Friday, March 26, 2010

Using Technology to Detect Insider Trading

There is a very fine line between insider trading and informed trading. A trader is supposed to gather all of the information he or she can in order to make decisions that make money - either for the company or for the investors. Often times that information comes from a seemingly innocuous comment overheard at a cocktail party, or even from a speaker at a conference. For example, in the oil business it is not unusual for a trader to hear at the weekly booze-up (oops, I mean business lunch) that his colleague's oil company has a refinery problem. If the trader goes back to work and trades on that information before it is known to the press and the outside world, is that insider or informed trading?
I once went to a conference where a software company that provides solutions to a mobile phone company told us that the mobile phone was selling like hotcakes in Europe and Asia and that the company was going to have a very good year. I bought shares in that company (although, being the worst trader in the world, by the time I bought them it had already hit its all-time highs and I ended up getting slaughtered). Was I guilty of insider trading? What about others in that room, those who maybe did go back to their offices and buy the shares (in far greater numbers than my paltry 20 shares)? Were they guilty too?
The line begins to become clearer when the activities that can be construed as insider move markets. Once those markets are moved, and it becomes clear to regulators that something funny was going on, it is a question of careful forensics to sift through whatever evidence they can find.
The SEC and FSA have been very busy of late doing just that - sifting through evidence and nailing criminals. The SEC found a high-ranking UBS investment banker was tipping off his buddies about health-care mergers over 2005-2009 using emails with code words like 'frequent flier miles' and potatoes (or something). The FSA, with the help of the police, just dug up a ring of up to 11 bankers and hedge fund traders, including Deutsche Bank, Exane and Moore Capital Management, who had been reportedly front-running block trades.Also in London a whistle-blower chastised the CFTC for not following up on his tip (in November 2009) that JPMorgan was manipulating the gold market there.
The pattern that is emerging in all of these investigations (or lack thereof) is that the crimes are being detected well after they happen. There is a reason that insider trading and front-running and market manipulation still goes on today - because people can make money from these practices. And the likelihood of getting caught is very small indeed.
Hector Sants, the outgoing CEO of the FSA, said that the regulator would be implementing an intensive supervisory model, which should make people "very frightened" of the FSA, according to the Economist. I think he was alluding to tougher cell-phone and email monitoring, which is what caught the most recent scoundrels. What would really make the wannabe inside traders tremble in their boots would be if the FSA, SEC and CFTC installed market surveillance software. Surveillance software can detect market anomalies and abuses as they happen, not after the fact. Using this kind of software, inside trades and market manipulation can be tracked down by compliance managers before the traders get to finish the deals. Position limits, such as those that were manipulated by Jerome Kerviel at Socgen in 2008 and hiding losses of nearly 5bn euros, can also be monitored real-time and alerts sent to managers to tell them when something fishy is going on. Fat fingered trades can be spotted and caught (and hopefully unwound) before they are settled and cause a firm big losses.
So the question is - why don't the regulators use this kind of software? Maybe the US Congress should think about adding a mandate to do so to the financial regulation reform bill. Then rogue traders would be afraid, very afraid.

Friday, March 19, 2010

Give the SEC the teeth to stop fraud

That Lehman Brothers had hidden its dire financial situation with the aid of accounting tricks is no surprise. Banks, trading companies and even Big Oil and Big Car have been doing this for years. Lehman was special in this, however, as the size of the losses was of such a magnitude that they nearly wiped out several other banks and helped to take down the global economy. Enron looks pale in comparison (and its execs went to jail). That Merrill Lynch staffers had spotted Lehman's trickery and grassed them out to the SEC is a surprise. Most banks tend to collude, or at least ignore others' peccadilloes with a nod and a wink, when it comes to the little tricks that keep them cozy with their shareholders. That the SEC somehow failed to grasp the significance of the so-called Repo 105 accounting practice is the biggest surprise of all. After the Bernie Madoff scandal, the SEC had a lot of explaining to do to the American public, and to the government. It went hat in hand for a bigger budget in order to hire experts to help sniff out and nail financial fraudsters. And got it. The task at hand now is to figure out how to hire people who actually understand the very things the SEC is supposed to be nailing people for. One idea is to hire outside firms with the expertise.
Last year in an article for Financial News, I wrote about the possibility of regulators cracking down on hedge funds and making them more transparent. At the time I spoke to former Securities Exchange Commission chairman Harvey Pitt, who is now CEO of business consulting firm Kalorama Partners. Pitt said that what needs to be done about hedge funds had already been laid out in an SEC request for comment in 2003: Data about hedge funds' activities should be available to regulators, and the SEC's concept of examination and inspections needs to be changed. Pitt said: "It is not structured to succeed."
Further, Pitt believes that all portfolio managers should be required to allow (and to pay for) a regular independent examination by a company that it has no relationship with. These independent examiners would then give their report to the audited entity as well as the SEC.
This tactic would work well for the whole of the TBTF businesses in America. There are independent firms out there including one run by ex-FBI agent Ken Springer - Corporate Resolutions. (Inexplicably, Financial News cut this part of my story - and I think it was the most important angle.)
Springer said: "Investors need to re-claim confidence and more regulation alone will not necessarily do it. Often, things fall through the cracks and investors need to take more pro-active steps." He advises conducting independent onsite financial due diligence with comprehensive background checks, and implementing an ethics hotline where employees, accountants, prime brokers, fund administrators can anonymously report wrongdoing to an independent third party.
Springer said: "Managers can hide trades or have brokers eat fees to boost the fund's performance. Up to now fund managers have resisted this enhanced transparency. Now they may have to do this as a condition of investment. The bigger funds won't want to, but the smaller ones will jump through hoops to get investors. Investors bring us in as part of due diligence."
The answer to a Lehman- or Enron-like conspiracy to bury bad news is twofold. Give the regulators the power to hire outside experts, and the power to insist on their use. Having the staff, the money and the will to investigate and find fraud is one thing. The SEC needs to have the power and the authority to go into these companies and actually do it.

Tuesday, March 16, 2010

You Put Your Right Foot in, You Put Your Right foot Out....

The US Congress and Senate appear to be doing the Hokie Cokie with the law these days, particular in the case of Chris Dodd's financial reform package. Put in an independent consumer protection agency - then take it out and give it to the Fed. Take out the Volcker Rule, then put it back in. I guess this is US politics at it worst. Water down the original concept so much that neither party can object to it (except the most extreme right or left-wingers), add a whole barrel of pork for each representative, and presto - instant crap. What I don't understand is how anyone can object to the consumer protection agency at all. It seems that Republicans think most people are extremely intelligent beings that completely understand if they are a day late paying their credit card bills their interest rate will go up to 124%. Democrats, on the other hand, seem to think that most people are dimwitted idiots who will use a credit card until it is maxed out then complain that they can't afford to pay it back. The Democrats are actually closer to the truth. So why are Republican politicians working so hard to knock it out of the financial reform bill? It can only be because the credit card and mortgage companies are lobbying them so hard they cannot resist the pressure.
The Volcker Rule debate confirms that Democrats think people are stupid. At first Dodd, a Democrat, took it out because it was too hard for his colleagues to understand it. Now I believe he has put it back in again precisely for that reason. His colleagues in the Senate will not be able to grasp the whole concept of separating out prop trading, despite hard lobbying from the bulge bracket, and will probably pass the bill in its entirety. Good plan.

Wednesday, March 10, 2010

Moral Hazard for Dummies

When I read this morning that banks want to take some of their taxpayer-fueled cash piles and distribute this as dividends or share buybacks, I saw red. Luckily regulators did too and stopped them. For now. It is obvious that the same banks that led to the current recession, and the biggest financial crisis since the Wall Street Crash of 1929, are once again courting shareholders in order to line their own pockets. CEO's that took massive pay cuts (again to placate shareholders) have had enough of their $1.00 annual salaries. In order to get back on the gravy train they have to convince shareholders that all is well. And maybe this is true, but I think it would be wise to take the billions of dollars of losses and write-downs from the property market crash before distributing any cash.
It seems to me that despite all that has happened to the world's financial markets and economies, little has been done to address moral hazard. Moral hazard remains the biggest risk to stability and recovery, and continues to run unchecked. Call me a hopeless optimist, but I was hoping that the US Congress at least would grow some balls and push out sensible regulatory reform. And then I thought, maybe no one really understands just what moral hazard means. Maybe the powers-that-be believe that "the markets" can sort themselves out, and let the buyer beware. So I thought a little primer might be in order to try and educate our politicians about the beast known as "the financial markets". (As I shamelessly cadge the For Dummies style, I beg the brilliant and totally cool Wiley Publishing not to sue me.)

Moral Hazard for Dummies

Understanding Moral Hazard - Moral hazard is what happens when someone (let's say a trader) who is insulated from risk behaves differently than he would if he were fully exposed to the risk. In other words, he believes that his short-term bonus will be bigger if he takes on a larger long-term risk. He tells himself that he will probably be working for another bank  by the time he is rumbled anyway (i.e. when the longer-term risk fails to pay off). He has nothing to lose personally, and everything to gain.

Making Moral Hazard Simple 
Derivatives trader - I just sold an unbelievably complicated interest rate swap to some idiot in Umbria. She thinks it will save her town from having to shut down schools and turn off the power. What she doesn't understand is that in order to keep from having to pay me off when it goes wrong, she has to keep paying me off. Win/win! It looks fabo on my P&L. (Anyway, what does Umbria need with electricity? The hospitals probably have generators, right?)
Oil trader - Obama is really getting hot under the collar about Iran's nuclear program. The authorities are leaning on us to stop selling them gasoline. But the margins are terrific. John -you like the beach, right? Take the next flight to Dubai and open me a little shell office. We can use that to keep selling gasoline to Iran and no one will be the wiser! A little bizzo in the morning and the rest of the day to sun yourself!
Executive of a bank -  Our share price still sucks and the Board meeting is coming up next week. I can't live on a dollar a year for much longer, I need a new carriage house. George, what can we do to make people think we have recovered from the downturn? Never mind the mortgage write-downs, those are for next year! Have corp comms leak it to the press that we are sitting on a mountain of cash and that we might institute a share buyback program.

Do's of Moral Hazard
  • Do regulate derivatives - beyond central clearing and making them trade on exchanges. They should NOT be a "buyer beware" product. 
  • Do regulate banks the Volcker way - take away prop trading, hedge funds and private equity.An instant reduction in temptation and moral hazard.
  • Do monitor oil markets - they are getting away with murder because you can't be arsed to upset the oil lobby. 
Don'ts of Moral Hazard
  • Don't leave the banks to make their own rules.

Monday, March 8, 2010

A Leopard and His Spots

Saturday's Financial Times had an article about London's cab drivers, saying that they need to go to 'customer relationship' courses as well as learning The Knowledge. It suggests that the cab drivers are too talkative and insensitive to those passengers that prefer not to chat. Now I am as antisocial as they come, being a good New England Yankee, but I beg to differ. Even a perma-grump like me (when I lived in London that is - I blame the severe lack of Vitamin D due to almost no sunshine) likes to chat to a London cabbie. They are funny, knowledgeable about all that is London, and mostly harmless. Many a late night they would pour me out of the cab and wait on the curb while I let myself into the house. One kindly driver, when learning that I was moving to New York City, helpfully advised me never to use the "C" word when swearing in America. Most cabs today have a speaker system anyway, and you can switch it off if you don't want to chit chat. But what would London be without chatty cabbies? They should not change - nor will they.
Talking about leopards and their spots never changing leads me to today's FT. The front page tells us that oil trading companies have "quietly" stopped supplying petrol to Iran. The paper says this is a clear sign that Washington's efforts are paying off.  Of course they are (sarcasm alert). The naivete of some journalists (and obviously politicians) makes me want to scream. The "small Dubai-based and Chinese" companies that are reportedly replacing the US/UK/Swiss trading companies as suppliers to Iran will be backed by the very same suppliers which are claiming to be getting out of Iran. The profit margins on supplying petrol there are simply too high to lose. This is how it has always worked, and I can't see it changing anytime soon. Ask any London cabbie, he will back me up.

Tuesday, March 2, 2010

The 51% Rule of Trading

An oil trader friend once told me that his job was to make money 51% of the time. That way he would probably keep his job and his employer (an energy division at an investment bank) would be happy. If the 51% rule is the standard for traders then Goldman Sachs has nailed it. It made over $100m in net trading revenues on 131 out of 263 trading days in 2009. It lost money on only 19 days. Total earnings of more than $13bn came from net revenues of $45.2 bn that more than doubled the previous year's.
To make these record earnings Goldman Sachs also took on more risk. In VaR terms, the bank said it estimated the most it could lose on any given day was $218m, compared with $180m in 2008. The bank also noted in its financial statement that reputational risk (i.e. bad PR) might be a negative factor going forward. I'd say that if taking on more risk against the government's wishes and spinning it into gold while weathering some of the worst PR Goldman Sachs has ever had creates a profit of $13bn, then they are doing something right. The traders' jobs are safe - for the time being.