Bear Stearns' Platform Made Market-Timing Easy

But whether anyone at the firm knew about it is a point of debate.
By Matthew Goldstein ,

Whether it meant to or not,

Bear Stearns

(BSC)

used to operate a mutual fund trading platform that was a market-timer's dream, regulators and industry sources say.

The platform enabled hedge funds and other wealthy investors looking to market-time to make more frequent trades, because Bear Stearns was able to "clear," or process, those trades faster than other Wall Street firms.

New Jersey regulators, in an enforcement action filed last week against

Pimco

mutual funds, said the Bear Stearns platform was particularly "advantageous for market-timers," because trades could clear within a day rather than the industry's three-day norm.

Bear Stearns, which boasts one of the largest trade-clearing operations on Wall Street, wasn't charged in the New Jersey action against Pimco, a division of

Allianz Dresdner Asset Management

. The allegations about Bear Stearn's trading platform should add more fuel to a

Securities and Exchange Commission

investigation of the firm's role in the mutual fund trading investigation.

Earlier this month,

TheStreet.com

reported that

the SEC has been questioning people about Bear Stearns' role in clearing trades for a number of small brokerage firms that may have permitted hedge funds to engage in improper trading of mutual funds. In the Pimco litigation, for instance, New Jersey regulators allege that

Brean Murray

, a small New York brokerage, used the Bear Stearns platform to place numerous market-timing trades.

The SEC and federal prosecutors in New York are trying to determine whether officials at Bear Stearns were aware that some investors could have used the platform to make improper trades.

In particular, regulators are trying to learn whether officials at the big Wall Street firm knew some brokers might have used deceptive measures -- such as multiple accounts and false identities -- to help their clients engage in market-timing.

Market-timing is the term for a shady strategy in which mutual fund shares are bought and sold frequently in order to profit from price differences in different markets. It's harmful for the vast majority of mutual fund investors, because it can dilute the value of a fund by driving up trading and administrative costs.

Yet investigators could have a tough time bringing a case against Bear Stearns over market-timing, because in most instances it's a legal, if unsavory, trading strategy. An executive with a small brokerage that cleared its market-timing trades through Bear Stearns said there's little doubt the big Wall Street firm knew what was going on. But the executive, who didn't want to be named, said everyone was under the assumption that as long as no deception was involved in placing those trades, market-timing was legal.

Bear Stearns, however, faces a harder time grappling with another trading issue the SEC and prosecutors are looking into, which is whether the platform enabled some hedge funds to engage in late trading.

In the eyes of investigators, late trading of mutual funds -- trades placed after 4 p.m. ET, but made at the 4 p.m. ET closing price -- is the more serious offense, not the least reason being that it is illegal. In late trading, an investor gets to buy shares of a mutual fund after the release of market-moving news, but before the impact of that news can be factored into the price.

Mutual fund shares are priced once a day, shortly after the close of the trading day at 4 p.m.

A number of officials with brokerages that cleared trades through Bear Stearns said the firm's trading platform accepted trades up until 6 p.m., and in some cases even later. These sources said any after-hour trades were supposed to be processed at the 4 p.m. closing price, but the platform lent itself to abuse by late traders.

One industry source called the Bear Stearns platform "a place of last resort" for late traders.

A putative class action filed last November against Bear Stearns has alleged that the firm knew its clearing customers were misusing the mutual fund trading platform to engage in late trading. Bear Stearns, the lawsuit contends, "generated substantial revenues and profits from participating in the illegal conduct." Bear Stearns has denied the allegations.

In fact, some industry sources said it is possible Bear Stearns was not aware of any illegal conduct. They noted that Bear Stearns, on a number of occasions, had warned brokers not to misuse the trading platform.

It's too soon to say whether regulators will be able to hold Bear Stearns liable for infractions committed by its brokerage customers. Clearing is often seen as an administrative task, and firms that do clearing work are generally held to a lower standard of due diligence than the brokerages they process trades for.

However, courts have been more willing to hold clearing firms to a higher standard of liability, since Bear Stearns paid a $38.5 million fine in 1999 to settle an SEC investigation into the firm's role in clearing and processing trades for

A.R. Baron

, a corrupt brokerage firm.

Loading ...