The SEC charged Merrill Lynch today with something that many people suspect happens all the time at big brokerage firms: Abusing the “Chinese Wall” that is supposed to exist between the firm’s proprietary traders and the traders who broker trades on behalf of clients.
The two branches, proprietary trading and client trading, aren’t supposed to discuss their trades, mostly for fear that the prop traders will learn about a big client order that’s coming in and “front-run” it — potentially earning millions off of a momentary uptick in price when the client’s purchase order goes through, for example.
The SEC didn’t charge the firm with front-running, but its clients suffered paying an unfair price.
The SEC alleges that Merrill Lynch’s prop traders on the Equity Strategy Desk desk (which closed in 2005) knew about the trades that their colleagues had recently brokered on behalf of clients and traded on the information. Because the firm’s prop trades took place after the client’s, says the SEC, what Merrill Lynch did is not front-running, but it was still (allegedly) trading over the “Chinese Wall” that is meant to be in place.
And it might have earned them MUCH more than $10 million. So this settlement is a big fat score for the firm.
Merrill’s proprietary traders had improper access to information about the firm’s customer orders, and misused it to place trades on the firm’s behalf.” Bank of America acquired Merrill Lynch with the assistance of government bailout dollars during the height of the financial crisis in 2008.
In the same lawsuit against Merrill, the SEC alleges that when the prop traders learned about the client trades, their own trades were executed at a better price than the firm charged its clients.
So the fact that Merrill’s clients were not front-run offers little relief to the clients, because they still (allegedly) suffered paying an unfair price.
From the WSJ:
The SEC also alleged that in some instances, Merrill charged customers undisclosed markups and markdowns by filling customer orders at prices less favourable to the customer than the prices at which Merrill purchased or sold the securities in the market.Without admitting or denying the SEC’s findings, Merrill consented to the entry of the SEC’s order.
We don’t know how much more the clients were allegedly charged, so we don’t know if being front-run would have been worse. But if they had been, the cost would have looked something like this for example: If a share was trading at $1 when the prop traders executed the trade, and one second later, when the client trade was executed, it was trading at $1.01.
In either instance, Merrill would have earned more than was appropriate (and legal) and their client would have lost out.
The firm (now owned by Bank of America) settled for $10 million without admitting or denying wrongdoing.
With the SEC’s doling out such light punishment, it’s a wonder Goldman Sachs had enough confidence in the former director of both its CDO prop trading and client trading desk, Jerry Ouderkirk, to observe the Chinese wall. Before the firm removed him from the post of director of the CLO prop trading desk in May, he managed both desks.