Fed Leaks, Dark Pools and Muni Bonds

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Insider trading and the news.

This Wall Street Journal article begins "A high-profile investigation into a leak of sensitive information from the Federal Reserve in 2012 has escalated to an insider-trading probe led by a key market surveillance agency and federal prosecutors in Manhattan, according to people familiar with the matter," and it is always fun to wonder who those people are. I suppose it is possible that they work for the target of the probe, "macro policy intelligence" firm Medley Global Advisors, but that seems unlikely; later in the article a Medley spokesman is quoted on the record. So that leaves ... the investigators? Leaking news about their investigation into leaks of news? The irony is compounded by the fact that this investigation is into information about Fed deliberations that were apparently leaked to Medley only after they were leaked to the Journal:

The important details of the Fed’s internal deliberations at the September meetings were supposed to be disclosed by the Fed in early October.

Before that happened, The Wall Street Journal published a story reporting that Fed officials at the September meeting were considering further action to stimulate the economy. The Sept. 28 story said there was a “strong possibility” the Fed would begin purchasing large amounts of Treasury bonds.

The next week, Medley sent a research note to its clients saying with more certainty that the Fed was “likely to vote as early as its December meeting” to begin monthly purchases of $45 billion worth of Treasury bonds.

Medley is fighting the investigation on the grounds that it is a media organization, and publishing news can't really qualify as insider trading. Medley, though, is the sort of media organization that sells expensive subscriptions to fewer subscribers (who trade on it) rather than cheaper subscriptions to more subscribers (who are entertained and enlightened by it). This seems like a hard line to police: The Wall Street Journal, which apparently got this leak before Medley did, also charges for subscriptions. How many subscribers do you need, or how cheap must your subscription be, to qualify as a media organization? 

Municipal bonds.

I mentioned the other day that a core role of an investment bank is to vouch for the bonds that it underwrites. Classically the way it does that is by doing "due diligence" on the issuer, making sure that everything is okay, and then making sure that the prospectus for those bonds is true and accurately reflects the risks. Yesterday the Securities and Exchange Commission reached settlements with 22 municipal bond underwriters for not doing adequate due diligence:

The SEC found that between 2010 and 2014, the 22 underwriting firms violated federal securities laws by selling municipal bonds using offering documents that contained materially false statements or omissions about the bond issuers’ compliance with continuing disclosure obligations.  The SEC also found that the underwriting firms failed to conduct adequate due diligence to identify the misstatements and omissions before offering and selling the bonds to their customers.

Sampling the individual settlements brings up a lot of due diligence errors like this:

Respondent acted as either a senior or sole underwriter in a municipal securities offering in which the official statement essentially represented that the issuer or obligated person had not failed to comply in all material respects with any previous continuing disclosure undertakings. In fact, certain of these statements were materially false and/or misleading because the issuer or obligated person had not complied in all material respects with its previous continuing disclosure undertakings. The offering in which the official statement contained false or misleading statements about prior compliance was

  • A 2011 negotiated securities offering in which an issuer failed to disclose that it filed an audited financial report on the MSRB’s Electronic Municipal Market Access system 499 days late, and failed to file the required notice of late filing.

That is: Municipalities issue bonds. When they do that, they promise to file current financial statements in a publicly accessible way. Sometimes -- quite frequently, it seems -- they forget to do that, or stop doing it, or whatever explains being a year and a half late with the financials. Then they want to issue new bonds. As part of issuing the new bonds, they again promise to file current financial statements, and also promise that they've never been late on their financials in the past. Even though in fact they have been 499 days late on their financials in the past. And somehow neither the issuer, nor the underwriters, nor the buyers of the bonds notice that this isn't true.

That is an obvious failing of due diligence and the underwriters should definitely be in trouble. But I'm kind of more worried about the fact that the municipality here was 499 days late on its filings, and no one noticed, or at least, no one cared enough that it was hard to sell the bonds in the future. And there are lots of cases like this; here's one with an issuer who "filed three annual financial reports which were between two and 50 months late." One gets the rather strong impression that no one is reading these filings, and that the whole disclosure system for issuing municipal bonds might be more or less ignored.

Elsewhere in munis: "Puerto Rico Said to Start First Post-Reform Plan Debt Talks."

Dark pools.

Here is a speech by SEC Commissioner Kara Stein on dark pools and electronic market structure. Some of this is about the need for better disclosure of dark pool operating procedures and routing, and better audit trails for the SEC to track orders and trades, all of which seems pretty hard to argue with. The more controversial part may be the cultural stuff:

Behind every algorithm, order type, and electronic trading network are human beings:  individuals program computers, individuals design trading algorithms, and individuals market products.  Individuals supervise and design compliance structures.  Regardless of the advancement of technology and innovation in our securities markets, humans – individuals – are necessary to what we do each and every day. 

All market participants need to be responsible for their work and, at the same time, its collateral consequences.  To do that, every individual within a securities organization – from the coder to the cybersecurity officer, the salesperson to the CEO – needs to understand the new electronic marketplace.  Everyone needs to be cognizant of how the work he or she is doing could affect the market as a whole, including from a technological and operational perspective.

It sounds very reasonable for a regulator to say, as Stein does, that "complex organizational charts should not shield individuals from accountability." I wonder how true it is. You could have a view of complexity as a shield intentionally designed to allow powerful individuals to disclaim responsibility for bad acts. Or you could have a view of complexity as an organic system, in which the complexity arises from the interaction of many individuals each working rationally to the best of their abilities, but in which sometimes errors and crises emerge from those interactions rather than from the evil intent of any of the individuals. I mean, this is a general problem of financial regulation, but it seems particularly acute at the millisecond level of modern equity market structure.

In any case good luck getting every salesperson and CEO to understand the new electronic marketplace! Elsewhere, "BATS Will Offer to Pay Companies to List ETFs on Exchange." And here is Robin Wigglesworth on the risks posed by "computer-driven 'systematic' investment strategies."

What else is up at the SEC?

Yesterday was a busy day for Securities and Exchange Commission enforcement actions. There was the settlement with Latour Trading over "market structure rule violations," which I wrote about yesterday, and the muni bonds stuff above. But the list keeps going. There's the $55.6 million settlement with "China-based advertising company" Focus Media Holding Limited and its CEO, which is pretty nuts:

In March 2010, Focus Media disclosed an incentive initiative in which some of its managers and directors and certain employees, managers, and directors of its wholly-owned Internet advertising subsidiary, purchased a 38% stake in the subsidiary, Allyes Online Media Holdings Ltd. The purchase price, which Focus Media said was based on an independent third-party valuation, represented an implied value of $35 million for the entire subsidiary. However, unknown to shareholders, before the sale was finalized, a private equity firm had begun discussions with Allyes about acquiring the company for $150 million to $200 million.  As described in the SEC’s order, the potential acquirer’s business records stated that Allyes asked it to “hold off the deal” until the insiders’ purchase was finalized.  In July 2010, Focus Media announced that Allyes had been sold to the private equity firm for an amount that valued it at $200 million, nearly six times what the insiders paid just months earlier.

You can't do that if you're a public company! The SEC also notes "the lack of corporate formalities surrounding the approval and execution of both transactions" as a red flag; basically the CEO wanted the subsidiary for himself and so he took it. Muddy Waters, the China short research firm, noticed these problems back in 2011, in a note saying that "Insiders have used FMCN as their counterparty in trading in and out of FMCN subsidiary Allyes, with several individuals earning a total of at least $70.1 million, while shareholders lost $159.6 million."

And there's this case charging "two former executives of ContinuityX Solutions Inc. with fabricating nearly all of the company’s revenue and enriching themselves in the process." The fascinating part to me is "nearly all":

ContinuityX reported revenues of $27.2 million from April 2011 to September 2012, but the complaint alleges that 99 percent of it came from fraudulent and fictitious sales.

The complaint ups that to "over 99%" and says that "ContinuityX’s Entire Business Was A Fraud," but I am still looking for the legitimate one percent. Maybe they ran a real lemonade stand out of their otherwise fake office? Anyway the alleged fraud was adorably simple: ContinuityX had real contracts with AT&T and XO to sell internet services to businesses, and would allegedly sign up fake customers, get a commission from AT&T, and pay part of the commission to the fake customer as a kickback. That was it. When AT&T sent bills to the customer, they wouldn't get paid, and when AT&T tried to charge back the unearned commissions from ContinuityX, it would just ignore them. AT&T had protections against this sort of scheme, but they didn't really work. For instance it checked prospective customers' credit by looking at their financial statements, but Continuity X's chief executive officer David Godwin and chief financial officer Anthony Roth allegedly just made up those financials:

For example, Straw Buyer “A.S.” submitted an order to purchase services from AT&T. In connection with that Order, on or about May 15, 2012, an AT&T representative emailed Godwin and requested that A.S. submit a cash flow statement or balance sheet. On May 16, Godwin forwarded the email to Roth asking him to prepare a “very comprehensive” cash flow statement and balance sheet for A.S. Godwin directed Roth to give A.S. a “great value” and cautioned him not to “skimp.” 

It's good to see a commitment to giving great value and not cutting corners on the fake financial statements.

Cockney rhyming slang.

What:

The Financial Conduct Authority was accused by a former spot-forex trader at Barclays and UBS of not respecting the normal investigative process in the forex-rigging scandal. A lawyer for Chris Ashton — who was a member of a chatroom nicknamed “the cartel” — told a tribunal on Wednesday that Mr Ashton had never been questioned over evidence relied on by the FCA, which misinterpreted Cockney rhyming slang as proof of a collusive code.

What? What even? What is the misinterpreted Cockney rhyming slang? There is some well-known rhyming slang in the FX manipulation evidence -- "Betty" (from "Betty Grable," rhyming with "cable," itself a bit slangy) is a term for the dollar/pound cross -- but I cannot find "cartel" in the Cockney rhyming slang dictionary, and generally the rhymes for it are pretty underwhelming. "Hard sell"? Is that even better?

Elsewhere, the Financial Stability Board released its report on FX benchmark reforms.

People are worried about bond market liquidity.

New York Fed President Bill Dudley gave a speech yesterday about "Regulation and Liquidity Provision" that I would broadly characterize as not worried about bond market liquidity, though like any sensible regulator he can't just come out and say "everything is fine, chill." He did say this though:

To investigate corporate bond market liquidity in more detail, let's examine three liquidity measures: the average trade size, "effective" bid-ask spreads and price impact.  The evidence on the average trade size for investment grade corporate bonds indicates a slight reduction from between $700,000 to $800,000 in the early 2000s to around $500,000 in the last few years. (Exhibit 6)  However, price measures of corporate bond liquidity do not substantiate the trend in this quantity measure.  The effective bid-ask spread has been trending down since the early 2000s, around the same time that TRACE reporting was introduced.  The spread spiked during the financial crisis, but is now lower than its pre-crisis levels. (Exhibit 7)  Similarly, price impact—the effect on price from a $1 million trade—has also been trending down since the early 2000s apart from the jump during the financial crisis. (Exhibit 8)

Here are those exhibits. Elsewhere in speeches, I seem to have missed it last week, but SEC Commissioner Luis Aguilar gave a public statement with the less auspicious title "The Importance of Being Earnest About Liquidity Risk Management." One section heading is "Fund Liquidity, What is it Good For?," and I hope that we've established by now that the answer is not "absolutely nothing." We are all in the gutter, but some of us are looking at bond market liquidity stories every day, which honestly does not help.

Elsewhere, TD Securities published some "Market Musings" about Treasury market liquidity finding that "daily changes in 10yr Treasury yields exceeded one standard deviation (σ) 58% of the time so far in 2015," which is "the highest reading going back to 1975, suggesting that recent volatility in Treasury markets is unprecedented." Here is Tracy Alloway with more, including pointing out that "heightened volatility could very well have little to do with liquidity."

And still elsewhere "Hewlett-Packard Co. raised $14.6 billion in the bond market to facilitate its split into two companies," despite all the worries about, you know.

Me yesterday.

I wrote about the Latour SEC settlement, as I mentioned above. Also yesterday I mentioned in Money Stuff that the strategy of shorting leveraged long and short exchange-traded funds on the same underlying asset seems like a long-gamma strategy that loses money if the market stayed flat. Several readers pointed out that really it loses money if the market trends in one direction, straightforwardly compounding the changes in both leveraged ETFs. What you want is a choppy market that causes slippage in both ETFs.

In somewhat related news, here's the story of a hedge fund blown up by leveraged ETFs. It's called Spruce Alpha, one of its former managers had previously "worked on simulations of laser defense missiles" (what?), it had under $100 million in assets, it launched in April 2014, it lost 48 percent this August, and it "has told investors that they can redeem what remains of their money." The fund "used a strategy that tends to perform best when markets are volatile in one direction as opposed to the big up and down swings in stock prices seen in August," so I suppose it was the opposite of shorting both long and short leveraged ETFs. Oh well. "The implosion in Spruce Alpha is unlikely to make waves in the more than $3 trillion hedge fund industry."

Things happen.

Gary Cohn has "really grown a lot" as a potential Goldman Sachs CEO successor. Paul Taubman's merger boutique PJT Partners goes public today. Former Twitter CEO who is also current Twitter CEO will be named Twitter CEO. Doing business in Cuba would seem to raise interesting FCPA issues. Finra Says It Accidentally Gave Failing Grade to 208 Test-Takers. Softbank leads $1bn funding for student loan provider SoFi. McKinsey warns banks face wipeout in some financial services. Carmen Segarra Loses Her Appeal. Reference Guide to U.S. Repo and Securities Lending Markets. Recalibrate the TIA for Today’s Debt Markets. Mikhail Prokhorov Hijacks Nets Practice, Demonstrates Insane Dribbling Workouts. Burger King Releases "Flame-Grilled" Wine to Pair with Whopper Burgers. Goat 'arrested' at Tim Hortons was possibly kidnapped

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To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net