Market Commentary
The Manipulations People Play
By Arne Alsin
Street.com Contributor
10/4/2006 10:05 AM EDT
If a market can be abused, it will be abused. There are players in every market who are motivated by greed and willing to bend or break rules if they can get away with it.
To illustrate this point, let's go back in time to the Enron scandal. A former Enron employee described to me in detail how certain traders manipulated the wholesale power market after deregulation in California in 1996. There are parallels here to current manipulation in the stock market.
As this former Enron employee explained, traders would aggressively "stress test" regulations, looking for "regulatory holes" that they could exploit. If one regulatory hole did not work, they would try another, and then another. They would keep trying until they could find a way to profitably game the system.
In particular, traders focused their sights on manipulating supply in the deregulated California market. That's because demand is difficult to manipulate.
At the time, demand for power was growing steadily in California at a mid-single-digit annual rate. But prices for power rocketed higher by tenfold in a short period of time. How did this happen?
Power was manipulated in California by intentionally withholding supply, by creating a volatile spot market, by shutting down perfectly working generators and by intentionally creating congestion in power lines -- and then relieving that congestion for a fee. This last strategy was called "Death Star" by traders. One trader commented, in public record audiotapes, that he always looked at a power line to see if he could "congest it." He said, "If you can congest it, that's a moneymaker."
When there are problems in a market, such as the power market or the stock market, lawmakers try to solve the problem with new regulations. The regulations are promulgated with good intentions.
Traders who are motivated by greed have the opposite intentions. As one Reliant Energy (RRI) trader said on another audiotape that became public record after the California market manipulation came to light, "You know when we might follow rules? If there's some penalty ... if it's economics, it's economics, and by God, that's what rules."
Markets are a zero-sum trading game. Manipulators in the wholesale power market achieved their gains while adding no value. Their gains came at the expense of California residents. In a taped call in November 2000, two traders are heard laughing about fleecing "Grandma Millie" and "those poor grandmothers in California."
Slow to recognize the market manipulation in California, lawmakers finally slapped new regulations onto the wholesale power market, including price caps. The regulations were stress-tested by traders and regulatory holes were quickly found.
For example, power was routed out of California and back into the state in order to avoid price caps, since out-of-state power was not subject to price caps.
Plugging Holes Swiftly
All markets -- including the stock market --- are subject to attack, to stress tests of the regulatory framework. The key to mitigating damage rests on a rapid response. If those who are entrusted with oversight and enforcement respond quickly to plug regulatory holes, damage can be contained.
Microsoft (MSFT) will release its next-generation operating system in the coming months. As soon as the new operating system is released, hackers will stress test the system, looking for holes in the code that they can exploit to their advantage.
There is a huge difference between the reaction to holes in Microsoft's operating system and to regulatory holes in the stock market. Microsoft limits damage by fixing a hole as soon as it is identified. That doesn't happen in the stock market. In the face of clear and obvious market manipulation, regulatory repairs move at a glacial pace.
As traders did with the wholesale power market in California, certain market participants are manipulating the stock market by manipulating supply. They do it because it is immensely profitable. They do it because they can get away with it.
Overstock: A Case Study
One example of market manipulation via supply is Overstock (OSTK), a stock I bought for my mutual fund in the first quarter of this year.
As I explained in a column in April, shares were not delivered in four out of five block trades. The sellers sold shares (supply) that they did not have. Many other buyers of Overstock have had similar problems, such as Research Capital, a Toronto brokerage that had failed deliveries in 42 separate purchases of Overstock this year.
Data recently obtained through the Freedom of Information Act clearly show manipulation in Overstock. The data disclose the number of delivery fails (shares sold but not delivered) through the end of last year. In the fourth quarter of last year, Overstock's failed trades averaged 2 million shares.
That number is jaw-dropping. By my calculations, between 2.5 million and 5 million shares of the float were active in the fourth quarter (note that half of the float is held by insiders and is not actively traded). That means that supply was artificially inflated by 40%-80% during the quarter.
In the case of Overstock and other targeted stocks, delivery fails don't occur because of a lost certificate or two. They occur intentionally.
Since market regulators can't seem to halt the manipulation of supply, perhaps the perpetrators should take a page from the Death Star strategy. Perhaps they should offer to clean up the trading "congestion" -- for a fee, of course.
P.S.: On a related note, and perhaps of interest to readers in the southern California area, I'll be participating in a panel discussion about manipulation in the stock market in an upcoming event on Oct. 19. For more information, click here.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Overstock to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
TheStreet.com and James J. Cramer, its co-founder and major shareholder, were subpoenaed in February in connection with an SEC investigation into allegations by Overstock that a research firm, Gradient Analytics, engaged in a conspiracy with short sellers (including Rocker Partners, which owns a small stake in TheStreet.com, the publisher of this Web site) to manipulate Overstock's share price. The SEC agreed that it would not, at that time, seek to enforce the portions of the subpoenas issued to the company and other media firms, including Dow Jones (DJ), that concern communications between journalists and their sources.
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