SEC Probes ETF Use in Disguising Insider Trading

The Securities and Exchange Commission is investigating whether Wall Street traders are using exchange-traded funds as a means of disguising insider trading.

ETFs have emerged as a possible mechanism for maximizing gains in one stock while potentially masking trading patterns, people familiar with the matter say.

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In one scenario, a trader could learn information about a company, buy an ETF that includes the company’s stock, and short sell the other stocks in the ETF.

The practice, known as ETF-stripping, would allow the trader to benefit from movements in the company’s share price without directly buying or selling that stock.

Regulators, who work closely with the US justice department, are concerned that traders are adopting this approach, and others, to mask insider trading.

They are also looking into whether traders are using swaps to stay off their radar. The Dodd-Frank law will require a portion of swaps to trade on exchanges.

The concerns come as US authorities escalate their probe into alleged insider trading.

Prosecutors, working with the Federal Bureau of Investigation and the SEC, have announced criminal charges against former hedge fund traders, company insiders and consultants at an expert network firm.

Two dozen have pleaded guilty and a number are co-operating with the investigation. Washington’s case is built on evidence from wiretaps, co-operating witnesses and trading data.

Law officials said they needed to use unconventional tactics because traders had become sophisticated.

The so-called mosaic theory, whereby investors gather large volumes of data to arrive at conclusions that look like they might be derived from insider trading, can be used as a legal defense.

One fund manager charged with insider trading on Tuesday allegedly told an analyst that he need not worry since he was using mosaic theory.