In early February, the SEC confirmed that it was investigating whether the major brokerage houses were tipping off hedge funds to the trades the brokers handle for big clients like mutual funds. If that’s happening, it would be a scandal.
The SEC is also likely to scour trading records to see if the brokers are using info about clients’ moves to invest their own capital. If the SEC finds evidence that they are, the scandal would be enormous – and go to the heart of Wall Street’s profit machine.
A big question mark hangs over Wall Street: How is it that the top firms consistently beat the odds, earning spectacular returns on their own investments? Last year the five biggest U.S. investment banks – Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers (Charts) and Bear Stearns – generated $61 billion from proprietary trading, about half their total revenue and a 54 percent increase over 2005.
Those returns have raised eyebrows for years. “Even the greatest investors lose money at some point, but the Wall Street firms never seem to lose,” marvels Tiger Williams, chief of Williams Trading, a firm that attributes its success to keeping its hedge fund clients’ trades strictly confidential.
Some Wall Street insiders are pretty sure they know the secret. “Privileged information is the real currency that runs Wall Street,” says Doug Atkin, the former CEO of Instinet who now runs the research boutique Majestic Research. “With what the traders at the big firms know, my 11-year-old son could make tons of money.”
Here’s a hypothetical example, gleaned from former Wall Street traders as well as outsiders who worked closely with them, of how some people think the Street exploits information. Say a fund company, call it Big Dog, wants to buy a million shares of Intel. A Big Dog trader calls a broker at a Wall Street firm – call it Megabux. The broker enters the order into the Megabux trading system. A dozen Megabux “sales traders” get the info on their computer screens. Their job is to find sellers for the shares. But first they call their top hedge fund clients, giving them the chance to buy some Intel before Big Dog pushes up the price. To cover their tracks, the hedge funds don’t buy the Intel shares through Megabux, but they reward their benefactor with a lot of other big trades and by paying higher commissions than the mutual funds do.