Stock Market Corruption - Just How Common Is It?

Your author has recently finished reading "Binge Trading" by Seth Freedman. Freedman was employed in The City - the London financial centre - for six years, and after a spell abroad had returned to write about his experiences and interview others in the markets.

His experience in the stock market and as a broker and trader enable him to write with knowledge, but to also have access to people that he may otherwise not have had.

He writes at some length about what might be termed corruption or insider trading within the stock market. Much of it is what might be termed 'victimless' but would still be classed as illegal.

In one interview, his anonymous subject tells us, "Everyone had dummy punters, friends or relatives who let you wash winners through their account. I had a setup with a friend who didn't work in the City. We'd go sixty-forty on each deal - but I had to see it in cash the same day, and of course I took the sixty. His account was entirely governed by me. I had tacit approval to move as much stock through it as I liked, so long as he was always up at the end of the week. The compliance department [company employees who were answerable to the FSA, who were supposed to check that all the deals were above board] barely batted an eyelid at his account's stellar performance, assuming he was a proper punter who knew the ropes - plus I threw in a few losing trades to throw them off the scent.""

Needless to say, he goes on - but you ought to read the book for that!

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The point, however, is that there does appear to be an undercurrent of corruption in most - if not all - major stock exchanges. This is simply the lure of fast and easy money. Money that can come from high-level skills and knowledge access - legal or illegal.

It is worth pointing out that within the world of M&A; (mergers and acquisitions), it is widely believed that there is rampant insider trading from those involved in negotiating and structuring the deals.

The regulators of major markets do not seem to have a great (or even simply bad) record in tracking down such offences and an even worse record in punishing them. Stock market corruption of this nature is illegal.

But it does raise some interesting questions. Just how clean do we need markets to be? How much are we willing to do to enforce these rules? And why does there seem to be so little interest in pursuing these people?

Answers to these questions have begun to emerge in the United States. After the debacle of the financial collapse in 2008, regulators have been empowered to really pursue criminal trades. There have been a number of cases (approaching 200) many of which have emerged from the web of contacts of convicted hedge fund manager Raj Rajaratnam.

In mid 2012 these prosecutions of stock market corruption seem to be drawing to a close. With sentences of over 10 years for a number of those convicted, the message being sent to traders and market participants is clear. Yet as this article shows, when the monetary rewards are high, morality seems to be pushed to the side by human nature.

Is winning everything?

As is typically the case though, the main characters in cases such as the one above earn high salaries and bonuses and do not appear to even need the money. Motive is not always easy to establish in such trials, but there clearly is a motive and probably relates to winning and getting away with taking risks.

My personal guess is that the level of wrongdoing on Wall Street is in part due to the nature of the recruitment process and required skills. To really do well and survive in an investment bank or trading outfit, a certain level of 'killer instinct' is required. Those that make it to the top must have it and those below them can surely see it in their superiors. In such an environment, being able to demonstrate that you have 'the right stuff' is likely to lead to believing that doing whatever it takes is the preferred modus operandi.

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While copying an aggressive boss or colleague is no excuse for illegal or immoral behaviour, it probably would not be a very big step for many people to cross the line. With the millions of stocks and shares traded every day, it cannot be easy for a regulator to spot unusual activities on a capital market. While the SEC and FSA have their own computer systems to look for unusual transactions, if the broker or banker in question is trying to hide their activities, it may be impossible to see.

Not alpha

What is really galling for the investors in insider traders is that they may have decided to invest in a fund without realising that some of the returns were based on illegal activities. That is hardly an investment strategy to depend upon with your life savings! 

But increased annual returns for a fund would normally lead to more investors and more money, leading to higher basic fees within the fund and for the manager or management team. Therefore, there is more at stake than the actual profit, there can be a flow of potential future benefits.

The problem is that unless there is a stock market scandal that hits the front pages, which they often do, there probably is no prosecution underway. It must be very easy for the market participants to become greed and feel immune as they push the boundaries or ethics and law further and further without being caught. At some point, human nature would make us feel invincible and then the trades would really start to flow!

We at StockExchangeSecrets do not pretend to know the answers to the thorny subjects of the markets and human nature, but we can at least identify some of the issues.

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