Bucket shop (stock market)

Definition and term origin

According to The New York Times in 1958, a bucket shop is "an office with facilities for making bets in the form of orders or options based on current exchange prices of securities or commodities, but without any actual buying or selling of the property".^[2]

People often mistakenly interchange the expressions "bucket shop" and "boiler room", but there is actually a significant difference. A boiler room has been defined as a call centre where high-pressure salespeople call lists of potential investors (known as "sucker lists") to peddle speculative, even fraudulent, "securities". In contrast, a bucket shop could be better thought of as a place where people go to make "side bets" – similar to a bookie. In the UK, a "bucket shop" usually means a travel agency that specialises in providing cheap air tickets, often packaged with bogus accommodation arrangements.

The origin of the term bucket shop has nothing to do with financial markets, as the term originated from England in the 1820s. During the 1820s, street urchins drained beer kegs which were discarded from public houses. The street urchins would take the dregs to an abandoned shop and drink them. This practice became known as bucketing, and the location at which they drained the kegs became known as a bucket shop. The idea was transferred to illegal brokers because they too sought to profit from sources too small or too unreliable for legitimate brokers to handle.^[3] The term bucket shop came to apply to low-class pseudo stock brokerages that did not execute trades.^[4][5]

Legality

"Bucket shop" is a defined term in the many U.S. states that criminalize the operation of a bucket shop.^[6] Typically the criminal law definition refers to an operation in which the customer is sold what is supposed to be a derivative interest in a security or commodity future, but there is no transaction made on any exchange. The transaction goes "in the bucket" and is never executed. Because no trading of actual securities occurs, the customer is essentially betting against the bucket shop operator in a game based on abstract security prices. While trading in a legitimate exchange also provides a similar game or wagering aspect, the one distinctive characteristic of a bucket shop is the mimicry of trading securities when no actual securities are traded. The bucket shop's exchange is a fiction, which the parties agree to imagine as following the events occurring in a real exchange. Alternatively, the bucket shop operator "literally 'plays the bank,' as in a gambling house, against the customer." ^[7]

Bucketing of orders violates several provisions of U.S. securities law.^[8][9] These prohibitions apply to legitimate brokerages as well as bucket shops.

In the United States (ca. 1870–1920)

Bucket shops specializing in stocks and commodity futures appeared in the United States in the 1870s, corresponding to the innovation of stock tickers upon which they depended.^[10] In 1889, the New York Stock Exchange addressed the "ticker trouble" (bucket shops operating on intraday stock price movements), and attempted to suppress bucket shops by disconnecting telegraphic stock tickers. This embargo instead proved a severe hindrance to the Exchange's wealthy local clients, as well as the Exchange's brokers in other cities across the country. It also had the surprising effect of favoring competing exchanges, and was abandoned within days.^[11]

Edwin Lefèvre, who is believed to have been writing on behalf of Jesse Lauriston Livermore, described the operations of bucket shops in the 1890s in detail.^[12] The terms of trade varied among bucket shops, but they typically offered margin trading schemes to customers, with leverage ratios as extreme as 100:1 (a deposit of $1 cash would permit the client to "buy" $100 in stock). Since the trades were illusory and not settled in the real market, the shop likewise made no real margin loans, but did collect interest in cash from the client. The client could easily imagine that he had been loaned a great sum of capital (in fact an illusion) for a small cash deposit and interest payment.

To further tilt possible outcomes in their favor, most bucket shops also refused to make margin calls. The elimination of margin calls was portrayed as a benefit and convenience to the client, who would not be burdened by the possibility of an additional cash demand, and touted as a feature unavailable from genuine brokerages. This actually made the client more vulnerable to a heightened risk of ruin, with the losses flowing entirely to the bucket shop. In this situation, if the stock price should fall even momentarily to the limit of the client's margin (highly likely with thin, highly leveraged margins in volatile markets), the client instantly forfeits the entire cash investment to the shop's account.

Margin trading theoretically gives speculators amplified gains, but trading in a bucket shop exposes traders to small market manipulations due to the shop's agency. In a form of what is now considered illegal front running and self-dealing, a bucket shop holding a large position on a stock, and knowing a client's vulnerable margin, might sell the stock on the real stock exchange, causing the price on the ticker tape to momentarily move down enough to exhaust the client's margins. Through its opportunistic actions, the bucket shop thereby gains 100% of the client's investment.^[13]

The term bucket shop came to apply to other types of scams, some of which are still practiced. They were typically small store front operations that catered to the small investor, where speculators could bet on price fluctuations during market hours. However, no actual shares were bought or sold: all trading was between the bucket shop and its clients. The bucket shop made its profit from commissions, and also profited when share prices went against the client.

Bucket shops were made illegal after they were cited as a major contributor to the two stock market crashes in the early 1900s. The activity flourished until outlawed in the 1920s. In the United States, the traditional pseudo-brokerage bucket shops came under increasing legal assault in the early 1900s, and were effectively eliminated before the 1920s.^[14] Shortly after the failure of many brokerages on the Consolidated Stock Exchange in 1922, the New York assembly passed the Martin Act, which essentially banned bucket shops.^[15]