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Side Running: A Time-Honored Wall Street Tradition

The Merrill Lynch bull logo inside the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
The Merrill Lynch bull logo inside the New York Stock Exchange.

The Wall Street Journal has a great write-up of the SEC case against prop traders at Merrill Lynch, who are accused of copying trades from client orders.

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The Journal reports:

On the fifth floor of Merrill Lynch & Co.'s headquarters at the World Financial Center in lower Manhattan, a small team of traders who bought and sold securities with the firm's own money for two years were close enough to see the computer screens of traders taking orders from clients and overhear their phone calls.

The Securities and Exchange Commission said Tuesday that the proprietary-trading desk, which traded electronic messages with its nearby counterparts, was illegally spoon-fed information about what Merrill's clients were doing, and then copied an unspecified number of trades between 2003 and 2005. Merrill also encouraged market-making traders to generate and share "trading ideas" with the proprietary-trading desk, according to the SEC.

These guys weren't exactly front-running client orders. Instead, it appears they were doing something that might be called "side running." This strategy certainly was not confined to Merrill Lynch. I know from my conversations with traders that it also went on at least three other prominent Wall Street firms. At Lehman Brothers, side-running was considered part of the job of the market makers.

Although front-running is much more familiar to critics of Wall Street, side-running was much more common. One tactic was for a trader to intersperse his own trades inside of a huge client trade. If the client wanted a block of 100,000 shares of Apple, you bought 20,000 for the desk while you were at it. Alternatively, you could just buy immediately after placing a client order, but before the market reacted to the new buying spree by raising the price of the shares (this tactic became harder to pull off as pricing went electronic).

It's only a small step from having market makers earn their keep by "side running" to having prop traders squeeze out some extra profits by using client information.

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