The Culture of Corruption

  I spent 20 years working on the fringes of the oil industry - mostly writing about trading and oil prices and OPEC, but also broking a bit and doing some (dreaded) marketing of oil price services. Once I left Platts, the oil industry bible owned by McGraw-Hill's Standard & Poors, people within the industry opened up to me a little and I got a taste for just how corrupt the oil industry is. From blatant bribery of government officials to inspectors and, yes, reporters the corruption in that business was (and still is to an extent) all in a day's work.
  The corruption I see today in the financial services arena makes oil traders look like amateurs: Rogue traders such as Kweku Adoboli at UBS, with his $2.3 billion worth of hidden trading losses; MF Global with $1.2 billion of customer money seemingly vanishing into the maw of a bad trade on European debt; Ponzi schemes such as Bernie Madoff's. 
  Few oil traders would steal money from their firms to pay a bribe or for a client's night with an 'escort'. Also, few of them would hide trading losses until they escalated into disaster. It is difficult to hide losses on a cargo that got delivered and paid for. Most of their activities, while under the radar of much of the world, were above board and known by management (if slightly less than legal).
  There is a culture of greed infiltrating the financial markets and it isn't pretty. It leads to the kinds of major corruption we saw in 2011 and all sorts of minor, though still significant, acts of creative accounting which we may never see. But shareholders and customers of these firms are paying the price. Occupy Wall Street may have had a point, even if they weren't quite sure what it was.
  Happy Christmas!

MF Global Story Goes from Bad to Personal

  The MF Global story gets worse and worse; the firm had been dipping into client funds for weeks and the customer shortfall may be as high as $1.2 billion. Therefore I was thrilled to hear that the Board resigned last week, and that Jon Corzine will be forced to testify in front of Congress. Meanwhile regulators moved quickly for a change. Bloomberg reported:  

U.S. derivatives regulators voted today to restrict how brokers can invest customer funds, acting on a delayed rule after as much as $1.2 billion went missing before MF Global Holdings Ltd. sought bankruptcy protection. The Commodity Futures Trading Commission voted 5-0 at a Washington meeting to limit how brokers invest clients’ margin in money market funds, and ban investments in foreign sovereign debt and in-house transactions such as repurchase agreements.

  This is a good start, but it doesn't address the client money segregation bit of the problem. In today's FT, two professors had some suggestions though. Darrell Duffie, Professor of Finance at Stanford University’s Graduate School of Business, and Joe Grundfest, Professor of Law and Business at Stanford Law School and a former Commissioner of the SEC, penned a comment suggesting that the rules be more stringent. 

  They offered two possibilities: 1.) Segregate customer funds with an independent custodian, and 2.) Form an information-technology firewall at the broker, creating a “virtual custodian”. Both of these are valuable and realizable solutions. So why did the comments to the article say things like this is "old news" and one wondered why such a big deal is being made of "tiny MF?"

  I'll tell you why it is a big deal. A good friend of my husband's, his boss, and some colleagues of his are missing hundreds of thousands of dollars of their investments. MF Global has made good only a tiny percentage of their money thus far, and they are very concerned that they may not get any more back. And I know people who are MF Global employees, they are also receiving a good rogering by the firm; part of their compensation was tied up in MF Global shares which are now as good as worthless.

  The fallout is large, it is personal and it tells a story of what happens when transparency is not mandated. And although investors are getting more savvy, as purported by the FT's Gillian Tett's column on November 24th, it should not be incumbent upon them to inspect every crevice and cranny of their broker's books before they turn over their money to be invested.  

Who Comes First - Traders or Shareholders?

  When UBS caught alleged rogue trader Kweku Adoboli with his hand in the till, it must have been pretty clear to other UBS traders that bonus season might be a tad disappointing. Indeed if the missing $2.3 billion wiped 40% off of third quarter profits for UBS, that new Lamborghini Gallardo could be a bit OTT. But it seems the bank had ring-fenced 90% of Q3 revenues for staff pay and bonuses. And although the new CEO Sergio Ermotti has said that the bonus pool will probably be cut (FT) it is likely to be only by 10%.
  This has infuriated shareholders who believe they are left holding the bag for UBS' shocking lack of credible risk management practices. But are they holding the bag? UBS' share price on NYSE actually went UP after the scandal was revealed, and it is hovering around the same levels today as it was pre-scandal. And although one rogue trader did a hell of a lot of financial damage, the other traders appeared to be making money. Do they deserve to be punished for Kweku Adoboli's actions?
  It is an age-old argument in any company that has trading desks. If one desk loses and the rest make money, do the winners get punished with lower-than-expected bonuses? The answer is invariably yes, unless they have iron-clad contracts that guarantee a share of profits. Andy Hall at Phibro had a contract like that, which is one of the reasons Citi had to get rid of Phibro - Hall's $100 million compensation during what can only be termed a market crash was considered obscene. Even though he had made Citi a lot of money (close to $2 billion).
  If UBS cuts trader bonuses by 10% or more, they will probably leave for greener pastures. This leaves UBS temporarily without the money-makers as it scrambles to attract new ones. Traders outside UBS will take one look at the mess the bank got into last year and demand a premium to work there. So UBS will end up paying more for traders than it would if it paid its existing ones their expected bonuses. Shareholders have to be careful what they wish for, because the pay and bonus pool could RISE.
  On the other hand, if UBS is really downsizing its investment banking arm maybe bonus cuts is a good way to achieve that.

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.