The Fine Line Between Incompetence and Criminality
A Bloomberg news story shows that derivatives traders at Barclays Bank encouraged their colleagues to manipulate the reporting of LIBOR so as to nudge the rate by a very small amount to their advantage. "On an $80 billion portfolio of swaps, a 1-basis-point (hundredth of a percentage point) move on one-month, U.S. dollar Libor could benefit a trader by about $667,000, according to data compiled by Bloomberg," the news service wrote. That doesn't quite wash, because it excludes transaction costs; to realize the gains from such manipulation, the bank would have to cash in the $80 billion portfolio, with transaction costs well in excess of $667,000. Traders don't get paid for short-term improvements in the notional value of their portfolio, but for their performance over a fiscal year. Advance knowledge of tiny moves, to be sure, could be exploited by trading desks to some extent, but this is the sort of trick one can't repeat every day. And when JP Morgan reportedly lost $7.5 billion on its prop book this year, a manipulation that brings in a few hundred thousand dollars before transaction costs doesn't sound particularly ominous.
Of greater concern is the issue of front-running research.
The New York Times reports:
What analysts tell investors about the companies they follow — and when — is central to the concept of a level playing field on Wall Street. When disseminated, analyst downgrades and upgrades can make a stock sink or soar. Getting that information early can be very profitable for traders. As a result, regulatory rules require brokerage firms to restrict the information flow from research departments to prevent the potential for trading ahead of research reports.
Questions about the selective release of analysts’ views came up when the brokerage firms charged with selling Facebook’s initial shares were found to have warned large buyers about some analysts’ doubts regarding the company’s prospects. That irked many small investors who had not received the guidance and sustained losses in their Facebook shares. The Securities and Exchange Commission is investigating these disclosures.
But documents obtained by The New York Times indicate that the hedge fund practice of trawling for analysts’ shifting views is systematic and growing on Wall Street. Questionnaires completed by analysts that can telegraph their thinking are being used by hedge funds run by BlackRock; Marshall Wace, a large British hedge fund company; and Two Sigma Investments, a United States hedge fund concern.
I supervised research groups on Wall Street for years, with up to 140 analysts reporting to me. As a research director I called our biggest customers to ask how we might serve them better, and the most frequent request was: "First look." Big customers wanted to see changes in recommendations that might move the market before other customers. That's flat-out illegal; in fact, it's a form of insider trading. Getting an advance tip on an analyst's change in recommendation isn't quite as damaging as an advance tip on a merger, for example, but it still involves the misuse of inside information. I spent a lot of time with lawyers and compliance people making sure the playing field stayed level, and any analyst who tipped a customer prematurely could expect summary dismissal for cause. As far as I knew at the time, my competitors did the same thing.
The fact is that the average hedge fund returned less than a balanced portfolio of stocks and bonds offered by any of the low-fee mutual funds. There are a few real geniuses in the hedge fund industry, but not enough to squeeze returns out of $2 trillion in capital commitments. The pressure to cheat is enormous. Because hedge funds trade all the time (unlike pension funds and insurers, who tend to buy and hold their investments), they are investment banks' most profitable customers, and the pressure to help them cheat is considerable. Where allegations of criminal behavior are concerned, let the justice system to its job.