Hidden Trading: SEC Aims to Shed Light on 'Insidery' Information

Ignorance might be bliss in some circumstances, but that's hardly the case when it comes to investing. And the average investor is currently kept in the dark about one of the biggest reasons that stocks climb or fall -- trades from hedge funds and other big investors.

The Securities and Exchange Commission, or the SEC, is proposing to track these market-driving trades and help keep smaller investors more informed about them. Under the new proposal, large traders -- defined as "a firm or individual that trades 2 million shares or $20 million in securities in a day, or 200 million shares or $200 million a month" -- would be required to register with the SEC, which would give them a unique identifier.

Before the registered traders made a trade, they would need to give their ID to the broker, who would, in turn, be required to submit trade details to the SEC upon request. The provision would be a good first step towards leveling the playing field for the average investor.

Taking a Stand on Flash Trading

Why is that? Well, the law currently contains a loophole that permits a practice called flash trading, in which traders intercept orders to buy or sell stocks less than a second before they are executed on the exchange. If a flash trader sees a huge sell order for a stock, he can place his own sell order that gets executed right before the one he intercepts and pocket the profit as that order gets executed and the stock price falls.

Flash trading is one example of something I call "insidery information." Insidery information is material market-moving information that gives those who have it a way to make risk-free profits off those who don't. Flash trading is an example of this because the clients who are selling behind the flash traders' orders unwittingly siphon some of their proceeds to the flash trader. Insidery information ought to be illegal, but it's not.

And flash trading, as I wrote last September, accounts for a huge proportion of trading volume. One analyst estimated that flash traders account for a whopping 70% of trading volume. Those traders raked in $20 billion in profits in 2008.

Investors Trade in the Dark

All that means those traders are playing a big role in moving the market, yet most investors are unaware of those moves. And without taking those big trades into account, the explanations investors are usually given for why stocks go up or down are often wrong.

For instance, when media reports say stocks went down because of a bad jobs report, reporters are confusing coincidence with causation. In other words, stocks went down and the bad jobs report both came out on the same day. But that does not mean that the bad jobs report caused stocks to drop.

The real reason stocks drop is because the highest volume traders decide to sell more of the stock than there is demand to buy it. But information about who was involved in these transactions and why they were making the trades isn't currently available. If it were, we could start to understand why stocks move.

A Good Start, But A Long Way to Go

That's where the SEC proposal starts to make a difference. By requiring big traders to report their trades to the brokerage firms, the SEC's proposal would kick off the process of making that information available to investors in real time.

But it's only a start. If the SEC's rule goes into effect, there will still be plenty more that needs to be done to truly level the playing field. Specifically, the SEC would need to ask the big traders why they are doing each transaction and make all that information available to all investors as they happen.

Until we know this, the market will continue to be tilted in favor of the biggest investors because we will have no way of knowing why stocks go up or down.