The financial services industry seemingly took a pause last week either to read or watch debates about Michael Lewis’ new book, Flash Boys. I would be derelict not to add my views to the fire.
As a result, the following matters are covered on this week’s Gary DeWaal’s Bridging the Week:
Also, this week I introduce a new abbreviated Video Version of Bridging the Week that I promise never will exceed five minutes. You can obtain a pretty high level summary of last week’s financial industry developments by checking that out!
I broke my habit this week of reading only softcover editions, and read the hardcover version of Michael Lewis’ Flash Boys. It seemed the least I could do given all the hubbub in the media about this publication.
As I have mentioned before, one of my co-majors in college was English literature, and I certainly applaud Mr. Lewis for his writing style. He is a gifted author, and is able to leave you hanging after most sentences, only too eager to pounce onto the next.
That being said, I found Mr. Lewis’ non-fiction account of high frequency trading more like a novel than the factual account it purports to be. Many times, Mr. Lewis takes the mundane and ordinary but through exhilarating manipulation of language makes it seem illegal. In other circumstances, Mr. Lewis spends pages upon pages attacking something only to insert a single sentence or phrase actually exonerating the practice he just mightily condemned. But the brief sentence or phrase is buried and boring, and not written nearly as excitedly as his other prose.
For example, Mr. Lewis’ novel, I mean study, begins with an account of the secretive acquisition of property by a company known as Spread Networks, and the installation through sometimes impervious rock of a near straight fiber optic cable from Chicago to northern New Jersey. Clearly Mr. Lewis’ colorful description of these efforts is meant to cast aspersion on the purpose of this project, which is to offer high speed traders a quicker way to route their orders between a data center that hosts the Chicago Mercantile Exchange and one next to NASDAQ’s stock exchange in Carteret, NJ. Just read two sentences:
“[The initial investors] named the company “Spread Networks,” though they disguised the construction behind shell companies with dull names like Northeastern ITS and Job 8. [One investor’s] son… came on board – to cut, as quietly as possible the four hundred or so deals they needed to cut with townships and counties in order to be able to tunnel through them.”
However, buying land quietly in small parcels using many dummy companies is not illegal, and in fact is a smart tactic in order not to drive up the price of property unfavorably. Just ask Walt Disney. Disney used many shell companies (many with mysterious names such as M.T. Lott Real Estate Investments, the Latin American Development and Management Corporation and the Reedy Creek Ranch Corporation) to acquire almost 28,000 acres of land near Orlando, Florida that ultimately became home to Disneyworld. Nefarious? Well maybe because of the high price of an admission ticket these days and the very salty popcorn that is served on Main Street USA; but I think most kids and their parents don’t think so.
Another example: Mr. Lewis spends the first 96 pages excoriating the practices of high speed traders, then casually has one of the heroes of his story (John Schwall, a Wall Street technology insider whose “father had been a firefighter…like his father before him”) ask the question, “[h]ow was it legal for a handful of insiders to operate at faster speeds than the rest of the market and in effect, steal from investors.” Wait, this is a book about folks who have done nothing more than take advantage of market opportunities in a legal way? The problem is that by dramatically juxtaposing the word “steal” -- which most folks think of as illegal -- next to the word “legal,” it is easy to conclude that something is terribly amiss.
Others have written on both sides of the debate regarding high speed trading far more eloquently than I can and debates about good and bad liquidity will go on for a long time. But to me, since the day I began to be involved with the markets professionally as a trial attorney for the Commodity Futures Trading Commission in 1982, it was apparent that some persons had an edge when they traded, either because they were exchange members or had access to the latest technology, and that other persons who did not share that edge were envious (including me). Every year, some folks clamored to acquire and use the latest, newest technologies while others decried progress or were frustrated because they did not possess such new advanced means (e.g., remember the outcry when some floor members wanted to use headsets or handheld computers).
This is not to suggest that some high frequency traders, like other traders, may not seek to bend rules illegally or engage in practices that cause real market harm (although, as Mr. Lewis acknowledges, the 2010 “Flash Crash” was precipitated by a mutual fund, not a high speed trading outfit).
This is not also to suggest that some market practices should be reviewed to understand their implications (e.g., make taker practices and rebates to promote market liquidity) and whether there have been unintended detrimental consequences to well intended regulation (e.g., Securities and Exchange Commission Regulation NMS).
But in and of itself, the fact that some traders have been smart enough to exploit technology and take advantage of legal situations created by regulation is not a problem let alone a crime. And as Mr. Lewis also points out, some folks, like the new exchange IEX, can endeavor to fix perceived problems for their own commercial benefit. This is what capitalism is all about. Carpe diem!
Again, Mr. Lewis’ book is exceptionally well written and engaging, and if you like innuendo and suspense, it’s for you. However, once you begin to deconstruct his tale, you will come away thinking that, ultimately, Mr. Lewis’ story “…is full of sound and fury. Signifying nothing.” However, in my view, Shakespeare’s drama Macbeth, which contains this famous soliloquy, is far more compelling! Better to spend your money on a paperback of that -- even an electronic version!
UK FCA Discusses Regulatory Priories and Assessment of Risks Impacting the Financial Services Industry; A Joint European Regulatory Committee Offers Insight Too
Last week the UK Financial Conduct Authority joined the group of international regulators who have published a list of their current regulatory priorities, by releasing its own business plan for 2014/15, as well its assessment of risks impacting the UK financial services industry.
Among the risks identified are “[e]nvironmental conditions [that] affect firms’ ability to make profits from their core products and business lines.” According to the FCA,
“…long running low returns and falling volatility in financial markets have contributed to reduced margins in core wholesale activities and have been a key driver of firms’ (reassessment of their) business models, trading strategies and cost bases. Where firms are unable to adapt to the new environment, there could be further consolidation that could affect competition in some markets.”
FCA raises concerns specifically that firms under financial pressure may move into new product lines, geographic locations, or adopt practices or standards “to the detriment of consumers’ outcomes or their financial crime responsibilities.” Likewise FCA raises concerns that new capital requirements could cause some firms to shed risk-weighted assets and withdraw from more complex products; this too could increase concentration in such products among fewer players. The FCA also expresses concern that firms’ drive to reduce costs could lead to their implementation of new technology without the support of adequate systems, controls and expertise.
Separately, the Joint Committee of the European Supervisory Authorities also issued their views regarding risks and vulnerabilities in the European Union’s financial system. Although most of the Joint Committee's report addresses EU macroeconomic issues, the report also takes notice that “[t]he profitability and income of EU banks have continued to face significant challenges which are unlikely to dissipate in the future…” The Joint Committee interestingly notes, that “[w]hereas banks were able to further reduce operating costs, the recent rise of costs from misconduct fines and settlements has offset cost containing efforts in some banks.” The Joint Committee is forum to encourage cooperation among the European Securities and Markets Authority, the European Banking Authority and The European Insurance and Occupational Authority.
Compliance Weeds: It generally is a good idea that, when a firm internally discovers an issue at one location (or it is identified by a third party), to review to see if the same or similar issue exists at other locations or if the issue exists in related circumstances. For example, a finding of a sales practice concern in one branch should prompt review of sales practices at other locations. A discovery of a problem with the calculation of one type of customer funds should be followed by a review of the calculation of other types of customer funds. In all circumstances, whenever a problem in practice is discovered, the procedures governing the practice should be reviewed and modified, as appropriate. Step back and think holistically!
Hard to Believe: When most folks’ spouses emphatically tell them not to do something, they generally listen. We all know the consequences for not! But not to listen and to engage in illegal conduct too? It is a sad reflection on the state of society that, despite all the adverse publicity cases involving insider trading receive and despite the potential consequences for engaging in such illicit conduct, some folks – ranging from ordinary citizens to respected traders -- continue to try to roll the dice and trade stock based on non-public confidential information they have knowingly received through inappropriate means. Me? I’m too scared not to take out the garbage immediately when asked!
And Even More Briefly:
For additional information, see:
Basel Committee Revised Approach for Measuring Credit Risk Exposures:
CFTC - Department of Treasury OFR MOU:
CME Application of CTI Code Requirements to Block Trades and EFRPs:
FATAF Updated List of Deficient AML/CFT Jurisdictions:
FCA 2014/15 Regulatory Round-up:
ICMA Collateral Fluidity Report:
IIROC Proposed Marketplace Threshold Guidance:
EU Supervisory Authorities Joint Committee Report on Risks and Vulnerabilities in the EU Financial Sector:
See also: CFTC Press Announcement:
ODRG Progress Report on OTC Derivatives Reform Cross Border Issues:
Peregrine Financial Group: Settlement with JP Morgan:
SEC Insider Trading Actions:
See also: SEC v. M. Jason Hanold:
SEC Order: Transamerica Financial Advisors:
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of April 5, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.