The Squawk Box Scam, Front Running &
The Rape and Pillage Factor in Market Trading
By Al Martin
The Wall Street Journal (March 22, 2006) reported: “Federal indictments unsealed against former brokerage firm officials in investigation of alleged abuse of Wall Street firm’s internal audio communication systems known as squawk boxes.” These were the charges against a brokerage firm called A.B. Whatley. So what does a “squawk box” does and what was the scam?
A squawk box is nothing more than a speakerphone that’s kept on all the time inside a brokerage house. They’re little square boxes, and all they have is an on/off switch and volume control on them. What they’re talking about is inter-office squawk boxes. The squawk boxes that are around the office and between that office and that firm’s brokers on the trading floor, as well as their jobbers and dealers, etc.
You can hear everything. You can hear order flows. You can hear the orders being placed. You can hear the brokers talking about the stocks. You can hear the conversations on the floor.
Very simply what happened was this. Someone at the firm of A.B. Whatley acted, in collusion with a larger Street firm, who are principal members of the exchanges, and bribed people within a larger Street firm to gain access to that firm’s squawk box. They were able to hear order flows and they were able to, what’s called, “front-run” the orders. In other words, they could get their buy orders in ahead of the orders of the larger firm that they were bribing to find out about.
This is what they were effectively able to do. They had already owned the stock, let’s say, 3 seconds or 5 seconds before Firm X’s million-share buy order hit the floor. This they are selling into the bid being created by a larger ticket that they’re hearing and that they know is going to be created by the execution of a larger tradek,foreding the rertaile buyer to pay a higher price for the shares. They were buyers before the bid hit the floor. They now become sellers into the bid into a rising market. It’s called “front-running.”
Jim Cramer waved his arms around about this on CNBC, saying this used to be legal up until 3 years ago and complaining about how former SEC chairman Bill Donaldson had come up with an awful lot of regulations making things that go on in Street firms and on the floors illegal that were legal for years. He was praising the new SEC chairman Christopher ‘Never saw a mega-corporation he didn’t like’ Cox, who has actually reversed or watered down some of the investor protection laws put in by Donaldson. Naturally, CNBC and Bloomberg hailed this.
Of course, they want the clock turned back to the way it always was, and that is to “rape and pillage the Joe Six-pack orders on the floor.” This has always been done. There’s nothing new about this.
This is how they front-run the orders. The guy in the pit that’s actually on the floor and who’s actually filling the order would either buy the same shares in his own account, usually an offshore account, or, more commonly, for the firm’s offshore account, before he filled the ticket.
The retail buy ticket then got marked up. And the firm he worked for, or the individual broker, would sell the shares they just bought into the ticket at a marked-up price.
This is known as front-running. We’ve heard a lot about front-running recently through mutual funds scandals, which is a little different. But, if you’re going to front-run and make money at it, mutual funds are the obvious place to go because they’re dealing in huge quantities of shares every day.
The same type of front-running has long been a feature in commodity future trading as well, probably more pronounced in commodity futures, where certain markets are less liquid than others, so that dealers can effectively rape and pillage Joe Six-pack market orders that come into the pits.
In the big liquid markets, which are the financials, the bonds, the dollars, the gold, you can’t do that. The less liquid markets, like coffee, cocoa, sugar and juice, lumber, otherwise known as softs and trops, where the volumes are much less are where the dealers oftentimes maintain the bid-and-ask, when there isn’t any paper necessarily on the floor. There can be gaps where there’s actual paper, paper being buy-and-sell orders coming in to the floor and to the pits.
The coffee pits are notorious for this. When a buy order comes in, if it is the floor dealers themselves maintaining the market, suddenly they’ll lift the bid-and-offer -- 20, 30 ticks, just to fill that market order. And then you’ll see that immediately, after the ticket is filled, they take it back down again.
This adds to the volatility factor in the markets, which is actually good. People have often said to me -- why do traders, people that trade commodities, put up with this? And I say, it’s because the unwashed are taught by financial media to believe these things. Have you ever listened to CNBC or Bloomberg? Notice when they start talking about futures trading, and the eyebrows get raised, and the eyes start to roll, and they start talking like the notorious bullish shill Phil Flynn, who says --Oh, you’ve got a fill 30 points away in the coffee? You’re lucky!
People are programmed to believe that they’re gonna get raped and pillaged. And if they only get raped and pillaged for 20 ticks in the sugar and 30 ticks in the coffee, they think they’ve done well.
The problem is that you have to allow some rape and pillage. It has to be done. Because if the seat holders are there on the floor acting as principal brokers, they are required to maintain a liquid market, a bid-and-ask at all times. It is the price you pay for a constant and liquid market. However, when the unwashed get raped for 30 points or 40 points, they believe they have done well. So people are used to it, and everybody promotes it.
The reason why it persists as a problem in the industry is because people don’t complain about it enough because they have been taught by the industry that if you only get raped and pillaged for 30 points, you’re lucky.
The point of the story is that if you are a trader and you do get raped and pillaged on an order, you should always request “time and sales,” a hard print copy from the firm you’re doing business with.
“Time and sales” means the time, the trading 60 seconds, what the market was when your order was there, what the prints were.
Another problem is that the floor guys are notorious for manipulating the time and sales reports to match the trades, or to fit the trade. But you can tell that you’ve got an outside trade, or an outside fill. What you do is you complain about it, you accumulate that information, and you keep notifying the enforcement division of the CFTC . The only way this practice is going to stop is when enough commodity futures traders and enough stock traders start doing this. And people have to stop saying it’s acceptable or even more so in the trade, the way you hear it put to the unwashed -- Hey, you’re gonna get bent over anyway, that’s part of the business.
Full-time day traders understand that you’re going to give up a little something - 10 ticks in the coffee and so on. But to give up 30 on a market order or 40 on a market order, that’s not right.
Remember that there is a whole food chain involved here – the dealers, and the brokers, shoppers, pit desks, and the dealers to the floors. And then the guy that’s trading is the last guy on the food chain.
Think about that independent guy on the floor, who’s charging two bucks commission to a firm to execute an order. Do you think he’s making a living off of that two dollars? Of course he isn’t. Where he makes a living is scalping those tasty market orders. Why do you think the brokers, when they see the market orders on the floor they go, “Tasty!”
Because they’ll be able to scalp, rape `em for 20, 30 pegs.
Why make two dollars as commission if you’re an independent, when you can scalp a coffee order for 30 ticks, which is $112.50. And you know that the client isn’t going to say anything about it.
The unwashed hear this stuff day in and day out, and I hear it too -- that when somebody puts in an order, when we’re trading the coffee and somebody buys in the market and gets filled 30 up, 30 ticks away, and they’re happy. And I say, “Hey, you just got raped for 30 points.” “Oh, no, no,” they say
Because Larry Kudlow says if you get 30 ticks from this guy or that guy, and this industry shill or that industry shill says, and they even use the language, “If you only get raped for 30 points, you’re happy.”
So low expectations yield low results. Low expectations is what allows this system, this age-old system to persist.
You know, years ago, when I first started in this business, it was different. I mean, if you got a quarter or a penny, a bad fill on a grain, on a corn or bean order or something, and you asked for time and sales, the brokerage firm would be all over it like stink on a boot.
And, boy, if you got a quarter point out of the range, they would adjust the order. The reason why the brokerage firms don’t like to adjust the orders is that, if the losers complain, it comes out of their pocket.
But now, I don’t care how much you tighten the laws because you can’t, because if the dealers right on the floor, the pit members, the seat holders in the exchange, they’re the ones who make the market. Literally they can make the market whatever they want to make it, and you are at their mercy.
The part of it I don’t like is the way that industry shills go on financial media like CNBC and Bloomberg to try to put into the consciousness of the unwashed this idea that, “Hey, if you put a market order in coffee and get raped for 30 points– And they even use the language, they’ll even say that. If you get a fill that’s, you’re raped for 30 points, you should be happy. You know how wild the coffee is!”
I hear the net result of that, running a trading advisory service. I hear the net result of the way this industry is shilled and presented to the unwashed, wherein I hear a potential subscriber who just got raped for 30 points in the coffee be happy about it.
You have to shatter this mass delusion, and it won’t come from the brokerage houses. The CFTC is always considered the SEC’s weak sister. I wouldn’t necessarily expect anything out of a regulatory change because (and this has always been a problem) in an open pit, or open outcry market, it’s hard to put in rules and regulations to say that you’ve got to maintain a 10-point spread or a 20-point spread.
And this is one of the fundamental flaws of an open outcry market. Open outcry market is the purest form of capitalism there is. One of the fundamental flaws of it is, is when you get a government entity, a regulatory body that comes into a marketplace and says, “You, the dealers on the floor, must maintain a liquid bid-and-ask at all times. If you do not do that, markets don’t work.”
Now, what is the pit dealers response? And this has always been the same way. It’s one of the downfalls of a free market. They claim and quite correctly so -- if you expect us to take the risk of maintaining a bid-and-ask all the time, a liquid market, even when there is no order flows, yet we are still required to maintain a bid-and-ask and to take paper at a price when we have no offsetting orders, then you’ve got to allow us to rape and pillage. And they’re right.
Why? Because markets wouldn’t work without it. There would be no investor confidence in anything. If an investor in anything–a stock, a bond, a commodity, anything–if they went in and couldn’t sell or couldn’t buy, markets wouldn’t work. One of the prices that you pay, that is paid in a free-market economy, wherein liquidity is ensured all the time, no matter what the situation is, liquidity is absolutely assured–one of the prices you pay for that is the “rape and pillage.”
If this is ever going to end, you have to speak up. So this is a warning about commodity futures trading -- yes, you can make money in it, but it is not for the unwashed.