To be clear, the SEC waking up and poking its nose into possible block trading abuses at major Wall Street firms is no where near as important, in terms of the potential to produce significant changes, than its proposed rule changes to greatly increase transparency in private equity.

However, this development is significant for a different reason: it demonstrates new chairman Gary Gensler’s seriousness in getting the agency out of the business of merely issuing parking tickets, um, going after insider trading.

Pursuing potential block trading cheating may not be the sexiest pursuit, but it’s the sort of basic market integrity policing that a badly cowed SEC has neglected for many years. A big part of an SEC institutional turnaround is letting staff know that the agency is in the business of regulating, not accommodating.

The Financial Times account points out that the investigation started under the Trump Administration, and looked to be going not much of anywhere until recently:

A slow-burning regulatory probe of big share sales on Wall Street has kicked up a notch as watchdogs examine whether banks and hedge fund traders are improperly profiting at the expense of institutional sellers and retail traders.

The US Securities and Exchange Commission first started asking banks with large equity trading arms about “block trades” during the Trump administration, according to two people with direct knowledge of the probe.

Since then, Morgan Stanley, which is a leading provider of block trade services, has received multiple requests for information. The regulator has also contacted other market participants including hedge funds that trade equities.

The SEC probe is looking at whether other traders are getting advance word of these large sales — either directly from the banks or in some other way — and improperly profiting by shorting the shares in expectation that prices will fall.

No enforcement action is imminent, and it not clear that any will result, the people said…

Under chair Gary Gensler, the SEC is making a push to prevent large traders from unfairly benefiting from information that is not available to ordinary investors. While much of this comes in the form of new disclosure proposals, the SEC enforcement arm is also part of the drive.

The Wall Street Journal said the Department of Justice had saddled up, meaning the SEC is looking into criminal referrals. That alone should focus some minds:

The Securities and Exchange Commission sent subpoenas to firms including Morgan Stanley and Goldman Sachs Group Inc. as well as several hedge funds, asking for trading records and information about the investors’ communications with bankers, some of the people said. The Justice Department also is investigating the matter, some of the people said.

Morgan Stanley has been an early focus of the probe, said people familiar with the matter. The issuance of subpoenas doesn’t mean charges will be brought against any of the firms or individuals whose activities are being scrutinized…

Investigators are looking at whether bankers improperly alerted favored clients to the sales before they were publicly disclosed and whether the funds benefited from the information—for example by shorting the shares in question. (In a short sale, an investor sells borrowed stock in hopes of buying it back at a lower price later and pocketing the difference.)

Shares of companies selling stock often fall because of an increase in supply hitting the market—and they do so frequently in the hours before a big block is sold, a phenomenon that has long raised questions on Wall Street.

Some of the funds that received subpoenas act as “liquidity providers” to Wall Street firms, according to some of the people, standing by to purchase large amounts of stock or other securities, including those that have few interested buyers.

The rules governing when and how Wall Street firms can tell clients about coming block trades are murky. In some cases, there are questions around whether divulging certain information or acting on it is improper or illegal, lawyers say.

The Financial Times article oddly described block trading as a growing business, which might give non-financial readers the mistaken impression that it’s a new business. It isn’t. Block trading was well established back when I was at Goldman in the early 1980s. It was also understood then to be an exercise in loss minimization. Block trading was an accommodation to large traders. One comment made some key points better than I could have:

Robo Chatter:

Banks are effectively committing capital for these large blocks and are taking these positions from their institutional clients against the short term market trend. Aka “negative selection”.

They do it for several reasons:
– Hidden payback for order flow.
– Liquidity for their “central risk book”.
– Market share in equities trading (very important when they pitch for an IPO).
– Other.
To minimize the losses on this ‘against the market’ trading, banks will effectively resort to every single trick known: front-run the client on correlated/cointegrated stocks (exploit the momentum created by the market impact), build ‘special interest pairs trades ‘ and offer them to other clients, abuse their IOI communication channels, etc.

If the SEC wants to check for improperly trading on this information, all they need to do is audit the banks’ departments involved in block trading in a detailed manner. Banks do not supervise adequately everybody with access to this information. And often, this information is leaked by the operators of dark liquidity pools – red flag if the bank operates (directly or indirectly) such a “systematic internaliser”.

Another Financial Times reader and the Journal both indicated that sellers would often solicit bids on a block from more than one dealer. Maybe my recollection of the stone ages of my youth is off, but that would not have been a normal practice then. Shopping a block was guaranteed to depress the stock price. Shopping did happen in the “basket trading” or “program trading” days, when sellers would offer a mixed bag of stocks and describe its attributes but not all of its constituents. That is not as crazy as it sounds. My former client, O’Connor & Associates, could have hedged a huge trade of Ford stock without shorting Ford or using Ford puts.

So even if no fines or sanctions come out of these investigations, merely having a more serious SEC breathing down the necks of the big boys should lead them to toe the line more than they have. And as the Wall Street Journal article alludes, it might also lead the agency to issue rules that draw some bright lines in now murky areas.