A Brief History of Chinese Day Traders Manipulating U.S. Stocks
Michael Friedman, Trillium
22 April 2015
Criminal charges against Canadian Aleksandr Milrud for leveraging an army of Chinese day traders to manipulate the stock market highlight a vulnerability in existing U.S. equities market structure: In order to effectively monitor trading activity to detect manipulation, it is necessary to identify which orders came from which customer, and consolidate order activity sent to different exchanges. For now, the exchanges can do neither of these.
This article originally was published Jan. 5, 2015.
Canadian Aleksandr Milrud was arrested in Florida last week on charges of orchestrating an international stock manipulation scheme.
According to the FBI, Milrud was caught on tape at a New York restaurant last June bragging “that he controlled approximately 60 percent of all China-based traders presently engaged in layering.” Milrud was trying to convince a foreign broker to give him access to U.S. stock markets so he could keep his army of layerers at work. The broker happened to be wearing a wire for the FBI, hence the fairly rapid (for this sort of thing) charges.
As sensational as this story is, it is not the first enforcement action to make headlines in recent years (or even in recent weeks) involving Chinese day traders manipulating U.S. stocks. What is going on here? How did this become a trend?
The first Chinese day trader layering actions were brought in 2011 and 2012 by authorities in the U.S., U.K. and Canada against
Canadian broker Swift Trade and
its U.S. affiliate, Biremis. Swift Trade and Biremis maintained day trading floors around the world, with the majority located in China, and provided them with access to U.S. and U.K. equities markets. (A 2014 action alleged similar conduct by the same group
in Japan’s stock market.) The overseas day traders regularly engaged in layering, with Swift Trade and its owners participating in the profits. Swift Trade and its affiliates wound up owing close to $13 million in fines to various international regulators.
Later in 2012, the
SEC and
FINRA announced concurrent actions against Hold Brothers, a New York broker. Hold Brothers’ owners shared in the profits of an offshore affiliate called Demostrate, which was also Hold Brothers’ largest customer. According to the SEC, “All of the persons who traded through Demostrate’s account were located outside the United States, primarily in China. Hold Brothers assisted Demostrate and its traders in accessing the securities markets by providing these foreign traders with access to front-end trading platforms and access to the U.S. securities markets.” Many of the Chinese Demostrate traders used that access to manipulate U.S. markets, specifically by layering. Hold Brothers was fined $6 million for its role in this scheme, of which the SEC is still trying to collect $2 million despite Hold Brothers continuing to operate.
In 2014,
the SEC charged a Los Angeles broker with failing to adequately supervise the trading of one of its largest clients, World Trade Securities. WTS is an affiliate of World Trade Financial Group, a Montreal-based prop trading firm that, according to
a Wall Street Journal story in May 2014, is the subject of a (possibly related) FINRA inquiry into Credit Suisse’s trading supervision. According to the SEC enforcement filings and some parallel (unresolved as of this writing)
charges brought by FINRA, WTS “had thousands of essentially anonymous foreign traders trading through a single customer account, … most of whom were in China.” The SEC ultimately fined WTS’s broker for failing to adequately monitor WTS for layering.
Another Los Angeles broker was
sanctioned by CBOE in 2014 for failing to adequately monitor the trading of its customer Vantage Point Securities. Vantage Point “had more than 1,000 individual traders, all of whom or most, were located in China.” While no layering was alleged, Vantage Point’s traders generated “the majority” of the exceptions generated on the broker’s wash sale report, and the broker was penalized for not conducting due diligence on Vantage Point’s individual traders.
Then we get to this week’s parallel SEC and criminal charges against Aleksandr Milrud. Apparently familiar with the above precedent, Milrud took some precautions in an attempt to evade detection of his Chinese day trader layering scheme. Unlike the previous schemes, Milrud worked with multiple brokerage firms in an attempt to obscure the relationship between his “dirty” orders that pushed prices around and the “clean” orders that harvested the benefit of those price moves. This strategy might have worked if not for the fact that Milrud confessed his entire scheme in tape recorded meetings after a prospective broker became an FBI informant.
What can we learn from this history?
First, what’s with all the Canadians? Three of the four China-US layering schemes passed through intermediaries in Canada. I don’t have a strong theory for why this is so; readers’ theories are welcome in the comments.
Second, it is worth mentioning that all of these schemes involved human manual day traders, not automated HFT machines. This is because layering is intrinsically slow. It requires waiting for multiple other market participants to react to your orders and adjust their prices. The time frames of each layering event discussed in these actions are measured in tens of seconds, plenty slow enough for humans to manually perpetrate.
Third, there is an apparent trend toward desperation for Chinese day traders seeking access to U.S. markets. Thanks to the above enforcement actions, and more importantly the SEC’s 2010 Market Access Rule requiring all U.S. brokers to maintain surveillance systems to detect market manipulation, would-be layerers who once enjoyed accounts at legitimate firms like Credit Suisse now have to resort to working with the likes of Milrud, and even then the FBI might be listening. While not all Chinese day traders are manipulators, the regulatory burden on U.S. brokers wishing to do business with Chinese day traders is significant. Chinese traders are running out of access points to U.S. markets, and soon may have no access at all.
Finally, Milrud’s split-brokerage approach to manipulation highlights a vulnerability in existing U.S. equities market structure. In order to effectively monitor trading activity to detect manipulation, it is necessary to both (1) identify which orders came from which customer, and (2) consolidate order activity sent to different exchanges. The exchanges can do neither of these things, because the order messages they receive are marked only by which broker sent them, not which customer, and because each exchange lacks access to orders sent to other exchanges.
FINRA, acting as the common market surveillance vendor to many of the exchanges (at least until
NYSE reclaims that role for itself at the end of this year), is able to consolidate order flow from different exchanges, but still only sees broker IDs, not customer IDs. Broker compliance desks are able to see both customer IDs and orders sent to multiple exchanges, but only for their own customers, and not for their customers’ accounts at other brokers. The planned Consolidated Audit Trail will ultimately fix this vulnerability, providing a single point of access to all relevant order details; but until CAT comes online, schemes like Milrud’s, when not caught on tape, will be very hard to detect. Perhaps this story will provide some urgency to speed that process along
.