OTC Markets Are Woefully Broken

| About: SPDR S&P (KBE)

From Professor Jayanth Varma’s blog, last Friday saw an interesting hidden news dump from the SEC related to ICAP and the the OTC market (pdf here).

On the UST desks, ICAP, through the Brokers, engaged in deceptive conduct by displaying fictitious “flash” trades on ICAP’s screens seen by its UST customers, who took that information into account in making their trading decisions. In addition, the firm represented to its customers that the ICAP trading screens would handle customer orders in accordance with certain workup protocols, which the firm and the Brokers circumvented when Brokers used manual tickets to liquidate house positions that were acquired through error trades or through ICAP’s posting of executable bids and offers. Between December 1, 2004 and December 31, 2005, certain ICAP UST brokers displayed thousands of fictitious trades on ICAP’s screens, and used manual tickets in thousands of instances to close out of house inventory positions acquired as a result of error trades or through ICAP’s posting of executable bids and offers, in certain of which instances ICAP’s customers’ orders received different treatment than the customers expected pursuant to the workup protocols.

They pay $25m in fees, don’t admit any guilt, and agree to bring in a consultant to give an all clear on deceptive, fictitious trading and traders liquidating their own positions. Finding a way to reform this market needs to be a priority for 2010. As Varma says:

The question in my mind now is how badly broken are the OTC markets. Whenever, people describe the stock exchanges as casinos, my response is that even if many of the participants are only gambling, the stock exchange still performs the socially useful purpose of price discovery. OTC markets that do not provide transparent price discovery do not perform this function and are much closer to pure casinos. Those that distort the price discovery are worse than casinos.