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Federal agents have raided the offices and homes of prominent short sellers, seizing evidence of possible market manipulation:

The U.S. Justice Department has seized hardware, trading records and private communications in an effort to prove a wide-ranging conspiracy among investors who bet against corporate shares….

Agents seized computers from the home of Andrew Left of Citron Research, a prominent GameStop Corp. short seller. Melvin Capital Management LP, another short seller of GameStop and AMC Entertainment Holdings Inc., is also a target of the investigation.

The Department of Justice is investigating possible collusion between hedge funds and research firms. Short selling hedge funds sometimes write research reports, then hand them to the research firms to publish as their own.

When the report comes out and the stock tanks, the hedge fund makes a tidy profit while obscuring its connection to the report.

Another practice in the DOJ’s sights: spoofing. From the WSJ:

Spoofing is essentially high-speed bluffing, in which one trader dupes others into transacting at artificially high or low prices. A spoofer, for example, might offer to sell a big block of shares at $10 when the last sale was at $10.03. After other sellers rush to match the lower price, the spoofer quickly pivots, canceling his sell order and instead buying at the $10 price he generated with the fake bid. Repeated enough times, spoofing can produce big profits.

Spoofing and phony research reports go hand in hand. Huge numbers of spoofed sell orders tend to flood markets at the same time these reports are published.

It’s a one-two punch: fake research and fake sell orders.

Let’s think of this investigation from a different perspective: that of the investor in hedge funds.

These investors are usually university endowments, public pension funds, and wealthy individuals. They tend to be fundamentally conservative.

How does it look when the fund manager’s house is being raided by the FBI? Umm, not great.

If it’s your job to run the pension fund, and you don’t take your money out now, how will you explain yourself if the fund is prosecuted and goes belly up?

Any prudent investor is going to pull their money, ASAP. There are plenty of funds not under federal investigation.

What’s more, some of the funds under investigation also happen to be performing horribly. Melvin has already lost $1 billion in January alone!

Expect to see big outflows from the troubled funds soon. This, along with volatile markets, could put some out of business.

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More on markets:

Melvin Capital Under Federal Investigation

AMC Fails to Deliver Skyrocket 9X

Huge Payouts for Hedge Fund Informants as SEC Vice Tightens

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