Attempts by traders to profit from market manipulation are probably as old as markets themselves. In Confusion de Confusiones, a book picked by the?Financial Times as one of the 10 best investment books ever written, De La Vega (1688) offers a first-hand account of 17th century manipulation on the Amsterdam Stock Exchange: “Manipulators would falsely bid up the prices of stocks through a variety of artifices, including ‘painting the tape’ (reporting false trades to convey the illusion of activity) and the spreading of overly optimistic news.”
Although most people have an intuitive understanding of what constitutes manipulation in trading, a ready definition proves elusive.
Normal, non-manipulative speculation is based on a trader’s expectation that he can predict future price movements with some accuracy. This could be because he has a superior understanding of the true value of a security, or because he can predict how other traders in the market are likely to behave in the future. The trader thus takes a position at some point in time and waits until, hopefully, prices move in the right direction, so he can unwind his position at a profit.
When a trader manipulates the market, he attempts to influence prices. If he succeeds, he may be able to trade profitably without any ability to predict the prices that a security would have obtained in the absence of his manipulative actions. This, of course, is not quite enough to constitute manipulation, since in some sense even a regular speculator may try to influence prices,?for example, by building a position slowly over time, so as to minimize the price impact of his trades. Manipulation is, therefore, typically associated with more sinister ways of influencing prices.
Broadly speaking, one can distinguish between three types of manipulation. Firstly, manipulation may be action-based. This requires that the trader be able to affect the fundamental value of the security. This may often be the case when a person is in a privileged position vis-à-vis a company. For example, a politician may buy the shares in a company to which he subsequently awards a profitable public contract.
Secondly, manipulation may be information-based. In this scenario, in addition to taking a position, a speculator deliberately spreads (mis)information about the security, say, by spreading rumours or posting bulletins on stock picking websites.
Finally, when the speculator takes no action other than merely trading in the stock—albeit with manipulative intent—then manipulation is said to be trade-based. This may occur, for example, when a trader holds a position in a derivatives contract and trades in the underlying around the settlement date, so as to affect the derivative’s settlement value.
In practice, the most straightforward way to make money from manipulation is probably action-based. However, only few individuals are likely to be able to take advantage of this possibility. Moreover, this type of manipulation is typically outlawed by insider trading legislations. It is, therefore, arguably somewhat less relevant in countries that enforce insider trading laws.
The ease with which information-based manipulation is possible depends crucially on two factors: how gullible the investing public is, and how many people disseminate correct information.
In the early years of the Internet, thanks to gullible investors, 15-year-old Jonathan Lebed made millions with the simple “pump-and-dump” strategy—artificially inflating stock prices through false hype in order to sell at inflated prices, or artificially deflating prices to buy stocks cheap. There have been recent reminders of this. Lucent Technologies, the telecom network?equipment giant, and Emulex Corp., a computer network hardware vendor, saw $7.1 billion (approx. Rs28,000 crore) and $2.6 billion wiped off their respective stock market values within hours of bogus press releases appearing on the Internet. NEIP, an obscure, nearly bankrupt company, saw its stock price rocket by 106,600% in a matter of days, thanks to Internet message boards.
In a recent paper, one of us (Han Oszolyev) and a colleague demonstrated that it is enough to have a small number of gullible investors to render rumour-based pump-and-dump strategies profitable. Also, intense regulatory enforcement, which makes dishonest rumour mongering costly, may not necessarily curb pumping and dumping: Rumours are worth as much as they cost to produce, and the presence of regulatory enforcement may give credibility to rumour mongers, rather than deter them.
In another paper, one of us (Alexander Gümbel) and a colleague demonstrated that purely trade-based manipulation may be possible, even if there are no gullible investors in the market. The main insight derives from the fact that in certain circumstances, trade may affect the underlying security value—not unlike in action-based manipulation, except the only action affecting value is the trade itself. This type of manipulation is, therefore, not covered by insider trading legislation.
This is how it works. Suppose the investment behaviour of a firm can be adversely affected by a fall in its stock price. This may be the case, for example, because access to capital becomes more restrictive, or because the management may infer negative information about its proposed strategy from the stock price drop. If this is the case, then a speculator can establish a short position in a stock, and then sell more shares to drive down the firm’s stock price. This can generate a self-fulfilling prophecy, because the drop in the share price now leads to a cancellation of a potentially profitable investment opportunity. This further reduces firm value and allows the speculator to close out his short position at a profit.
This type of manipulation can only be carried out profitably via short sales: that is because manipulation destroys firm value—something that only a trader with a short position can gain from. This raises the question whether short sales should be regulated. Clearly, speculators’ ability to sell short a stock has the desirable side effect that negative information can find its way into stock prices more effectively. On the downside, an established short position provides its holder with an incentive to damage a firm. A potential way to limit this problem would be to require that short positions be disclosed once they reach a certain magnitude. In a way, such a rule would merely mirror disclosure requirements that have been applied to long positions for many years.
Alexander Gümbel (left) is universitylecturer in finance at Oxford University’s Saïd Business School.
Han Oszolyev is university lecturer in financial economics at the School.
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