Stock Market Efficiency: Regulating Speed Trades

A flurry of international activity aimed at putting limitations on computer-based speed-trading was striking during the Fall of 2012 in the U.S. because regulators had been slow to act. Typically, the NYSE has been viewed by the world as the Mecca of efficient investment markets. Paradoxically, however, efficiency may be improved by restricting—meaning regulating—the masses of computer-enabled quick trades that take advantage of momentary microscopic arbitrage opportunities that are too quick for the human hand. The American conventional wisdom seems to be that regulation and market-efficiency are inversely related, rather than complementary. This assumption might be overly simplistic, coming from an inherited ideology. Fortunately, the rest of the world has not been following the SEC.

 A trader on the floor of the NYSE.   Getty Images

The broadest and fastest changes to unfettered speed-trading as of September 2012 were in Canada, where regulators had began increasing the fees charged to firms that flood the market with orders back in the spring of that year. According to the research and trading firm ITG, the change made trading more rather than less efficient because the crush of data burdening the market’s computer systems was reduced. Too much information coming all at once can be distinguished from perfect information, and can even overwhelm a market’s very infrastructure, eviscerating any possible gain from the additional information. For computer science folks, all this can be pretty sexy language; for the rest of us, the mundane fact of the matter is that more information does not always make a market more efficient. Exploiting small increments of arbitrage at a high volume so as to make a quick fortune may not actually improve a stock market’s efficiency because the market itself might crash. Regardless, any increase in the micro efficiency of the stock prices may not be significant, which is perhaps why such volume must be thrown at the problem to make enough money at the macro level.

Nevertheless, the SEC was proposing nothing to hamper the unfettered wild-west of computer trading. Meanwhile, Canadian trading desks were preparing for rules coming into effect on October 15, 2012 that would curtail the growth of the sophisticated trading venues known as dark pools, which the U.S. Government had allowed them to proliferate in the United States. To be sure, the Canadian rules had been hotly debated, but many Canadian bankers and investors determined that they did not want to go any further down the road that has taken the United States from having one major exchange in 2002 to having 13 official exchanges and dozens of dark pools in 2012. In the interim, trading firms and investors on Wall Street were hardest hit by a series of market disruptions, including the flash crash of 2010 and the runaway trading in August 2012 by Knight Capital that cost it $440 million in just hours.

What is striking about Canada is not so much that it was not following the SEC; rather, even the rules going into effect in mid-October were seen by some banks there as insufficient. “We don’t want to look like the U.S., but we have to do it better than we are now,” said Greg Mills, the head of stock trading at Canada’s largest bank, Royal Bank of Canada.[1] Major market participants urging the state to better protect the viability of the market itself through more regulation is a case of statesmanship, or a sort of enlightened self-interest that fuels principled leadership over opportunism in the short-run. To be sure, legislators and regulators should not depend on such “industry self-regulation,” but it is quite beneficial as a supplement. That is to say, the cart should not lead the horse, but it is nice when the cart voluntarily lessens the load.

In the “theory of regulation” literature, market participants urging more regulation are typically presumed to be invoking the comparative advantage of regulation. A bank that would benefit over its rivals if computer-trades were not allowed in such time-volume as they were in the U.S. as of 2012 is typically assumed to be the only player willing to advocate for more government. Admittedly, the strategic use of regulation is not lost on businesses invested in the profit-motive. Nevertheless, this motivation does not exclude the possibility that market participants may urge more regulation out of a realization that if the market freezes up or collapses even for a time, every participant suffers financially.

Perhaps business practitioners in the U.S. are missing not only the forest for the trees, but also the trees for the branches, and the legislators and regulators are following in suit—in part due to the shared perspective (as it is so subtle being everywhere) and in part due to the corporate campaign contributions and intense lobbying. That is to say, the limiting nature of a perspective, unknown to the holders, is as it were a common denominator that tacitly supports a corrosive plutocratic (i.e., rule by wealth) symbiotic relationship between business and government that undermines the system itself. That there are other systems, such as Canada, that are founded on a different set of assumptions can mean that the basic form of the American perspective, which would otherwise be invisible or taken as a given, can be seen, or at least finally glimpsed. From this transparency, the assumptions taken for granted can be put as a problem to be solved. 

1. Nathaniel Popper, “Beyond Wall St., Curbs on High Speed Trades Proceed,” The New York Times, September 28, 2012. 

The SEC and the Courts on Wall Street Settlements in 2011

The SEC enforcement staff, including its chief, Robert Khuzami, decided to kick a gift horse in the mouth rather than to “take a lesson” and perhaps come out stronger for it. At issue was the rejection by U.S. District Judge Jed Rakoff of the SEC’s proposed $285 million settlement with Citigroup. In his ruling, Rakoff denounced the penalty as “pocket change” to the bank, which would not even have to admit to any wrongdoing. Investors duped into buying into a $1 billion deal called Class V Funding III had lost $700 million. Betting at the time of issue against half of the assets in the deal, Citigroup did not share knowledge of its hedge with the investors.

The reaction of the SEC staff in Khuzami’s department was simply to “put down their pencils” and wonder how they should go about arranging settlements with financial firms accused of misconduct before and during the financial crisis of 2008. The SEC “doesn’t know what to ask for anymore in the settlements,” one of the people familiar with the Citigroup settlement said. Rather than take the judge’s judgment to heart, Khuzami urged the five-person commission running the SEC to vote to approve an appeal, and they did so. Rather than take the less convenient course of insisting that the banks too big to fail that manipulated their own clients at least admit wrong-doing and reimburse the losses, Khuzami viewed the judge’s ruling as if it were a political obstacle to be obviated by asking an appellate court to ignore it. Given the political muscle that must surely go with Citigroup’s wealth, Khuzami could have been assuming that the bankers would see to it that sufficient pressure would plied on enough appellate judges to make the obstacle easily avoidable. In other words, Khuzami was likely assuming that Rakoff was a fluke, given Citi’s influence—perhaps even in the SEC itself.

Considering the power of regulated banks such as Citigroup, it is not unreasonable to expect the chief executive of the U.S. Government, the President of the United States, to deviate from his avocation of influencing legislation far beyond his minority role as a veto. Rather than spending so much time hitting the stump to get voters to 1) influence their representatives in the legislature and 2) re-elect him, the president could get involved in the question of whether the verdict would be appealed. Lest it be said that that would introduce politics into the mix, I would counter that politics were already very much in the mix both in terms of the five-person SEC vote and in Khuzami’s response to the ruling (i.e., as an obstacle rather than as something to incorporate into future settlement offers). I would even say that politics was involved in Treasury Secretary Tim Geithner’s blessing of the decision to appeal, and therefore also likely a factor in the president’s decision not to intervene. Citi (and one of its major stockholders) had been Geithner’s sponsor when he was chosen to be president of the New York Federal Reserve.

Politics might also have been involved in the timing of the SEC’s announcement on the day following the appeal decision that the agency was suing the former chief executives of Fannie Mae and Freddie Mac for misleading investors and Congress on the volume of subprime mortgages on the books. Khuzami made the announcement himself, and it was well-covered in the media. Lest the decision to appeal in order to save a settlement deemed by a judge as too friendly to a major Wall Street bank be viewed with lackluster by the public, the timing of the Fannie and Freddie announcement could be anticipated to quickly impose a perception of going after the bad guys—even if the two conveniently-demonized organizations had been taken over by the very government that was suing them. The public would not be likely to suspect a double-standard for private-sector, well-connected banks, such as Citigroup.

Regardless of the political connections of Wall Street banks, for the U.S. president to tell the public that Wall Street should be held accountable only to look the other way on the SEC’s appeal decision—perhaps with the stated reason that politics should not be involved—seems duplicitous at best. As the chief executive, the president has a legitimate superordinate role to play in overseeing the decisions in the agencies within the executive branch. For a chief executive to claim that he or she should not impose on a subordinate department is a good indication that a subterranean agenda is in play. Furthermore, such an excuse evinces a refusal to assume responsibility (see #2 above). Too accustomed to seeing presidents obsess over pending legislation and propose still more (and act as commander in chief as well as figure head), the American citizenry has nearly lost any appetite for holding its presidents accountable as the chief executive of the executive branch—which extends beyond the West Wing. In the case of the SEC’s decision, the president was doubtless not willing to overrule his Treasury Secretary for political reasons.

Rather than deciding to appeal the ruling, the SEC should have accepted—with the president’s (or Treasury Secretary’s) intervention if necessary—the judge’s feedback as valid. Given the power and “too big to fail” risk of financial institutions like Citigroup, the government regulators act recklessly in accepting a “pocket change” no-guilt settlement. In announcing the decision to appeal, Khuzami said Rakoff’s position was “at odds with decades of court decisions that have upheld similar settlements by federal and state agencies across the country.” Precedent for precedent’s sake could merely be a vote for the status quo that favors even the fraudulent on Wall Street. We cannot assume that the stream of past court decisions necessary warrant being kept.

Clearly, Khuzami believed that requiring wrongdoers on Wall Street to admit to the wrongdoing would backfire on the government. Requiring an admission of guilt from defendants “could in practical terms press the SEC to trial in many more instances, likely resulting in fewer cases overall and less money being returned to investors,” Khuzami said. Just because powerful banks have a lot of money and power to throw at a trial, however, does not mean that the U.S. Government should cower over in trepidation or try to out-maneuver an inconvenient ruling that can actually be useful. Had he kept to the judge’s ruling, Khuzami could have gone back to Citi to say that more would be needed to avert a trial. It would not be his own opinion, after all, and contrary to Khuzami’s view, a judge’s opinion is not just an opinion; it is a ruling.

As for the issue of money damages and the number of trials, Khuzami was missing the forest for a few trees. For the viability of the U.S. and global financial system (and economy), banks too big to fail should be held accountable. It is therefore worthwhile even going to trial and staying the course through any appeals fueled by the banks’ deep pockets. At the very least, establishing a few precedents in terms of seeing that justice is served might have aided in the SEC’s credibility in negotiating settlements with teeth. Higher money damages would undoubtedly have followed.

In short, it would appear that the staff at the SEC needed more of a public service mission in which they could feel that they were making a difference in standing up to real power. In other words, they were not sufficiently fighters for the public good—the viability of the financial system and the economy as a whole. Instead, they were too interested in taking the route that is most convenient in terms of fear and stasis. It is in this realm that the chief executive can and should lead, if indeed he has that fire in his belly.

Sources:

Jean Eaglesham and Suzanne Kapner, “SEC Cops Want to Fight U.S. Judge,” The Wall Street Journal, December 15, 2011. 

David Hilzenrath, “SEC to Appeal Federal Judge’s Rejection of Citigroup Deal,” The Washington Post, December 15, 2011. 

Chad Bray and Nick Timiraos, “SEC Sues Former Fannie, Freddie Executives,” The Wall Street Journal, December 16, 2011.

Fraud in Selling Sub-Prime Mortgage-Based Bonds: Beyond Accountability

“In December 2011, the S.E.C. publicized its civil securities fraud charges against top executives from Fannie Mae and Freddie Mac for understating their exposure to subprime mortgages, which resulted in the government taking them over.”[1] Robert Khuzami, then the head of the S.E.C.’s enforcement division, said at the time that “all individuals, regardless of their rank or position, will be held accountable for perpetuating half-truths or misrepresentations about matters materially important to the interest of our country’s investors.”[2] Pursuing even senior ranks has the air of fairness economically as well as in terms of the dictum, no one is above the law. So much for words; how about the accompanying deeds?

The full essay is at "Essays on the Financial Crisis."

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[1] Peter Henning, “Prosecution of Financial Crisis Fraud Ends With a Whimper,” The New York Times, August 29, 2016.

[2] Ibid.

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Apollo Global Flew Too Close to the Sun: Personal and Institutional Conflicts of Interest

I submit that people tend to get more upset over the exploitation of personal conflicts of interest than the institutional sort. That is to say, our blood boils when we learn of another person contravening a duty in order to gain financially, yet we don’t mind when a CPA firm falsely gives a qualified opinion on an audit so the company being audited will continue with that audit firm the following year. Logically, as the money involved is more in the case of the CPA firm and individuals within the firm stand to benefit personally as the firm is enriched by the continued business, yet even so, we cannot stand direct personal enrichment resulting from a conflict of interest. In August, 2016, Apollo Global, a large private equity firm, settled with the SEC. Both personal and institutional conflicts of interest brought on the $53 million fine. Hence, this case is useful in comparing the two sorts of conflicts of interest.

The S.E.C. accused the private equity firm of misleading investors and failing to supervise a senior executive who was twice caught “improperly charging personal items and services” to Apollo’s funds (and, by extension, to the investors).[1] Misleading investors here is an institutional conflict of interest because the activity is 1) systemic in an organization rather than being done by a person and 2) premised on the institutional relationship between the investor class and the firm. A person improperly charging personal items constitutes a personal conflict of interest because the individual’s personal gain is put before the person’s obligation to the company. In both cases, a narrower gain supplants a wider benefit, which in turn is usually associated with a duty.

The misleading of investors involves the private equity firm’s failure to inform its investors of “so-called monitoring fees.”[2] Apollo had been charging the fees to some of the companies it owned as compensation for the consulting and advice it had provided to them. The Apollo executives were essentially breaking out the supervisory aspect of owning a company and charging the latter for it. In short, Apollo was charging some of its companies for being owned. The private equity firm was even accelerating the monitoring fees when one of its companies was about to be sold or gone public. Specifically, “Apollo would accelerate the remaining years of monitoring fees into lump-sum payments.”[3] According to the S.E.C., these payments effectively reduced the “amounts available for distribution to fund investors.”[4] Apollo, and therefore its management, stood to gain. This represents a narrowing of the beneficiary group (from the companies and the fund’s investors to Apollo itself) by exploiting the fund’s duty to inform its investors. This is known as an exploitation of a conflict of interest.

Regarding the personal conflict of interest, one of Apollo’s senior executives submitted “fabricated information to Apollo in an effort to conceal his conduct” from 2010 to mid-2013.[5] The SEC charged Apollo’s management with knowing of the manager’s misconduct yet failing to do anything about it. In charging the fund for personal items, the manager gained personally, while the fund paid the price. Hence, here again the narrowing of a benefit is involved. The manager exploited his duty to report only work-related expenses in order to gain personally.

Which conflict of interest here aggravates you more? Another person enriching himself—stealing, in effect—or the fund’s charging its companies for functions that are part of ownership and misleading investors about it? I contend that most people would say the former, even though the misleading of fund investors has been a recurring problem. “A common theme in our recent enforcement actions against private equity firms is their failure to properly disclose fees and conflicts of interest to fund investors,” said Andrew Ceresney, the S.E.C.’s head of enforcement.[vi] Ceresney could cite the Blackstone Group and Kohlberg Kravis Roberts & Company as just two such cases.

I submit the following explanation. We humans are more easily resentful of other people enriching themselves unethically than of organized groups of people doing the same thing institutionally. A person found stealing raises our ire more than a company found misleading investors so to profit more at their expense. Something about groups and institutionalization mitigates our reactions. As a result, better legislation and improved regulatory enforcement oriented to breaking up institutional conflicts of interest (even before they are exploited!) find insufficient political will. The Dodd-Frank financial reform law of 2010, coming on the heels of a major financial crisis, thus leaves the CPA and rating company conflicts of interest in tact. We can expect, likewise, that private equity firms will continue to be tempted to exploit their conflicts of interest even as individual managers found to be stealing from the company "trough" will face prosecution. I contend that American society, including its business sector, could do worse than regard institutional conflicts of interest as more rather than less harmful than the personal variety.

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1. Ben Protess, “Apollo Global Settles Securities Case as S.E.C. Issues $53 Million Fine,” The New York Times, August 23, 2016.

2.Ibid.

3. Ibid.

4. Ibid.

5. Ibid.

6. Ibid.

SEC Investigating a Hedge-Fund Priest: Christianity’s Pro-Wealth Paradigm Lapsing into Greed?

It is against U.S. securities law to knowingly make false statements or publish false information about a company you are shorting (selling stock now and buying the shares later, hence betting the stock price will go down). In other words, you can’t try to drive the company’s stock price down you are shorting so you can profit from the trade. Besides being illegal, the practice is unethical. Just go to Kant for that! The guy was fanatical against lying.

You wouldn’t expect to read, therefore, that the SEC is investigating a Greek Orthodox priest who sidelines as a hedge-fund manager for trashing commercial reputations in order to make money off shorting stock.  BloombergBusiness reported on March 18, 2016 that the SEC was “examining whether the Reverend Emmanuel Lemelson of Massachusetts made false statements about companies he was shorting.”.”[1] He reportedly referred to his trading skills as a “gift from God.”[2] Such a claim is on a slippery slope, theologically speaking.

The priest who may have lapsed off the plank of Christianity's pro-wealth paradigm onto outright greed hidden under rationalizations as to means and ends. Is Christianity itself at risk for having gone so far into this worldly realm? The again, the Medieval Roman Church was very worldly as a political power.

When the story broke, I had just days earlier finished revising my second book on Christian attitudes toward profit-seeking and wealth in relation to greed. Lemelson’s “gift from God” language reminds me of the pro-wealth writings during the Italian Renaissance two centuries before the Calvinist work-ethic of industriousness. The Italian theologians of the fifteenth century tended to lighten up on profit-seeking and wealth. Cosimo de Medici got a pass from Pope Eugene IV in spite of a fortune based on usury (lending at interest). One priest, Fancini, went so far as to claim that humans are gods on Earth, given the dominion we have over its resources. Far from the camel who could not get through the eye of the proverbial needle, a Christian during the Renaissance (and after) knew he had to be rich in order to exercise the Christian virtue of munificence. Whereas liberality pertains to typical gifts, munificence involves donating money to build a cathedral, for instance. Being able to make a lot of money was a “gift of God” that would enable the successful Christian to give philanthropically on a scale worthy of God’s majesty.

Of course, the pro-wealth paradigm in Christianity is vulnerable to lapsing into love of gain (i.e., greed). Luther’s extremely anti-wealth stance can be interpreted as an effort to put on the brakes before the by-then dominant pro-wealth attitude in Christianity hit the skids and flipped over into greed. Luther did not succeed. Nor did Calvin or the Puritans, though they were more accommodating to the dominant perspective. The result was a clear line to the Prosperity Gospel—the notion that God rewards true believers with not just salvation, but material wealth as well. This idea came from the Old Testament, wherein God promises Israel that material wealth would come if His People hold to the covenant.

In my book, God’s Gold, I search for a theological undercurrent below the graduate shift from anti-wealth to pro-wealth dominance. I discount the impact of the commercializing context. With regard to the hedge-fund priest, I would be hesitant simply to say he was a manifestation of a pro-business American culture. This may be so, more significant, I submit, are the rationalizations presumably going on in the guy’s head. Bearing false-witness (i.e., lying) to harm others is difficult to view as a gift from God. Even as a means to a salubrious end, the juxtaposition of a gift from God and lying without concern for others’ welfare is odd at best.

In the book, I come to a discussion of how the human brain functions in the domain of religion. If we are vulnerable to certain “short-circuiting” cognitively and yet we have a religious instinct, are we not as a species in a double-bind? Put another way, if Lemelson can neither cognitively nor perceptually recognize his own rationalization, is his urge to be religious compromised? I don’t think so; rather, other aspects of the brain, or mind, may obstruct or circumvent it as it manifests itself. I do think these short-comings can be made transparent, and thereby reduced at least somewhat in severity, or swollenness, but denial is indeed a formidable and intractable obstacle. I suppose the dominance in Christianity since the Renaissance of the pro-wealth paradigm (i.e., profit-seeking and wealth decoupled from the stain of greed) renders the “mind-games” that much more harmful in terms of rationalizing some rather un-Christian behavior toward others. For one thing, in order to make money in order to serve God better can enable some pretty nasty means-ends justifications.  In this way, Christianity itself is now more vulnerable than the religion was when being wealthy and Christian were presumed to be mutually exclusive (i.e., greed was assumed to be tightly stapled to virtually any wealth). Ironically, the theology may be partially to blame, in so far as anthropomorphism unwittingly lifts the religious status of money and property.[3]

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1. Matt Robinson, “Hedge Fund Priest’s Trades Probed by Wall Street Cop,” BloombergBusiness, March 18, 2016.

2. Ibid.

3. The secret to that sauce is in chapter 12 of the book, God’s Gold. I got so into the writing of that chapter in revising it that in retrospect the chapters on the historical shift seemed a bit like a very long preface.

Breaking Up the Biggest Banks: The Impact on Moral Hazard

Citing the “slap on the wrist” culture at the U.S. Federal Reserve and the Securities and Exchange Commission (SEC), U.S. Senator Elizabeth Warren called on Congress in April 2015 to break up the big banks such as Bank of America, Citigroup, JPMorgan Chase, and Goldman Sachs.[1] She coupled the ‘break-up” approach to reducing the systemic risk with limiting the Fed’s ability to bailout individual banks. The synergy in Warren’s approach is worthy of further analysis.

The full essay is at "Breaking Up the Biggest Banks."

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[i] Reuters, “Elizabeth Warren Calls on Congress to Break Up the Big Banks, Change Tax Rules,” The Huffington Post, April 15, 2015.

Standard & Poors: Internal Controls Enabling a Conflict of Interest

After the financial crisis of 2008, rating agencies reassured the public that additional “internal safeguards” would prevent the sort of over-stated ratings that had contributed to the crisis. Congress did not deconstruct the structural conflict of interest wherein a rating agency is tempted to overstate the rating on financial security such as a corporate bond because the agency’s revenue would be higher if more of the bonds are sold. I contend that reliance on a company’s internal “fire walls” is naïve, given the strong, sustained temptation that exists as long as an institutional or structural conflict of interest is in place. To obviate the problem, the conflict itself must be deconstructed.

The full essay is at "Standard & Poors."

Efficiency and Ethics: On the Fairness of High-Speed Trading

Two months into 2012, the SEC announced that it had been examining the trading activities of high-frequency trading firms.  According to the Wall Street Journal, the SEC was “examining, among other things, whether high-frequency firms benefit from delays in the dissemination of prices from various corners of the markets. . . . High-speed firms use direct feeds from exchanges that can give them a leg up on slower traders.” High-frequency traders “can access prices a split second faster through their access to direct feeds.” This is accomplished by placing the trading computers in the same data center that houses the exchange’s computer servers. Just over a year later, the Wall Street Journal reported that high-speed traders were using “a hidden facet” of the Chicago Mercantile Exchange’s computer system “to trade on the direction of the futures market before other investors get the same information.” Even getting the confirmation of a high-speed trade just one to ten milliseconds faster can enable a computer to know the direction a commodity is going and trade on it. According to the Wall Street Journal, the “ability to exploit such small time-gaps raises questions about transparency and fairness amid the computer-driven, rapid-fire trading that increasingly grips Wall Street and confounds regulators.” Both the increasing use of high-speed trading and the problem of accountability from a regulatory point of view raise the stakes in determining the ethics of the practice. 

The full essay is in Cases of Unethical Business, available in print and as an ebook at Amazon.com.  

Rating Moody’s and S & P: A Structural Conflict of Interest

For years, banks and other issuers have paid rating agencies to rate their securities. This is a bit like restaurants paying food critics to write on their food.  In the wake of the SEC’s charge that  people at Goldman Sachs built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it, the Senate’s Permanent Subcommittee on Investigations questioned representatives from Moody’s and Standard & Poor’s about how they rate risky securities. Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.” Throughout the testimony, the institutional conflict of interest was salient whereby credit-rating agencies put market-share considerations foremost in rating securities presented by the banks that are paying the agencies.

The full essay is at Institutional Conflicts of Interest, available at Amazon.