information to Zvi Goffer, a proprietary trader at New York-based firm Schottenfeld Group. Goffer promptly tipped four traders at three different broker-dealer firms and another professional trader Craig Drimal, who each then traded either for their own account or their firm's proprietary accounts.

Goffer was known as "the Octopussy" within the insider trading ring due to his reputation for having his arms in so many sources of inside information. Cutillo, Goldfarb, and Goffer at times used disposable cell phones in an attempt to conceal the scheme. For example, prior to the announcement of one acquisition, Goffer gave one of his tippees a disposable cell phone that had two programmed phone numbers labeled "you" and "me." After the announcement, Goffer destroyed the disposable cell phone by removing the SIM card, biting it, and breaking the phone in half, throwing away half of the phone and instructing his tippee to dispose of the other half.

This is a real case, not a TV drama.

HKMA Guideline on Sound Remuneration System

HKMA has recently developed this Guideline on the basis of the recommendations issued by the Financial Stability Board (FSB), which have been endorsed by the G20 as an international standard on sound remuneration practices. This Guideline serves to provide broad guidance on the governance and control arrangements for, and operations of, banks' remuneration systems. It is intended to apply to both locally incorporated banks and local branches of foreign banks.

The Guideline covers the following areas:

1. Governance – formulation of remuneration policy; board oversight (including the establishment of a remuneration committee); and the role of risk control functions (including, but not limited to, risk management, financial control, compliance, and internal audit) in respect of an bank's remuneration system.
2. Structure of remuneration – proportionate balance of fixed and variable remuneration; use of instruments for variable remuneration; and exceptional use of guaranteed minimum bonuses.
3. Measurement of performance for variable remuneration – pre-determined criteria for performance measurement; adjustments to performance assessment in respect of current and potential risks and the overall performance of a bank and relevant business units; and the exercise of judgement in the process of determining variable remuneration.
4. Alignment of remuneration payouts to the time horizon of risks – deferment of variable remuneration (including minimum vesting period and pre-defined performance conditions); claw-back provision and restriction on hedging exposures in respect of the unvested portion of deferred remuneration.
5. Adequate disclosure on remuneration – disclosure in respect of the design and implementation of remuneration systems; and aggregate quantitative information on remuneration broken down by senior management and by other employees whose activities could have a material impact on the risk exposure of a bank.

HKMA intends to finalize the Guideline by the end of 2009 and expects all banks to fully implement it within 2010.

It appears that even last year's financial tsunami has not caused a disaster affecting the stability of Hong Kong's banking industry, HKMA is more proactively intervening in the banking industry by following the international recommendations. If banks' remuneration system has to be regulated, how about insurance companies and the securities industry?

As a compliance practitioner, I am also interested to know how the remuneration policy would be formulated for the compliance function.