Legal Insider Trading for $6,000 a Month

If you've been on the hunt for the market's Holy Grail, then I have good news for you. Not only does it exist, but you can have access to it for a few thousand bucks a month. And no, this isn't a sales pitch, or, at least, it's not my pitch.

At the beginning of last week, Thomson Reuters announced that it was suspending its practice of releasing data from a closely watched consumer confidence survey to a subset of subscribers before the rest of the market had access to the information. For a mere $6,000 a month, a number of high-frequency traders had a two-second jump on the market.

How big of an advantage was this? As James Stewart of The New York Times reported, it was "arresting." In the first 10 milliseconds of the two-second window this past Friday -- that is, the first time the report was issued without a head start -- only 500 shares of a leading S&P 500 (SNPINDEX: ^GSPC  ) exchange-traded fund changed hands. In the same 10 milliseconds last year, a staggering 200,000 shares were traded.

The "news-feed" trade
Known as the "news-feed" trade, this has been one of Wall Street's best-kept non-secrets over the past few years. A veritable cottage industry of data aggregators and providers has sprung up. According to The Wall Street Journal, "the delivery of machine-readable news will generate $75 million in revenue for financial-news providers this year, up almost 50% in five years."

In addition to the Thomson Reuters/University of Michigan consumer sentiment survey, there's the Chicago Business Barometer distributed by the German financial exchange Deutsche Borse, the monthly manufacturing index supplied by the Institute of Supply Management, data about monthly shipments of appliances by the Association of Home Appliance Manufacturers, the Bedding Barometer which gauges the monthly sales of mattresses, and on and on.

All told, there are dozens of such reports that paying customers can get access to before the rest of the market. But while it seems like this burgeoning trend must be bad for individual investors who don't have the means to compete on a level playing field, the evidence doesn't necessarily support that assumption.

An appearance of impropriety
It's impossible to deny that this practice appears, at least on its face, to be both unfair and bad for the markets. "It sends a really bad message to people, that markets aren't fair, transparent," my colleague Ilan Moscovitz observed.

"The reason America's markets are the best and strongest markets in the world, is that individuals always believed they could get a fair trade," New York Attorney General Eric Schneiderman told the Times' Stewart last week. "If you did your research well, you weren't at a disadvantage because of information you couldn't possibly access. It wasn't a rigged casino."

The practice also seems to fly in the face of the securities laws that govern the dissemination of information from publically traded corporations. The rules against insider trading are obviously paramount here. But even beyond these, there's Regulation Fair Disclosure, which mandates that all publically traded companies must disclose material information to investors at the same time.

To be clear, the sale of information like this isn't illegal. "The activity is widespread and legal," Michael Rothfeld of The Wall Street Journal noted. "Federal securities law doesn't prevent investors from trading based on nonpublic information they have legally bought from other private entities."

In addition, viewed from the perspective of economic theory, it might very well foster inefficiency. One of the fundamental predicates of a competitive market is that there is "perfect information," which means that all consumers and producers are assumed to have the same (and thereby simultaneous) knowledge of things like price, quality, and production methods. Clearly, this isn't the case when a subset of market participants gets access to critical data before others.

Thinking beyond the headlines
The idea that high-frequency traders exploit their preferential access to data in order to turn a quick and often generous profit makes for salacious and clickable headlines. But whether or not the practice is actually bad for individual investors is more nuanced. If you dig a bit further into it, in fact, there's reason to believe that all of the hoopla is much ado about nothing.

Nobody would deny the fact that economic reports such as those discussed here are important. What fewer people appreciate, however, is that it's expensive to collect and disseminate the underlying data. "People need financial incentives to dig up information, and the marketplace benefits," former SEC Chairman Harvey Pitt told the Times.

Richard Curtin, the economist who runs the consumer confidence survey at the University of Michigan, agreed. "Hardly anyone would pay for it if they didn't see a profit motive," Curtin told the Journal's Brody Mullins at the beginning of last month. "This research is totally funded by private sources for the benefit of scientific analysis, to assess public policy, and to advance business interests. Without a source of revenue, the project would cease to exist and the benefits would disappear."

Beyond that, if you take a step back, you can't help but wonder: What's the difference between the market surging or tanking at 9:57 a.m. versus 10:00 a.m.? None, quite frankly, or at least not from the perspective of a long-term investor. "Ordinary investors aren't betting on consumer confidence numbers within two seconds of their release," Moscovitz said in the same conversation.

Does it erode confidence in the market?
Now, there is an argument that allowing high-frequency traders to game the system, if you will, is bad in a more general sense, by discouraging people from investing in stocks in the same way that they don't gamble at a casino. The results of a recent Gallop poll are instructive on this point. According to its estimate, only 52% of Americans own stock outright or as part of a mutual fund or self-directed retirement account. This was the lowest level since Gallop began monitoring the metric nearly 15 years ago.

Charles Schwab, the founder and chairman of the eponymous The Charles Schwab Corp. (NYSE: SCHW  ) , touched on this in a recent op-ed piece. "[L]ooking at our capital markets today, we should all be concerned. It's becoming increasingly difficult for individual investors to compete on a level playing field. The system seems rigged against them. And they are responding by walking away."

In response, I would say: Consider the source. Stockbrokers like Schwab, Morgan Stanley (NYSE: MS  ) , E*TRADE  (NASDAQ: ETFC  ) , and to a lesser extent, Bank of America's (NYSE: BAC  ) Merrill Lynch make money on trading commissions. And as day traders, their bread and butter customers, come to terms with their complete competitive disadvantage, they will presumably trade less.

Beyond this, while individual investors may be abandoning individual stock ownership, as Schwab points out, the explanation behind the trend isn't clear-cut. The Gallop poll cited above, and quoted by Schwab to bolster his point, concludes that it's probably a function of Americans' ability to buy stocks more than anything else. Meanwhile, its 2011 survey had this to say: "The financial crisis and the losses it produced for many investors have combined with government bailouts and Wall Street scandals to turn many Americans away from investing in stocks."

Our last remaining edge on Wall Street
The point is, we really don't know whether or not high-frequency trading is bad for the market. To cite my colleague Ilan again, "There's a larger point about what markets have turned into, but public policy-wise, you often want to think of [high frequency trading] as an alternative to other forms of market making, not to investing."

At the same time, we can say with greater certainty that there's little to no harm done to long-term investors. Activity like this may even play into our favor. "I'm a long-term investor," fellow Fool Morgan Housel recently wrote. "The fact that you and I don't have to play these insane short-term games is the last remaining edge we have over Wall Street. And frankly, it's enormous."

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Read/Post Comments (12) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2013, at 9:46 AM, OnTheContrary wrote:

    If it's illegal to release information ahead of time to a privileged group of insiders, then the practice referred to here is illegal: it's just that the law isn't being enforced.

    SEC regulation, like all government regulation, is always sham regulation. The purpose of the regulatory laws is to create a structure of privilege that can be exploited only by established vested interest, who are thereby given a monopoly on a particular market niche, and legalized protection from competition, backed by the coercive power of the government. Meanwhile, the politicians and bureaucrats are rewarded not only by being able to wield coercive power over others, but also by bribes, kickbacks, and patronage.

    All government regulation works this way, and in fact it it the whole point of government: to make the rich and powerful, richer and more powerful.

  • Report this Comment On July 16, 2013, at 10:42 AM, nucTrader wrote:

    Would someone please explain to me why there is so much conern to make this practice illegal. Full disclosure: I was a high frequency energy trader many years ago, and although I still trade energy, it is at a much longer hold time. I just don't see how people can argue this is unfair. The information is a propritary piece of data University of Michigan releases that is privately funded (Reuters). I don't see it as much different than the Gartman letter or any other piece of financial data/news created by the hundreds of private financial news providers. The only important difference is that this data tends to be quite good, so intrepreting it correctly can be very profitable to the right people (these profits tend to be had in the index futures and along the FI curves.The 200k shares of SPY mentioned that trade in those 10 ms pale in comparison). If this was the USDA crop report or a DOE inventory number, something that is a government sponsered data point, sure, I understand that would be a major issue. But this is an index based on information you could mimic by spending a week on the phone. Any information to enlighten an old trader like me would be appreciated.

  • Report this Comment On July 18, 2013, at 10:23 AM, Mega wrote:

    You don't seem to understand the definition of insider trading. It's completely different from high frequency trading.

  • Report this Comment On July 18, 2013, at 11:46 AM, CoreAndExplore wrote:

    This is basically copied from last week's Wall Street Journal article on the same subject.

  • Report this Comment On July 18, 2013, at 1:50 PM, StockGamingCom wrote:

    Congress gets more than two seconds of lead time to do insider trading.

  • Report this Comment On July 18, 2013, at 2:21 PM, ggodoy wrote:

    Nice article, just bear in mind that it is Thomson Reuters, not ThomPson

  • Report this Comment On July 18, 2013, at 2:55 PM, grahamsway wrote:

    I bought my first stock in the early 80's and it took me awhile but finally learned that if you don't take the view that just about all financial markets are crooked, you're at a big disadvantage.

    After getting burned in the Internet bubble, then the housing bubble, maybe the public has finally wised up and may stay out of this one. But the Street and the Fed are really pushing.

  • Report this Comment On July 18, 2013, at 10:05 PM, Bingwang12 wrote:

    I agree with NucTrader is the average investor really going to benefit from getting a complex financial report two seconds before it's released to the public?

    And beyond that, especially for the so called "value/long-term" investors complaining about this. High frequency and tech trading is the sole reason it is still plausible to be a value investors and make money. If everybody only traded off of fundamentals and all had access to the same information there would be no opportunity to make money. High frequency and tech traders making a stock drop 20% because of slight miss in earnings allows long-term investors to beat the market when the scoop it up and ride it out as the business model succeeds.

  • Report this Comment On July 19, 2013, at 5:51 AM, fermionic wrote:

    <quote> How big of an advantage was this? As James Stewart of The New York Times reported, it was "arresting." In the first 10 milliseconds of the two-second window this past Friday -- that is, the first time the report was issued without a head start -- only 500 shares of a leading S&P 500 (SNPINDEX: ^GSPC ) exchange-traded fund changed hands. In the same 10 milliseconds last year, a staggering 200,000 shares were traded. </unquote>

    Although getting access to the data is a big advantage, the example above is flawed in many ways:

    (1) trading is done on deviations from the expected value. It could have been that the latest release of the number came inline with expectations and hence did not create an opportunity to trade...

    (2) trading opportunities diminish as the market "learns" to widen out before the release of numbers. There was a time when the opportunity was quite good. As nucTrader mentions, the big opportunity is not exactly in the equity cash markets.

    (3) anyone concerned with a 2 second advantage (latency sensitive firms) will sign up for the service, and this is just from a defensive measure. After a couple of release cycles, this service almost becomes a source of guaranteed income for the data provider. Offer the service and if one latency sensitive firm signs up, the rest will also follow behind [thus achieving nash equilibrium]

  • Report this Comment On July 19, 2013, at 11:53 AM, SkepikI wrote:

    Hilarious... I sort of agree with Morgan H, but think he far to mild about the advantage it creates for those of us who are long term investors. First I have always believed these sort of short term crony insider "advantages" existed so I am NOT tempted to try and beat them...it keeps me to the long view. Second, it induces if not compels these short term pirates to over buy and oversell on the news or whim of the moment and take thousands of other panic stricken "investors" (I use the term loosely) with them. I count on them to (mostly) produce the buying opportunities I want and occasionally the selling opportunities... they are the essence of BDM..Big Dumb Money.

  • Report this Comment On July 20, 2013, at 6:52 AM, Grahdodd wrote:

    As Buffett has pointed out, all of this is just noise and has no impact on the stock investor. As article points out, if the market moves a 9:57am instead of 10:00 it means nothing to owners of businesses via stocks.

    The Charles Schwab commentary is disingenuous.

    I also agree with previous post that the only difference between this PRIVATE data and, say, a newsletter is..it's Good.

    If I could charge people to subscribe to my comments following Fool articles 2 minutes before published, what would be wrong with that ? :)

    Btw...horses gallop, but the survey company is Gallup.

  • Report this Comment On July 23, 2013, at 8:29 AM, gkirkmf wrote:

    Agree with Buffett. The government should concentrate on Goldman Sachs and other banksters who are working on picking our pockets via the commodities market... as in the well documented NY Times article on Detroit area aluminum warehouses shuffling aluminum from one location to another, using 0% fed dollars to finance the operation. How about an article on this scheme John... you do a great job of digging, and might be able to show how this practice is actually good for America.

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