Monday, 18 August 2008

Insider Dealing or Insiders Scheming?

This should have gone up Friday, as I posted on RGE, but I've been up against a deadline and juggling multiple commitments before traveling this week.
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In the early 1990s, when Britain was in deep recession and banks and investment banks were under nasty financial pressures, the new Chairman of the Securities and Investments Board started a crusade against insider dealing. We all thought his obsession bizarre as London was then widely regarded as being the cleanest securities market in the world. Largely institutional, dominated by 25 or so market makers and fewer than 200 significant fund and pension managers, abnormal conduct was easily detected and brutally sanctioned. Since the average trade size in the cross-border market exceeded $270,000 and in UK stocks exceeded $80,000, it was very difficult for anyone to undertake a pattern of activity that went unscrutinised by their peers. NatWest (Blue Arrow) and Goldman Sachs (rigging the FTSE 100 options expiry) found to their cost at the time that their market counterparties and clients were very unforgiving of misconduct. A director of Goldman Sachs complained to me then that London was their least profitable operation globally.

Nonetheless, the SIB Chairman instigated a crusade, rallied the government, demanded tougher investigative powers and tougher penalties, and carried on as if London were a cesspool of corruption. We scratched our heads and wondered at it. He was and is a good man, even if we thought his efforts then over the top.

While insider dealing prosecutions never picked up much, he succeeded in imposing strict new transparency rules on the London Stock Exchange which quickly eroded its global dominance of equity markets. Transparency made market making impossible, as market makers need time to work a large order to quote a fine spread in institutional size from their own capital. Market making on the basis of quotes was gradually abandoned in favour of electronic order routing systems that transacted thousands of small orders dribbled out piecemeal into automated execution systems instead of finely priced large orders in size. From over 85 percent of global cross-border equity trading going through the London Stock Exchange at the peak in 1991, London’s market share collapsed as trading fragmented to smaller, more opaque markets elsewhere and to derivatives. Goldman Sachs profitability soared as the London Stock Exchange declined.

In this week’s announcement that the SEC will remove insider dealing enforcement from exchanges and concentrate it in two mega systems policed by NYSE and FINRA, I get an echo of this earlier era. I hope I am wrong, but it would not surprise me if once again police powers of regulatory authorities are used – with or without their conscious collaboration – to rig the market in favour of preferred models of interaction and preferred intermediaries.

Insider dealing is no more a threat to market integrity now than it was five years ago, ten years ago, or twenty years ago. If anything, insider dealing is more rampant in bull markets than bear markets.

On the other hand, it is true that insider dealing was much easier to detect when all dealing in securities was concentrated on exchanges rather than fragmented to multiple automated systems, dark pools and cross trading networks. It is also true that insider dealing was easier to detect before half the market volume fragmented to 8,000 unregulated hedge funds.

My concerns may have started with an echo of the UK in the 1990s, but they are aggravated by the pattern of state control and abuse of information observed over the past twenty years in the USA. George H.W. Bush created the “War on Drugs” in 1981 as vice-president of the United States to gain federal authority to monitor bank transactions and telecommunications and to seize property from anyone targeted by his special squads of DEA agents who were empowered to act outside normal due process and judicial review. Reagan then declared the "War on Terror" which Bush intensified as president later that decade, arrogating to himself and US intelligence agencies even broader powers beyond the review of democratic checks and balances. That morphed into the “War on Terror” under George W. Bush, who gained even more powers for the state to spy on its citizens and treat everyone as guilty until proven innocent, extrajudicially arrest and detain citizens and non-citizens alike, render them for torture globally, and otherwise abuse government powers.

It all started with sweeping up huge streams of data into unreviewable hands weilding huge power to seize and redistribute wealth. Forgive me then if I am sceptical when the SEC wants to protect investors by further concentrating both information and police powers.

The imposition of huge data sweeps in the name of “anti-money-laundering” in the banking sector and combating “insider dealing” in securities markets reeks of the same tactics and objectives as telecoms or internet search engine sweeps to the NSA.

Ronald Reagan once quipped that the biggest lie was, "I'm from the government and I'm here to help you." Given the pattern of abuse in his administration, and the subsequent treatment of US workers and taxpayers, he may have been more truthful than he knew. So what should we think when we hear, "I'm from the SEC and I'm here to protect you"?

Needless to say, the more data collection and police powers are concentrated in a single authority, the more difficult it becomes for anyone to contest an investigation or enforcement action by that authority. Without objective protections, alternative sources of confirmatory data, guarantees of judicial review and due process, it becomes impossible to challenge the arbitrary use of authority or the deliberate misuse of authority.

Think of just one scenario: a target firm becomes the subject of a very public investigation and charges. Its share price collapses, and investors flee. Enter a well-funded vulture fund who takes out the very best assets and a very well-connected competitor who sweeps up the choicest clients.

I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.

I would like to see more substantiation of the rationale for centralising data collection and enforcement, and more controls on the abuse of information and powers, before trusting that the regulators are acting in the interests of investors and of the greater economy as a whole.

Why not have an open database of anonymised transaction data that is reviewable and searchable by all market intermediaries and investors? That would allow anyone to investigage suspect patterns of transactions for reporting. But then that might catch the wrong people in the net and expose too many to scrutiny.

It has taken me many years to understand my discomfort with reforms in the early 1990s recession. I am worried that the proper function of markets in the intermediation of capital investment so critical to the prosperity of any economy may be further distorted and eroded. If competition is so good for capitalism, then surely markets should have to compete to demonstrate their ability to uphold efficient price discovery and market integrity. Regulators too should have to compete if only to promote vigilence in each other by maintaining reputation risk.

Harmonisation of market structure and regulation may be harmful if it tends toward sub-optimal choices. Without competition and independent data collection, we may never be able to prove that the choices our regulators make for us are not in our best interest.

10 comments:

Pancho "El Villan" said...

Ok, admitting... slightly OT...


...more bad news 2 come?

From the FT today:

"Working for nothing an the h.... for free?" i.e.: "Hard-pressed consumers refuse to read from the script"

"...and it scares the hell out of us"

"The concern is that the losses on risky subprime mortgages could soon swell further as people with good credit histories decide it is not worth continuing to make payments on houses now worth less than the loan. Houses prices in the US are already 20 per cent from 2006 highs, according to the S&P/Case-Shiller Home Price Index, and are forecast to keep falling.
"Lenders were saying to me: 'We can see this behaviour ant it scares the hell out of us'..."



From The Economist:


"Brother in ARMs" i.e. "Ticking time bomb"

"A nasty mortgage product promises yet more misery

Optimists, look away now. Prices in America's housing market may have slumped, but the pain for a significant subset of homeowners has barely begun. Even at Barclay's Capital, which spotted some of the improvements mentioned in the previous story (Home Economics), there is still concern. The bank's Nicholas Strand says that roughly 1.4m households, most of them in California, hold a particularly nasty type of adjustable-rate mortgage called the "option ARM". Although the overall value of option ARMS is slower than that of subprime loans, - some 500 billion, according to Mr Strand, compared with about $1 trillion in subprime loans - their sting is more venomous.
The option ARM allows borrowers to pay less than the formal rate for a limited period (the vast majority of customers choose this option). In return, the unpaid interest is added to the original loan, a process soothingly called "negative amortisation". While house prices are rising, the product just about makes sense. If borrowers do get into trouble when they start paying off the loan in full, higher property values offer some wiggle-room. But when house prices are falling and refinancing is difficult, as is now the case, the option ARM is the financial equivalent of a "bikini?" in winter. Homeowners end up owing more on a property that is worth less."


Hasta luego

Pancho "El Villan"

Anonymous said...

A terrific post. I agree, it's taking me many years to understand *why* i'm uncomfortable with certain things. Thank you for continuing to work on it.

m

OkieLawyer said...

LB:

I think I am right in my observation that a majority of the most visible bears in the U.S. are also on the political left. Notice the recent cries of "market manipulation" was tied to "those shorting the markets."

I think these two paragraphs need to be emphasized:

Think of just one scenario: a target firm becomes the subject of a very public investigation and charges. Its share price collapses, and investors flee. Enter a well-funded vulture fund who takes out the very best assets and a very well-connected competitor who sweeps up the choicest clients.

I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.


I am not familiar with what happened in Britain in the 1990s. Perhaps you could expound on that? Was the same scenario played out in Britain in the 1990s?

Jesse said...

"London was then widely regarded as being the cleanest securities market in the world....abnormal conduct was easily detected and brutally sanctioned."

Significantly I would not use those words to characterize the US financial markets at this time.

dink said...

"Why not have an open database of anonymised transaction data that is reviewable and searchable by all market intermediaries and investors? That would allow anyone to investigage suspect patterns of transactions for reporting. But then that might catch the wrong people in the net and expose too many to scrutiny."

As an amateur conspiracy buff, this would please me to no end ;)

armchair said...

What a great post. It makes a great point. In the U.S., all of this surveillance and centralization of power in a unitary excecutive isn't just about the ACLU and civil rights, 'it is about the economy stupid'. Inevitably, the executive branch will weasel its way into lucrative deals, and certain information will be dispensed to cronies, and investigations will be geared up solely to affect the outcome of deals. The business executive class in the U.S. is extraordinarily influential, and could probably do more than anyone to put the clamps on the unitary executive power grabs, but they have never thought for a second that they were being disadvantaged by the loss of due process and increased surveillance powers. They thought this loss of rights was for hippies and dark-skinned people, not anything that would touch the executive suites. Think again, there is so much money to be made by enterprising politicos, and greed is good, so if you're trying to negotiate a merger, close a deal, or get an air tanker deal please remember that the executive branch is listening to your every word.

Now, I wish these CEO-bozo-types would read London Banker, wise-up and realize that a government with checks and balances is good for them too.

Thai said...

LB- Thanks for the wonderful posting again.

Dink- Sometimes it 'seems' we think so much alike! Alas Okie just reminded me why this is an illusion.
:-)

Armchair, please forgive me, I have trouble making a conclusion from your comment. Are you saying the new centralized structure is a good idea but that an additional 'watcher of watchers' program needs implementation? Or are you saying centralization is already too great, and we need to prevent such a superstructure from forming?

Jesse- I 'think' I am begining to see your point of view (you have a wonderful blog by the way). Your point has merit (and you are more 'Platonic' than I thought!)

Anonymous said...

London Banker,

Today 'moral hazard' has evolved to the 'socialization of loses' and the placing of these loses onto the public purse.

The situation in the U.K., the Eurozone, and the U.S. are not much different.

We all allowed debt to increase to unsustainable levels and now the bill is comming due.

Saving the shareholders in the banks is not the answer. But, that is what our central banks try to do as they are the shareholders in the central banks.

I think we will eventually reach the point where the banks will be nationalized as they currently are all insolvent.

Northern Rock was the tip of the iceberge.

Indy Mac, Wachovia, Washington Mutual, etc., etc. will follow.

Insiders know where the biggest risks are and can profit from it.

Politically, the game is all about pushing these problems out into the future.

The sh*t h*ts the fan after the U.S. Presidential election.

{* = i}

Volitility will rise!

Equities will fall!

But not all.

fedwatcher

Anonymous said...

Wonderful post -- as are all of your previous posts/comments on other blogs.

It would be heartening to see a way to stop the concerted destruction of civil liberties in the US by the present administration...I know there are several courageous individuals/groups who are trying, but I fear that this will not be possible...

Jesse said...

Speaking of the need for banking regulation, Citi just settled charges of widespread theft of customer funds.

http://jessescrossroadscafe.blogspot.com/2008/08/citigroup-settles-charges-of-theft-of.html