Kirby Partially Boycotts 3 Brokerages : L.A. Fund Manager Cuts Dealings 20%-25% Over Index Arbitrage Trading

The chief of a $15-billion investment fund said Thursday that his firm has slashed business with four major brokerages by 20% to 25% because of the firms’ extensive use of “index arbitrage” trading for their own accounts.

Robert G. Kirby, chairman of Capital Guardian Trust Co. in Los Angeles and a member of the presidential commission that studied the causes of the Oct. 19 market crash, said he has cut back business with the firms because their use of index arbitrage trading for their own accounts hurts customers and contributes to market volatility.

Index arbitrage is a technique in which computers detect tiny price discrepancies between stocks and stock index futures, which represent a basket of stocks, and direct trading to profit from the differences.

The technique was blamed for contributing to the market crash by increasing pressure to sell stocks. It also can be used as part of a practice known as “front running,” in which a broker places his orders ahead of or in anticipation of orders from a big institutional customer.

Thorny Ethical Issue

Kirby’s boycott, which he said may be copied by other big money managers, has probably cost the brokerages millions of dollars in commissions. It has also focused new attention on a thorny ethical issue on Wall Street.

“Nobody is accusing them of any wrongdoing,” Kirby said. “But when they are trading for their own account at the same time they are acting as agent for you, there is a conflict of interest that introduces the possibility that they could be utilizing the knowledge of their customer order flows to earn a profit.”

He said the business reduction has occurred over the past six weeks, but he did not want to discuss it publicly until the Brady report was issued. He said his fund has found that it cannot reduce its reliance on the big firms any more than 25% and still maintain the best trading execution for its own customers.

Kirby identified the four brokerages in a Times article on Wednesday as Goldman Sachs, Merrill Lynch, Morgan Stanley and Salomon Bros. Morgan Stanley declined to comment and the other firms did not reply to telephone calls on the subject.

The Brady Commission did not name names, but it recommended that regulators examine potential problems posed by brokers that trade in anticipation of customer orders.

Nicholas F. Brady, the investment banker and former senator who headed the commission, said earlier this week that there was insufficient information to focus in detail on front running. But he said regulators should examine the issue. Another commission member, Howard M. Stein, suggested the New York Stock Exchange should also address the issue.

“What is the New York Stock Exchange going to do about its own members?” asked Stein, chairman of Dreyfus Corp., another major money management fund. “It should be looked into. We didn’t have the capacity.”

The Brady report was compiled under a 60-day deadline. A staff member said Thursday that there was not enough time to pursue evidence that indicated widespread front running by some brokerage houses.

Most Likely Suspects

“We saw what looked to be prima facie front running, but it depends on whether the trading records were arranged properly in a time sequence,” said the staff member, who spoke on the condition that his name be withheld.

He said commission personnel felt a more extensive examination of the trading data might yield stronger evidence of the tactic.

A survey of representatives of big buyers and sellers last year named large mainstream brokerage houses as most likely to be guilty of front-running abuses. Over half the respondents to the Traders Forum survey blamed the problem on declining brokerage commissions, which forced the big houses to search for other sources of profits.

A major alternative source of profit for the big firms has become proprietary trading, or buying and selling stocks and futures contracts for their own accounts.

Matter of Training

John J. Morton, managing director of trading for Dewey Square Investors, a division of the Bank of Boston, told securities analysts on Dec. 3 that concerns over front running have contributed to the ethics crisis on Wall Street.

“How did all of that happen?” Morton asked in his speech. “In the first place, Wall Street decided some time ago that they would forgo long-term relationships for short-term profits. Many of the young professionals actually think that this is the way business should be conducted. They were trained to go for the dollar instead of supplying services.”

Similar criticisms have surrounded the insider trading scandal, and variations of front running are similar to insider trading.

For instance, a broker who receives a big sell order from an institutional client knows the order will probably send the stock price down. Before executing the customer order, the broker can use his own trading desk to buy cheap futures contracts in Chicago that will increase in value when the stock goes down.

In another example, which Morton used in his speech, a middleman who matches buyers and sellers on the the exchange floor can hold an institutional client’s buy order from a broker long enough to purchase stock for himself. The middleman then sells at a profit after the institutional order sends the price up.

Middlemen, while not working directly for brokerage houses, pay more commissions to brokers than most institutional accounts, which makes them valuable customers, Morton said.

In a telephone interview Thursday, Morton said: “It is time for intelligent people to sit down and discuss these problems. Bob Kirby probably started that dialogue with his comments.”

ONE VARIATION OF ‘FRONT RUNNING’ 1.An institutional client telephones his broker and places an order to sell 300,000 shares of xyz stock. 2. Before passing the order to a floor trader at the New York Stock Exchange, the broker buys futures on the Chicago Mercantile Exchange that will be valuable if the price of XYZgoes down. 3. The purchase of the futures contracts stirs other traders to follow, pulling down the price of XYZ stock on the NYSE. 4. The customer order is executed, but the price has declined because of the downwardpull from Chicago. The 300,000-shares sale pushes XYZ stock down futher. 5. The broker unloads his futures contracts and collects his profits while also pickingup a commission from the unknowing institutional client.