Market Manipulation

Abstract

Market manipulation is the deliberate intent of hindering or influencing the market from its free and fair functions by creating and/or spreading false or misleading information, fake appearances and perceptions, deceitful practices or pricing, and any other behavior that would interfere with the market. In general, market manipulation most often refers to manipulation of stocks or securities exchange markets and to behaviors engaged in for personal gain. Most of these behaviors, albeit not all, are forbidden in the Securities Exchange Act of 1934, as well as other regulations that appeared after cases of market manipulation caused grievous harm to the national economy and the public good. Some cases of market manipulation, however, are legal to date.

Overview

Market manipulation is purposeful interference with the free market by engaging in deceptive or manipulative practices. Also known as price manipulation, market manipulation usually refers to stock manipulation, that is, engaging in actions that lead to the increase or decrease of stock market prices for personal profit. Market manipulation involves artificially impacting the price of securities or otherwise influencing securities market behavior. Common forms of manipulation are spreading false or misleading information about a firm, artificially inflating or deflating a security price, fixing prices or trades, cornering a particular market, and trading on insider information that has not been made publicly available. In the United States, most forms of market manipulation were banned in the Securities Exchange Act of 1934. Short selling is one form of manipulation that remains legal.

Securities are fungible goods—that is, they are mutually interchangeable financial goods that hold a monetary value, such as stocks and bonds. These are traded in secondary markets, which are markets that allow banks and financial institutions to sell securities, mortgages, and commodities (agricultural or other basic goods that can be traded in the stock market). Besides investors, people who trade in the stock market usually represent or own a publicly traded corporation, that is, those companies allowed to sell their shares in the stock market. Company owners sell shares and investors buy them, usually through a stock brokerage.

Investors are influenced by the actions of all stock market actors, whether these actions are legal or not. Because of its volatility and the often ambiguous or hard to ascertain value of its goods, the stock market is vulnerable to manipulation. Anybody in the stock market can engage in these activities, from stockbrokers to traders, bankers, and analysts; even corporate CEOs can engage in intentional deception or misrepresentations with the purpose to alter prices. These actions usually harm other investors and companies, which is why it is illegal in most countries.

Even though it is illegal, it is hard for government agencies and other regulator entities to detect and control manipulation, given the size, dynamism, and volatility of the market. Bigger companies are better watched, so much of the manipulation takes place through smaller companies and stocks, known as penny stocks, microcap, or nanocap stocks. The trading of “penny stocks”—cheap and highly risky shares—often occurs at the margins of the markets, with limited disclosure and lack of liquidity; it pertains to companies with a capitalization of less than $50 million. One way the SEC detects market manipulation is when the supply or demand for a given security rises and falls suddenly and significantly, for no obvious reason.

Manipulators use many tactics, the most common of which are spreading false or misleading information about a firm, engaging in actions aimed at inflating or deflating a security price (to provide the appearance of higher or less demand), rigging prices or trades, and illicitly sharing information about trades. Insider trading is among the most common and popularly visible of market manipulations and involves the use of non-public information to gain unfair advantage in the market for personal gain. Insider trading can be done by anyone at any stage of the market, from stock brokers to corporate executives. For instance, if an executive from a publicly traded firm discloses information about his or her firm’s earnings and another person overhears the information and trades with it, it is considered an illegal act of insider trading by the SEC.

The SEC can detect illicit insider trading by watching the trading movements of the stock market. Usually, a stock volume rises naturally after material news (e.g., company information about unexpected earning results, financial developments) is issued by its firm to the public. However, when volumes rise dramatically for no apparent reason, this acts as a red flag for SEC regulators and is often followed by an investigation. In 2017, the New York Stock Exchange (NYSE) required that publicly traded firms notify the NYSE at least 10 minutes in advance of any material news release during trading hours and changed its rules to forbid them from issuing material news after the market’s closing time.

Another market manipulation tactic is known as “cornering.” Cornering a market refers to the process of buying a significant number of shares with the intention of manipulating its price illegally. An uninterrupted buying action bolsters the security price, making it more attractive to unaware buyers, who increase the buying frenzy and make the price rise even faster. At a culminating point, the initial buyer sells the accumulated stock—at the artificially inflated price—knowing that it will fall once the stock returns to its normal supply and demand stage. This is illegal because, as with illegal insider trading, it clearly involves purposefully deceptive practices and creates an unfair advantage.

“Wash trading” is a process by which a trader buys and sells a security with the intention of generating misleading information. Sometimes, wash trades are performed by colluding traders and brokers selling to each other. Wash trades may also be done by traders acting as both buyer and seller of the security. The purpose is to push up the value of the security for personal gain, such as by later short selling it. Wash trading became illegal in the United States by the Commodity Exchange Act of 1936.

Another illegal practice is that of “churning.” Churning refers to the process of a trader buying and selling securities in excess, to generate a higher rate of commissions for him or herself. By churning, a broker is taking advantage of his or her client, so that it includes a violation of trust. It is for this reason that experts recommend that investors not give stockbrokers full control over their investment portfolios.

“Bear raiding” refers to the practice by a trader or a trading group of banding together to bolster a stock price through short selling and spreading rumors about a particular company. Short selling is a very complex process that involves the sale of securities that the trader has borrowed (often from a broker); in this case, the seller profits if a security’s prices fall. The seller intends to buy it back eventually at a lower price and keep the profit. The firm targeted by bear raiding is commonly going through a rough phase and is in a weakened position. Short selling is not illegal by itself. It is, experts explain, a speculative trading activity. Nevertheless, the SEC considers short selling market manipulation even though it is legal.

Applications

In order to understand how market manipulations can occur and the harm they cause, it is useful to look at case studies. One of the most notable is the insider trading case of Enron Corporation, founded in 1985. In the 1980s, the deregulation of energy markets allowed companies to speculate on futures prices, charge higher prices, and other profitable developments. Enron created Enron Finance Corporation in order to profit from these developments. Kenneth Lay, the CEO, appointed Jeffrey Skilling to head it. Skilling, in turn, created a novel accounting method known as mark to measure (MTM), approved by the SEC. With this instrument, a firm could create an asset and claim its “future profits” in the books as actual, even though the profits did not exist yet. However, because it is not based on actual cost it is ambiguous and easier to manipulate. In 1999, with the spread of the Internet, Enron created an electronic online trading website, Enron Online, which in a few years was trading nearly $350 billion.

However, a recession hit in 2000, leading Enron to falter. To hide its losses and appear more profitable in the stock market, Enron began to engage in deceptive and illicit practices. When Enron finally imploded, its top executives were charged with conspiracy, insider trading, securities fraud, wire fraud, and other fraudulent actions.

Enron’s collapse is iconic, because it was the biggest corporate bankruptcy to occur in the financial markets. In time, it was followed by others, including Washington Mutual and Lehman Brothers. Enron shareholders lost around $74 billion in the four years before its collapse; its employees lost millions in company shares and pensions. For many, it was their lifetime savings, and they were left emptyhanded and largely unemployable after Enron’s reputation crumbled.

The catastrophic harm caused by Enron’s actions led to new legislation aimed at promoting financial accuracy of information and transparency for publicly traded firms. The Sarbanes-Oxley Act of 2002 increased the penalties for destroying, altering, and fabricating financial reports and other acts aimed at defrauding investors. Other regulating institutions also raised their standards for conduct. These actions are important steps in limiting the ways in which corporations can manipulate the market.

As an independent agency of the U.S. federal government, the SEC has the power to suspend trading when it suspects it is necessary in order to protect the public. The SEC clearly lists all factors that might cause a trading suspension. Among these are lack of accurate information (a firm has not filed appropriate or timely reports), doubts about the accuracy of the information made available (anything from financial status to operational conditions), potential market manipulations, and all other questions raised about trading behavior and information.

Some firms, however, are not required to file reports with the SEC. The SEC recommends that investors be careful about the risks of trading in such companies’ shares, as there may not be enough information available for an informed investment decision. The SEC has listed several recommendations for the public to follow to protect themselves from predatory or manipulative market behaviors. Among these, it urges caution with unsolicited stock or investment advice, promotions, or advertisements. Fraudulent behavior often involves the offer of a promising and novel investment product, such as a new pharmaceutical or medical discovery or an undervalued real estate property. While some of these may provide lawful investing opportunities, there may be situations in which companies are trying to sell shady investments or pump up a price for a “pump and dump” scheme.

Pump and dump schemes are market manipulations, in which traders spread misleading rumors about a firm in order to “pump up” its stock price. These rumors may be positive or negative, and often via Internet. Rumors may be spread by companies or by traders who stand to gain by selling, or “dumping,” their shares when the price has risen.

Finally, the SEC warns that signs of fraud include heavy stock promotion, shell or storefront companies (those which can prove no real operations), sharp increase in trading price or volume, an SEC suspension, improbable claims, and frequent changes in company name.

Further Issues

A novel and legal form of market manipulation is high frequency trading (HFT). HFT became popular with the rise of high-speed Internet. The most important benefit of HFT, according to experts, is that it added liquidity to the market—that is, it allows speedy sales and purchases without significant change in pricing. These show higher trading volumes because the profits are smaller.

Critics of HFT argue that the liquidity it provides is a “ghost” or fictional liquidity that exists too briefly, preventing traders from truly being able to trade this liquidity. It is not that the trades are not real, but that they are added and removed before it is possible for them to be really executed. These trades have gained a hold on popular imagination and been portrayed in myriad books and films, such as Michael Lewis’ Flash Boys: A Wall Street Revolt (2014), the documentary Ghost Exchange (2013), and the novel Rogue Code (2014), by Mark Russinovich.

HFT has been controversial since its inception. Because its high speed requires it be based on algorithms and complex mathematical models, HFT has taken human decision making and action out of the system, often dispensing with brokers and professional traders. Decisions are made in milliseconds and markets may surge and crash faster than ever before, without the reason being apparent to people in real time. For instance, the market was deeply shaken when in May 2010, the Dow Jones Industrial Average, one of the strongest stock indexes worldwide, was hit with its largest daily point drop ever, falling by 1,000 points in a matter of minutes before immediately rising again. It was, in fact, a flash crash. A follow-up investigation blamed it on a massive sell-off order. Since then, concern has grown about flash crashes.

HFT advocates posit that, besides adding liquidity to the market, HFT facilitates the exchange and interconnection between buyers and sellers, making it more efficient. Its longest lasting impact has been higher and faster trading volumes, even though many complain that this higher rate of activity is not real, benefits only traders primed for speed, and harms slower moving investors. Moreover, by concentrating trades on the most liquid and biggest securities, it is unfair to the smaller firms and has lowered the profit margins overall.

Despite these criticisms, market experts agree that after a decade, HFT is probably here to stay. It has undeniably changed the market, for good and bad. Prior to the arrival of high-speed Internet instant trading did not exist. In order to trade, investors called their brokers, who then placed their trades. With the Internet, what in the 1980s and early 1990s could take a whole morning, occurs in the matter of seconds.

Other issues of contention in the market is that some manipulation behaviors generally barred from stock market actors are allowed for specific entities, mainly central banks. Central banks entered the market during the Great Recession of 2008 to “rescue” endangered firms considered too big to fail. In time, their actions shifted toward bolstering the stock market by purchasing company stock, even those of the healthiest firms in the market. Central banks hold great sway over the U.S. stock market and there is much debate about the extent to which they can do things such as forbidding stock markets from correcting in any significant measure. Central banks also engage in actions such as buying national company stocks, to bolster the perception that an economic recovery is working. Experts calculate that central banks have accumulated trillions of dollars in stocks and become the biggest market manipulators to date.

Terms & Concepts

Brokers: Also known as stock brokers or share brokers, professionals associated with a brokerage firm and authorized to buy and sell stocks.

Capitalization: Conversion of income or assets into capital, or providing capital for a firm.

Commodities Exchange Market: Market in which various futures and options on various commodities, such as agricultural products, interest rates, or contracts, can be traded in the stock market.

Liquidity: Liquid assets are cash or currency, as well as a high-volume of activity in a given market.

Penny Stock: Very cheap and highly speculative common stock.

Securities: Financial assets tradable in the market. They can be stocks, debts, and bonds, among others.

Securities and Exchange Commission (SEC): Government agency meant to protect the public, specifically investors, from illicit and unethical fraud from companies offering financial trading services.

Stock Market: Another name for the stock exchange, the market for all stock trade. The New York Stock Exchange (NYSE), located in Manhattan, is the world’s largest and most important stock exchange.

Bibliography

Austin, J. (2017). Insider trading and market manipulation: Investigating and prosecuting across borders. Northampton, UK: Edward Elgar Publishing.

Calo, R. (2014). Digital market manipulation. George Washington Law Review, 82(4), 995–1051. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=98845774&site=ehost-live

Evans, M. (2015). Regulating electricity-market manipulation: A proposal for a new regulatory regime to proscribe all forms of manipulation. Michigan Law Review, 113(4), 585–605. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=100700633&site=ehost-live

Gerace, D., Chew, C., Whittaker, C., & Mazzola, P. (2014). Stock market manipulation on the Hong Kong stock exchange. Australasian Accounting Business & Finance Journal, 8(4), 105–140. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=99674062&site=ehost-live

Kamenopoulos, S. (2018). Rare earth elements: A historical comparison—favouritisms as probable factors causing market manipulation by China. World Economics, 19(2), 129–148. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=130888025&site=ehost-live

Manahov, V. (2016). Front-running scalping strategies and market manipulation: Why does high-frequency trading need stricter regulation? Financial Review, 51(3), 363–402. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=116791815&site=ehost-live

Nyström, K., & Parviainen, M. (2017). Tug-of-war, market manipulation, and option pricing. Mathematical Finance, 27(2), 279–312. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=121744526&site=ehost-live

Putniņš, T. J. (2012). Market manipulation: A survey. Journal of Economic Surveys, 26(5), 952–967. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=82092508&site=ehost-live

Taylor, G., Ledgerwood, S., Romkaew, B., & Fox-Penner, P. (2015) Market power and manipulation in energy markets: From the California crisis to the present. Reston, VA: Public Utilities Reports.

Teschner, F., Rothschild, D., & Gimpel, H. (2017). Manipulation in conditional decision markets. Group Decision & Negotiation, 26(5), 953–971. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=125842736&site=ehost-live

Suggested Reading

Fletcher, G.-G. S. (2018). Legitimate yet manipulative: The conundrum of open-market manipulation. Duke Law Journal, 68(3), 480–554. Retrieved January 1, 2019 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=133418286&site=ehost-live

Klöck, F., Schied, A., & Sun, Y. (2017). Price manipulation in a market impact model with dark pool. Applied Mathematical Finance, 24(5), 417–450. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. https://doi.org/10.1080/1350486X.2017.1406438

Tontoupoulos, V. D. (2017). Manipulation in Illiquid Markets—A Tale of Inefficiency? European Company & Financial Law Review, 14(3), 458–489. Retrieved November 26, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=127524617&site=ehost-live