Reuters: Traders manipulating cheap stocks

In our white paper that we released last week, one of the suggestions we made was for the SEC to abolish the maker/taker model.  We stated:

 “Maker rebates encourage volume for the sake of volume. This has generated high volume among the top 100 stocks, giving the illusion of a deep, liquid market. A good percentage of this volume is from firms engaged in rebate arbitrage, however.”

 Yesterday, Reuters ran an article titled “Traders Manipulating Cheap Stockshttp://www.reuters.com/article/idUSTRE68P27W20100926  The article states:

 “Some traders are manipulating U.S. stocks that are worth less than $1 by taking both sides of trades in order to earn big rebates, according to an official at Knight Capital Group Inc.  “It happens for hundreds of millions of shares per day,” Nazarali said, adding that this type of market manipulation is hard to prove. The gaming costs Knight “tens of thousands of dollars” per day on some days, he said.

 While the article deals with sub $1 stocks that are priced in sub-pennies, rebate arbitrage also occurs in the top 100 stocks that are priced over $1.  Due to the disparate rate structures at different market centers, it is very possible for firms to profit not from trading but from capturing rebates.  Recently introduced inverted fee schedules for select securities will only exacerbate this problem (http://www.cboe.com/publish/cbsxfeeschedule/cbsxfeeschedule.pdf)

This “hot potato” volume that these rebate arbitrage strategies creates is distorting average daily volume statistics and could be distorting a key piece of information that many investors rely upon.