Scam Science: Chop

Ask any of the older guys at your firm about chop and you're guaranteed to get a chuckle. Chop goes by many other names on the Street (inside, rip, tear, gash, juice, grease, and others too numerous to list) and it is simply excess commission charged to a customer without that customer's knowledge or consent. Get a few drinks in a guy who's been around awhile, and you're sure to hear tales of massive chop in the old days.

Like most things, though, chop got out of hand and caught the attention of the regulators. By the late 90's, firms once satisfied to make an extra eighth or quarter on the spread began pulling out all the stops and selling Rule 144 and Reg S stock to the public and making dollars per share on the sly instead of pennies. The mob, always on the periphery of the markets, saw the opportunity and opened or took over numerous chophouses. Gary Weiss covered the whole tawdry mess in his excellent book Born To Steal and Jordan Belfort (former CEO of Stratton Oakmont) gave a first-hand account in The Wolf of Wall Street, if you can get through it.

For the first 200 or so years of the New York Stock Exchange, an orderly market in securities was maintained by floor traders known as "specialists". They were called specialists because they specialized in one (or sometimes a few) stocks. In other words, if you wanted to buy IBM stock, you had to go through the IBM specialist on the floor of the NYSE. (Well, you didn't, but the firm that held your account did.)

At the beginning of each trading session, the specialist would line up the premarket buys and sells and figure out the price at which the stock should open, ideally striking a balance between longs and shorts. The specialist would establish a buying price (the offer or ask) which was higher than the selling price (the bid). In other words, customers buying the stock would pay more for their shares than customers selling the stock would receive for their shares. The difference was kept by the specialist as his compensation, and is known as the spread.

Fast forward to 1971 and the birth of the NASDAQ. In the beginning, it was just an electronic bulletin board listing stock prices. Market makers (the NASD term for specialists) would call each other on the phone and buy and sell stocks. This was the early Over-The-Counter (OTC) market. The advantage was that market makers could be anywhere and didn't have to be on the floor of the exchange.

This worked well until the crash of 1987, when many market makers just refused to answer their phone. At this point, the NASDAQ computerized the exchange, starting with the Small Order Entry System (SOES). Never again would customers be unable to buy or sell because a given market maker bailed on the market. The new system listed the bids, the offers, the volume, and most important who was bidding for the stock, who was offering the stock, and how much they were willing to buy or sell.

The NASDAQ offered a home to thousands of companies who couldn't otherwise qualify for listing on the New York or American stock exchanges. By the mid-80's, many companies (mostly high tech or biotech) who could qualify began to choose the NASDAQ over the old school exchanges. This created legitimacy for the NASDAQ and enabled the chophouses to ride the coattails of the popularity of the new market.

In order to maintain an orderly market in a given security, a firm's trading department must sometimes buy the stock when it doesn't necessarily benefit the firm and likewise sell the stock when it isn't necessarily to the firm's advantage. In order to maximize profits to the firm, trading departments would often "inventory" stock they expected purchase orders for in order to hedge against the risk of the market moving against them. The firm's brokers would then sell the inventoried stock to their customers.

When I got started in 1992, there was a maximum mark-up rule. Mark-up was the term the NASD used for commission. The maximum mark-up at the time was 5%. So if your customer bought a stock offered at $10 per share, your 5% mark-up would be 50 cents and the customer's trade confirmation would reflect that he purchased the stock at $10.50 per share. That was all completely above board and fully disclosed to the customer.

Now, let's say that the bid for that stock was $9.50 and the offer was $10 when he bought it. Your trading department inventoried some of that stock earlier in the day at the $9.50 bid and now wanted to unload it. In order to encourage you to recommend it to your client, the trading department offered to split the spread with you. In this case, they would tell you that XYZ stock was "up from" $9.75. What that meant is that your customer is going to buy the stock at $10.50 per share (including your mark-up) but that you are going to receive 75 cents per share in commission instead of only the 50 cent mark-up ($10.50 - $9.75 = .75).

The customer is only going to see the 50 cent mark-up he was charged on his confirmation. The other 25 cents is between you and your trading department, and kicks that 5% mark-up up to 7.5% - a violation of the maximum mark-up rule that was tolerated for decades. Firms argued that any in-house commission arrangements were just that, and were of no concern to the regulators.

To give you an idea of how prevalent the practice was, every firm I worked for and every firm my friends worked for held a pre-market conference call with trading each morning to run down the list of inventoried stocks and how much the chop was on each.

Here's one final delicious twist. Every once in a while trading would fuck up and be short a stock they needed in inventory. In order to avoid the expense of buying the stock on the open market, trading would sometimes "pay down" for a stock your customers owned. In other words, if your customer sold the stock trading was looking to buy, you would not only make the 5% mark-down (mark-up on purchases and mark-down on sales) but trading would also throw you a little chop for easing their pain.

I'm of the opinion that chop in and of itself is not necessarily a bad thing. The market maker is going to make the spread anyway, so who cares how they divvy it up within the firm? Where chop becomes a problem is when it is used to motivate brokers to screw their customers.

It doesn't take a rocket scientist to figure out that the greatest amount of chop is going to come from those stocks with the most egregious spreads. By and large, this phenomenon no longer exists today, but back then it wasn't uncommon for a customer to be down 40% on some stocks the minute he purchased them. If a stock was trading at 2 7/8 x 3 1/2 (not uncommon) and you marked that stock up 5% on top of the offer, your customer was down 23% the minute he drove that stock off the lot.

Particularly greasy deals might pay the broker 25-30% commission on the trade, including the mark-up, and the customer would only see the 5% commission on the confirmation. But he was buried in the stock. The bid would have to come up 40% for him to break even. Unfortunately, a lot of guys went for the easy money and buried their clients in this way.

The regulators eventually caught on and drove the practice of chop far underground. It still exists today, but you'd have to be a fool to think any legitimate shop would risk it. I will leave you with one good chop story, though, just so you can see that fairy tales do come true.

I was building a pretty sizable position in a company that manufactured plastic bags, of all things. I know, not sexy, but stable growth, good management and great prospects. Anyway, the company had a set of warrants outstanding that were due to expire in three weeks. I knew the company didn't want the warrants to expire because the warrants enabled the company to raise more money without further registration hassles, so I expected the board of the company to vote to extend the expiration date of the warrants.

I called trading to see what the story was on the warrants and they just laughed. The warrants were trading at 1/4 x 3/8 and trading told me I could have all I wanted with an eighth in it. Think about that for a minute. 3/8 with an eighth. I could put them out to my customers with no mark-up and still pocket a 33% commission.

My buddies thought I was crazy. They told me I might as well mug my customers in the parking lot. But I had a feeling about the warrants, and I told my customers so (all of them already owned the stock so they were familiar with the company - I didn't take the trade to anyone who didn't already own the stock). Most of them agreed with me, and committed however much they were willing to see disappear in three weeks if it didn't work out. I made a bundle.

Fast forward two weeks and the board approves the extension of the warrants. I'm able to unload every last one of them for a half, and each of my customers made a 33% profit in less than a month. The guys I worked with were howling mad, let me tell you. Big chop never works out like that, but every once in a while lightning strikes.

And you can't win if you don't play.