Financial Firms' Shenanigans Show Need for Transparency

  I have been thinking a lot about transparency lately (sad, I know), especially since Pipeline Trading's sneaky tricks and MF Global's seemingly full-scale fraudulent activities were exposed. Since the dawn of financial markets (I include energy and commodities here) people have been able to make great profits, not all of them legal. Over the years I have reported on some of these barely-legal activities, and there are many more that I cannot write about for fear of reprisals. So whenever lawmakers and regulators try to make strides toward transparency I applaud. Transparency makes investors happy, it gives them a warm and fuzzy feeling that the markets or companies they are investing in are as straight-forward as possible.
  MF Global let the transparency side down for brokers and broker-dealers by using segregated customer money for prop trading. What it allegedly did was not only illegal, but immoral. Customers were harmed, the CFTC and CME's reputations for being the good guys were damaged. A slightly loony post today on Zerohedge went so far as to say that MF Global has destroyed the whole system. Written by a broker called Ann Barnhardt from Barnhardt Capital Management, the post blames everyone from Obama to the government for orchestrating a conspiracy to defraud her customers. She has closed her business and says she won't get back in until everyone in power today is either dead or deposed. Here is one alarming passage:
Finally, I will not, under any circumstance, consider reforming and re-opening Barnhardt Capital Management, or any other iteration of a brokerage business, until Barack Obama has been removed from office AND the government of the United States has been sufficiently reformed and repopulated so as to engender my total and complete confidence in the government, its adherence to and enforcement of the rule of law, and in its competent and just regulatory oversight of any commodities markets that may reform. So long as the government remains criminal, it would serve no purpose whatsoever to attempt to rebuild the futures industry or my firm, because in a lawless environment, the same thievery and fraud would simply happen again, and the criminals would go unpunished, sheltered by the criminal oligarchy.
  Hers is an extreme case, she even invokes God at one point, but it shows how pissed off people can be when their protectors let them down. But regulators and exchanges are only human, and cannot read the minds of fraudsters and tricksters. They can only sniff around the edges and try to ensure that financial firms are doing the right thing. MF Global clearly wasn't, but its timing was perhaps the key to getting away with swiping customer money. A Dealbook article in today's New York Times says that the brokerage probably used some of the money to cover trading losses. Where the rest went is thus far a mystery. The NYT said: "The firm may have used some of the cash to keep its own lenders at bay, which means the money could be sitting in an account at another firm." OK...which firm? Who are the trading partners? This is the opposite of transparency and I can see where this might royally piss off clients and counterparties.
  One firm's actions post-M F Global warmed my little heart. Market maker Jefferies Group's shares got hammered when it was mentioned in the same breath as MF Global as having a preponderance of European debt on its books. Jefferies took the bold step of revealing its positions, then selling out of about half of them to mollify shareholders. Now that's what I call transparency. Unfortunately, the firm remains tarred with the MF Global brush.

Goldman Sachs Taste on an MF Global Budget

  Jon Corzine, the Goldman Sachs trader/governor/Senator/broker, thought he had MF Global under control. He would leverage what little cash the brokerage had, make a huge bet on European debt, flatter his contacts at the ratings agencies, and walk away with a gigantic bonus for 2011. Except he ran out of money - even customers' money it appears.
  There is an old saying in the markets that goes "He who has the most money wins". It refers to playing poker, where if you have more money than your opponents you can keep on betting until they all fold - broke. But it is also applicable to trading. If you have a very large position which you believe is right and will be profitable, you have to have enough capital to stick with it when it is going wrong. Jon Corzine made the mistake of using his Goldman Sachs champagne taste on MF Global's beer/broker budget. The money wasn't there. Capital requirements are not just for large investment banks, Mr. Corzine.
  Corzine never really seemed to understand what a brokerage actually did. He started out on the wrong foot, I heard, when he told the brokers that they would all take pay and bonus cuts. They responded by putting two fingers up and walking into other brokerage shops, for the same money they had been making previously at MF Global. I get the feeling he had no idea what brokers actually do, and tried to treat them like lowly floor traders.  Then took the money they brought in and tried to leverage it into a Goldman-like fortune. You can file this blog under "hubris."

Pipeline Trading Systems Takes Privacy Too Far

  One of my favorite companies to cover over the past few years, dark pool provider Pipeline Trading Systems, has been nailed by the SEC for operating an affiliate company that was actually trading against its customers. 

  The Pipeline case is disappointing, and brings to light a whole new area that regulators now have to worry about - privately held trading venues. Because Pipeline Trading Systems LLC and Pipeline Financial Group are both registered in Delaware, the state that offers the least litigation and the most privacy (does not require director or officer names to be listed in the formation documents), there is little information to be found on its owners or its subsidiaries. 

  What can be found online is that Federspiel's original company - eXchange Advantage Corporation - exhibited at a venture capital beauty pageant in 2001, so it stands to reason that it received backing somewhere. This was apparently Pipeline's vehicle for providing liquidity to its dark pool ATS, it changed the name to Aurora then to Milstream, and was residing in the same NYC building as Pipeline. The whole thing flew in the face of Regulation ATS, and you would think both partners must have known that. Yet no one sussed that something was off.  
  The financial press has barely scratched the surface in this story, only looking at the SEC filing and not digging much further.The FT did turn up one interesting nugget: A non-exec at Pipeline, Giles Vardey, also serves as non-exec chairman at London micro cap exchange Plus Markets Group. He has been asked to step down from Plus Markets by a Middle Eastern investment syndicate. Curiouser and curiouser... 

  It isn't an easy task putting the pieces together. With private companies there are no legal identifiers, and audit trails often end in - well, Delaware. I believe in privacy but this goes too far. Scary.

A Tale of Two Regulatory Regimes

     One of these things is not like the other. In a tale of global regulatory disharmony, European regulators say they are going to crack down on high frequency trading, perhaps by forcing perpetrators to become de facto market makers, according to today's FT. They are concerned that HFT algorithms can remove liquidity when trading conditions go against them or are too volatile to read - as happened on the May 6th Flash Crash.
     Fair enough. But forcing HFTs and banks to be market makers in each and every instrument they trade is begging for trouble. It would require a huge amount of additional capital, an issue banks are already whining about. And it flies directly in the face of the U.S. Volcker Rule, the guidelines for which have just been laid out. Specifically, no bank should end up with a long or short position while performing market maker or hedging duties for customers.
     U.S. banks are already confused about the distinction between proprietary trading and taking the other side of a customer's trade, along with the risk exposure that it creates. If they sense that regulators will knock heads every time a client-related position is not fully hedged, they might just move their business elsewhere. This is exactly the regulatory arbitrage that Wall Street was worried about, because it could cost them a lot of business. NYC traders will be polishing up their EU passports.

When China Sneezes

     The old cliche 'when America sneezes the world catches cold' still holds true. Look at the damage we did to the world with our housing and credit bubble, and subsequent crash. In the past decade or so the world has morphed into a single organism, a collection of interdependent countries thanks to cross-border trade. With countries such as the USA outsourcing it workforce to Asia, and financial markets becoming increasingly fungible across geographies, the knock-on effect of an event in one country can be devastating. The earthquake and tsunami in Japan earlier this year, for example, is still reverberating through supply chains and damaging revenues globally.
     So, when I read today in the FT that property development in China is looking shaky I got a chill. There are half-built luxury residential properties dotted throughout China's largest cities, and demand for these apartments has all but dried up. If developers are forced to reduce the prices on them in order to sell, it could have an immediate impact on sky-high real estate prices across China. The knock-on effect of this could be significant. Demand for steel, cement, copper and other building materials could hammer prices globally. For a start, China is the world's largest consumer of steel and, according to the FT, real estate construction accounts for 40% of China's steel use. And because China hoards building supplies its demand for fresh stock could languish for years.
     If a housing collapse could flatten the US economy, it could surely do the same for China. If China slides into recession - and I'm being kind, analysts think that it will have a hard landing - we could see the biggest knock-on effect yet. Global recovery would stop dead, and the worst-off economies (Greece, Italy, Spain, etc.) would teeter off the cliff. The US would sink like a stone - China is the largest investor in US treasury bonds, and further investment would likely be curtailed if it fell into recession.
     I am not an analyst, but sometimes the writing is on the wall and this is written in neon. I think my 401K is about to be converted to cash.
   

High Frequency Trading and Your 401K

     I have had a few people asking me lately about this phenomenon called high frequency trading or HFT. They are - quite rightly - concerned about their 401K's and their stock portfolios, and have been reading some of the sensational headlines about HFT causing the market plunges.
     As a reporter, I started covering HFT and algorithmic trading about 10 years ago, so I know a little bit about it. Quite simply, it is electronic trading of stocks and other automated instruments such as oil and corn futures. What high frequency traders do is build clever computer programs, called algorithms, to dip in and out of these markets and shave off a penny here and there. If they do it enough times - and they do - they can make quite a bundle.
     What is not entirely clear at this point is whether they are ripping off the average investor. My retail brokerage has a low latency trading platform, so in theory it stands a fighting chance of getting me a good price at any given moment. Having said that, last week when Apple shares were puking I put in an 'at market' bid (I know, stupid, but I'm lazy) when Apple was at $363 - I got filled at $366.79. Quite a difference, even though it was done in seconds - seemingly instantaneously. HFT's, however, can get a deal done in less than a millisecond - some a lot less because their trading machines sit right next to the exchanges' machines.
     The jury is out whether regulators will throw their weight around and try to control HFT. The reason? That is where the money is. When the firms that own the big HFT machines trade more than 50% of the equities market volume, there is bound to be some pushback. My advice is this: if you can't watch your investments on a VERY regular basis - not daily but all day long - you are bound to get trampled when the machines take over. Once those magic stop-loss numbers are hit, they will sell all the way down. Until the computer says it is time to buy, that is. In the meantime you will be crushed.

     As Kyle Reese said in the Terminator movie: "Listen, and understand. That terminator is out there. It can't be bargained with. It can't be reasoned with. It doesn't feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead." Or broke.(Thanks for the line, Tim!)

    

Removing the Taint of News of the World

     When it became public in 2007 that Rupert Murdoch's News Corp had taken over my one-time employer Dow Jones I was horrified. First because I used to work for Dow Jones. Second because I was then working for Financial News, which a year prior had been taken over by Dow Jones, which meant I was now somehow working for Murdoch's evil empire. And third, because Dow Jones and the Wall Street Journal were some of the last bastions of solid, honest financial news and I knew that Murdoch would damage that reputation. Luckily Murdoch's first move was to axe freelance budgets so I lost my Financial News gig. I was relieved not to have to watch from the inside as News Corp's culture slowly changed Dow Jones into a sensationalist stream of headlines; and the WSJ into USA Today with a fuzzy business angle.
     I was saddened but not surprised that the Bancrofts, the ruling family board of Dow Jones, would sell to such a notorious publisher as Murdoch. The original phone hacking scandal was out there in 2006, so the Bancrofts had to have known what kind of company News Corp was. But money is money, and that is what they wanted. This generation of Bancrofts had never been interested in the newspaper business, only that the share price remained stable so that their fortunes were safe. (One of my favorite tales of the Dow Jones Board came from a London sales VP who attended a meeting. She said that one Board member got so bored that she rolled up her cardigan to use as a pillow and went to sleep on the boardroom floor!)
     Some of my ex-colleagues at DJ were actually thrilled about News Corp, simply because they were hoping Murdoch would throw some money back into the company after years of the Bancrofts sucking it dry. I doubt that they are now so thrilled.The Bancrofts are now saying that they would not have sold to Murdoch if they had known about the extent of the phone hacking scandal. Murdoch's own senior executives who were in charge at the time claimed they didn't know either. This is absolute rubbish. I have never worked for an editor who was so bad as to not know where our stories came from - and I have worked for some clueless editors.
     It may be pure schadenfreude but I am pleased that News Corp's true colors are being shown. News Corp, The Sun, NOTW, and now even The Times give journalism a bad name.  There may yet be hope for the WSJ, since the Bancrofts’ agreement with News Corp included a clause to preserve the integrity not just of Dow Jones, but of all the company’s “publications and newsgathering services,”says the New York Times. A special Dow Jones committee, created to assuage concerns over News Corp tainting Dow Jones and the WSJ's journalistic integrity, is reportedly keeping an eye on the evolving phone hacking situation. But the committee, which inexplicably includes Nicholas Negroponte, co-founder of the Media Lab at the Massachusetts Institute of Technology, is largely toothless. But the rest of the media world is not, and it is pissed off. I think Rupert Murdoch should be afraid, very afraid.