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Some 33% of US stock trading activity takes place outside of exchanges. Four years ago, only 20% of trading did. What does that mean? Now, only two-thirds of trading actually sets the price of a stock that zips along the ticker, down from 80% in 2007. Where has all the trading gone?

Call it high frequency trading or automated market making or any number of other monikers, but trading isn’t happening on the exchanges. Instead, they might be traded within a dark pool, through a crossing network, or absorbed within the platform of a broker-dealer. The prices in these venues, however, don’t make it to the tape, and we are left with a question: is that a good thing? Read the rest of this entry »

High Frequency Trading (HFT) and the market’s shift to the edge

The whiz-bang technology in markets today means that when things go wrong, they go wrong very fast

Bart Chilton, CFTC Commissioner, on the flash crash and the perceived instability of trading outside of exchanges: via Reuters

Is the smoke clearing for expert networks?

From a modest hotel room in the Omni Shoreham in Washington DC, the SEC gathered a smattering of reporters, lobbyists, and others for a best practices seminar. But the somber title belied a dramatic observation to be made by an SEC official on expert networks. They’re not the problem.

Carlo di Florio, director of the U.S. SEC Office of Compliance Inspections and Examinations, spent just over six thousand words on reforms made under Chairman Mary Schapiro, the implementation of the Dodd-Frank Act, the focus on examination and training, and various enforcement actions in the advisory community. And then, almost 6000 words in and nearing his final remarks, he decided to “briefly mention the ‘Expert Network’ insider trading cases that the Commission and the Department of Justice have recently brought, and that have received much recent press coverage.”

Contrary to some reports that I have seen, I believe these cases do not represent some inherent hostility by the Commission toward expert networks Read the rest of this entry »

JUSTICE BREYER: So that would mean that every — every businessman — perhaps not every, but every successful businessman typically has something. His firm wouldn’t be successful if he didn’t have anything that others didn’t have. He thinks of a new way to organize. He thinks of a new thing to say on the telephone. He thinks of something. That’s how he made his money.
And your view would be — and it’s new, too, and it’s useful, made him a fortune — anything that helps any businessman succeed is patentable because we reduce it to a number of steps, explain it in general terms, file our application, granted?

MR. JAKES: It is potentially patentable, yes.

JUSTICE BREYER: Okay. Well then, if that were so, we go back to the original purpose of the Constitution. Do you think that the Framers would have wanted to require anyone successful in this great, vast, new continent because he thinks of something new to have had to run to Washington and to force any possible competitor to do a search and then stop the wheels of progress unless they get permission? Is that a plausible view of the patent clause?

….

JUSTICE SOTOMAYOR (addressing Jakes): No, but a patent limits the free flow of information. It requires licensing fees and other steps, legal steps. So you can’t argue that your definition is improving the free flow of information.

:: via Bilski v. Kappos – oral arguments, Monday, November 9, 2009. Later, Justice Breyer would ask Jakes, counsel to Bilski, whether his novel method of teaching antitrust law is patentable.

I strongly believe that the recent trend to patenting algorithms is of benefit only to a very small number of attorneys and inventors, while it is seriously harmful to the vast majority of people who want to do useful things with computers. When I think of the computer programs I require daily to get my own work done, I cannot help but realize that none of them would exist today if software patents had been prevalent in the 1960s and 1970s. Changing the rules now will have the effect of freezing progress at essentially its current level.

Donald Knuth, letter to the Commissioner of Patents & Trademarks, USPTO, February 1994

Inventions must be tied to a particular machine or transform something. Useful, concrete, and tangible result of State Street is inadequate.

David Kappos, Federal Circuit, in re Bilski, 30 October 2008

Patents aren’t bad. They’re an essential element of our economic system. The patent system and the 1952 shift to the protection of a process is the problem.

The 1952 Patent Act expanded coverage to include industrial processes. With the increasing importance of manufacturing to the economy, Congress had been successfully lobbied to provide a layer of protection around industrial manufacturing processes. With the Act, however, it introduced the framework by which to patent business processes – patents such as one click buy. The patents have muddied the water and introduced an expensive and chilling sense of uncertainty to business and information-oriented innovation.

Patents start with a basic tension. Economies benefit from the dispersion of ideas accompanied by sharing the details of inventions. Inventors, however, have little incentive to share the details if it results in no more than a roadmap for competitors to follow. Patents offer inventors a simple trade-off. Make public the details of your invention, and the government will in exchange grant the exclusive right to exploit it.

The 1952 Patent Act was designed to advance manufacturing quickly. Industrial processes, without the protection of a patent, might remain trade secrets, and these trade secrets were perhaps too valuable to the economy to be kept private. A patent system designed to protect them would open them up and accelerate growth. Or maybe it was more facile than that. Patents would provide legal protection and accrue enterprise to those that developed them. Either way, the patent system shifted from one organized around physical designs to one accommodating of processes. Read the rest of this entry »

Contrary to some reports that I have seen, I believe these cases do not represent some inherent hostility by the Commission toward expert networks, nor do they indicate that the Commission is seeking to undermine the mosaic theory, under which analysts and investors are free to develop market insights through assembly of information from different public and private sources, so long as that information is not material nonpublic information obtained in breach of or by virtue of a duty or relationship of trust and confidence.

Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, remarking on the misplaced focus on expert networks during the unfolding of the various insider trading scandals that “seem to have spawned some urban legends and misunderstandings”: via speech at the Omni Shoreham Hotel, Washington, D.C., March 21, 2011

Does relying on “industry experts” constitute insider trading?
There is nothing inherently wrong with hiring a company that arranges conversations between analysts or hedge fund managers and those who offer legitimate expertise to assist investors in making investment decisions. The information provided by experts can be part of the “mosaic” of information gathered by analysts or investment managers to assist them in the process of investment decision making. This type of information can include economic or industry forecasts.

Even if a piece of non-public immaterial information takes on significance when combined with primary research or other non-public immaterial information, the information may still be considered immaterial. This concept is known at the mosaic theory.

Michael McMillan, director, ethics and professional standards at CFA Institute, and Jon Stokes head, standards of practice, driving at the difference between expert networks and insider trading: via FT

Integrity Research has done the investment industry and general public the good service of providing more lengthy excerpts from the February 8th news conference in which Preet Bharara and Robert Khuzami outlined the contours of their investigation into insider trading. At the time, most major news coverage centered on a single quote from Bharara that suggested the networks were “verging on a corrupt business model” — without qualification. The expanded excerpts provided by Integrity Research, however, provide a great deal of qualification.

Neither Khuzami or Bharara would say that expert networks are verging on corruption. Bharara, to whom the press has attributed the statement, specifically says, “There is nothing inherently wrong with or bad about hedge funds or expert networking firms.” Khuzami, who heads the SEC’s enforcement division, echoed his statement: “Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions.” Far from suggesting that expert networks are verging on a corrupt business model, Khuzami and Bharara understand and validate the role of expert networks in primary research.

The US Attorney and SEC’s focus is insider trading, not expert networks. Bharara later clarified that the exchange of insider information could transpire in any circumstances, and expert networks may encounter these situations just as any other circumstances might. What matters to the SEC and the US Attorney is that it’s bad people doing bad things: “whether or not it’s done through an expert networking firm or its done as a McDonalds, it really doesn’t matter.”

Why, then, did the press come to characterize expert networks as verging on a corrupt business model?

Now let me begin by making something crystal clear. There is nothing inherently wrong with or bad about hedge funds or expert networking firms or aggressive market research for that matter.  Nothing at all. But if you have galloped over the line, if you have repeatedly made a mockery of market rules, if you have converted a legitimate enterprise into an illegal racket then you have done something wrong and you will not get a pass…If you made criminal activity your business model, then business as usual has to stop or the consequences, as dozens of defendants have now discovered will be severe. There are rules and there are laws and they apply to everyone.  No one is above the law, and those who would excuse or rationalize, brazen criminal conduct of the type of alleged today, are neither friends of Wall Street nor allies of business and they are certainly not supporters of the investing public.

Preet Bharara, US Attorney for the Southern District of New York: via Integrity Research

Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions. We allege that the charges reveal thoroughly corrupt conduct through and through….The only thing I would add to that is if you engage an expert networking firm, you are wise to conduct due diligence, to determine whether or not public company employees are engaged as consultants, and if so, there are a variety of devices and practices, that have arisen, across Wall Street, and in many regulated entities, to ensure that material non-public information is not crossing the transom, and that you are not receiving it.

Robert Khuzami, Director of the Securities and Exchange Commission’s Enforcement Division: via Integrity Research

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