Thursday, February 10, 2011

ETF "Stripping" - The Latest Way to Disguise Insider Trading?

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An interesting article in FT.com via CNBC's website - something I've never heard of before called "ETF Stripping".   Considering the methodology involved you would need to have a super good prime broker (hello vampire squid) to pull this off, since you'd need to borrow short a whole lot of inventory but essentially here is the game.  If you want to hide the fact you have inside information on an advantage of information (i.e. you are called "smart money"), and you don't want the SEC to know about it by building a big position in the stock or via call options, you can use an ETF.  How?

Find an ETF which owns the stock - build a big position there while concurrently shorting every other stock in the ETF.  This makes you uber long the stock you have insider information an information advantage on.  Again, genius.  More of God's work done by people 2 generations ago who would have been working at NASA or creating the next innovation in science or medicine. 

While no fan of the SEC's lax oversight let me be the first to say "oh my gosh", it appears the agency is actually investigating the practice.  Almost shocking. Kudos! 

  • The Securities and Exchange Commission is investigating whether Wall Street traders are using exchange-traded funds as a means of disguising insider trading. ETFs have emerged as a possible mechanism for maximizing gains in one stock while potentially masking trading patterns, people familiar with the matter say. 
  • In one scenario, a trader could learn information about a company, buy an ETF that includes the company’s stock, and short sell the other stocks in the ETF. The practice, known as ETF-stripping, would allow the trader to benefit from movements in the company’s share price without directly buying or selling that stock.
  • Regulators, who work closely with the US justice department, are concerned that traders are adopting this approach, and others, to mask insider trading.  (key words - "and others")  They are also looking into whether traders are using swaps to stay off their radar. 

That said, the people doing "God's work" are not stupid and already have defenses lined up.  After all only amateurs walk into a heist without an exit plan.
  • The concerns come as US authorities escalate their probe into alleged insider trading.  Law officials said they needed to use unconventional tactics because traders had become sophisticated. The so-called mosaic theory, whereby investors gather large volumes of data to arrive at conclusions that look like they might be derived from insider trading, can be used as a legal defense.  One fund manager charged with insider trading on Tuesday allegedly told an analyst that he need not worry since he was using mosaic theory.
Boo yah - mosaic theory explains it all.  Simple as that... now let me out of these cuffs.

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