Research Conflicts and Speed Bumps

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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Here are two models of sell-side equity research.

Model 1

  • Sell-side analysts are in the business of finding out what stocks will go up and then telling you.
  • They tell you to Buy stocks that will go up, Hold stocks that will stay flat (why?), and Sell stocks that go down.
  • You believe them, and do that.
  • Sometimes they lie to you, but it is always a shock when they do.

Model 2

  • Sell-side analysts are in the business of helping institutional investors get access to corporate management teams.
  • They flatter management teams by giving most companies good ratings, to maintain access.
  • They help their clients, because investors who meet with management tend to outperform investors who don't.
  • The clients aren't too worried about the Buy/Sell/Hold stuff.

I more or less believe Model 2, though I recognize that it is imperfect and incomplete. But there is plenty of empirical evidence for it.

Model 1, however, strikes me as obviously, a priori silly. For one thing: Why would a sell-side analyst be particularly well suited or well incentivized to know what stocks would go up? If she knew that, wouldn't she just, you know, buy those stocks, instead of writing research reports? Why would it make sense for professional investors to outsource their stock-picking functions to people who don't even own the stocks? Isn't stock-picking the investors' job? But also, there's that empirical evidence: If you actually look at what sell-side analysts do, and what institutional clients ask of them, it seems to me that the management/client meetings are fairly important and the headline Buy/Sell/Hold ratings are not.

There do seem to be three classes of people who believe Model 1:

  1. Retail investors? I mean, sure, why not. They are not going to the management meetings.
  2. The Securities and Exchange Commission, whose research enforcement actions focus on dishonest Buy/Sell/Hold recommendations, possibly because it is essentially in the business of protecting retail investors (why?).
  3. The news media, which has a reliable subject for anger when Buy/Sell/Hold recommendations are wrong or conflicted or silly.

Anyway, here is a story about how "only about 5 percent of the ratings on 1,778 U.S. companies worth at least $1 billion are 'sells' or the equivalent":

Upbeat guidance can mean golf and soirees with company executives, hosting them at investor conferences and being picked first to ask a question on quarterly conference calls.

“To have good relationship with management, the least offensive thing you can say is ‘hold,’ but really ‘hold’ means ‘sell,’” Serafeim said.

If you believe Model 2, that all makes sense. If you believe Model 1 you will, of course, be outraged.

Or there is the story of the Longbow Research analyst who covers mattress company Tempur Sealy International, and who still has stock and other incentive-based compensation from Tempur Sealy because he used to run investor relations there. (Miriam Gottfried's glorious headline: "Is This Analyst In Bed With Tempur Sealy?") Gretchen Morgenson:

Still, it’s hard to imagine that Mr. Rupe’s stake in Tempur Sealy and his close relationship with the company won’t color his view. The question is, why would Longbow, a firm that appears to pride itself on independent research, want to open itself up to this kind of criticism?

If you want an inside line into the company -- Model 2 -- then the company's former head of IR seems like a good person to talk to. If you want an unbiased recommendation from a neutral source -- Model 1 -- then you will, of course, be outraged. But if you believe Model 1 -- or if your own business model requires you to profess belief in Model 1 -- then you will constantly be outraged, because Model 1 never fits the facts.

Market structure.

The bad news for IEX, which wants to become a public stock exchange as the Investors' Exchange, is that the Securities and Exchange Commission's decision on its application has been delayed again. The good news is that the delay came with a long interpretive letter that basically makes it sound like the SEC is on board with IEX's plans. The main controversy in IEX's application has been about the 350-microsecond "speed bump" that delays order information going to and from IEX. The speed bump seems not to fit with previous SEC guidance requiring exchanges to execute orders immediately, but IEX has argued -- convincingly, I think -- that its speed bump doesn't slow down orders any more than many other exchanges do. The SEC seems to agree. From Friday's "Notice of Proposed Commission Interpretation Regarding Automated Quotations Under Regulation NMS":

Specifically, the Commission preliminarily believes that, in the current market, delays of less than a millisecond in quotation response times may be at a de minimis level that would not impair a market participant’s ability to access a quote, consistent with the goals of Rule 611 and because such delays are within the geographic and technological latencies experienced by market participants today. For example, IEX’s proposed POP/coil would introduce a 350 microsecond delay for a non-routable IOC order before it could access the IEX matching engine. The additional delay introduced by the coil itself, which is approximately 38 miles long, is effectively equivalent to the communications latency between venues that are 38 miles apart. The Commission understands that today the distances between exchange data centers, or between the order entry systems of market participants and exchange data centers, may exceed, sometimes by many multiples, a distance of 38 miles. The Commission does not believe that these naturally-occurring response time latencies resulting from geography are inconsistent with the purposes of Rule 611. At the same time, permitting the quotations of trading centers with very small response time delays, such as those proposed by IEX, to be treated as automated quotations, and thereby benefit from trade-through protection under Rule 611, could encourage innovative ways to address market structure issues.

Of course that interpretation is now open for public comment, and lots of people disagree. More people are worried that IEX lets certain orders skip the "speed bump," thus advantaging those orders, and that approving IEX's application will lead to further market-structure complexity. Remco Lenterman says: "It means that it will be impossible to deny exchange applications with asymmetric speedbumps under 1ms. It will become very messy." And remember that Nasdaq is already working on its own speed bump. In any case, "the decision also commits the SEC to a hard deadline—June 18—to rule on IEX’s application," and it sure suggests that the ruling will be positive. Here is Rajiv Sethi with the bull case for IEX's potential effect:

A transition to a truly national market system will affect the competitive balance between information traders and high-frequency traders. It is in the interests of the former to prevent information leakage so that they can build large positions with limited immediate price impact. It is in the interest of the latter to extract this information from market data and trade on it before it has been fully incorporated into prices. Other things equal, the ability to extract information from a partially filled order and trade ahead of it at other exchanges benefits high-frequency traders at the expense of information traders. A truly national market system would mitigate this advantage.


The shift in competitive balance between these trading strategies would have broader economic implications. The returns to investment in fundamental information would rise relative to the returns to investment in speed, which should result in greater share price accuracy. Furthermore, there is a real possibility that the aggregate costs of financial intermediation would decline, as expenditures on co-location, rapid data processing and transmission, equipment, energy, and programming talent are scaled back.

Elsewhere in market-structure-ish news, "data company IHS Inc. agreed to acquire Markit Ltd. in a deal that values the combined firms at more than $13 billion, another sign of consolidation in the financial-infrastructure industry."


We talked the other day about the eerie coincidence that Point72 bought 8.3 percent of a small drug company called Celator Pharmaceuticals by "the close of business on March 14, 2016," which is also when Celator -- at 4:01 p.m. -- announced positive results in the Phase 3 trial of a leukemia drug. The stock closed at $1.68 on the 14th, and at $8.94 the next day. It turns out the coincidence wasn't as eerie as it looked: A Point72 spokesman informed me that all of the buying occurred after the announcement on the 14th. (That is: between 4:01 p.m. and the "close of business.") So, yes, Point72 knew about the successful drug trial result before buying -- but everyone knew, because it was public before Point72 started buying. The average price in after-hours trading on the 14th was about $7.97. "There was no magic or intrigue here," notes the Point72 spokesman. Oh well.

Poker finance.

Jean Tirole says that "the essence of corporate finance is that investors cannot appropriate the full benefit attached to the investments they enable," but what should we make of this delightful Planet Money story about poker players who buy and swap stakes in each other? Apparently it is common for professionals at big poker tournaments to swap small stakes in themselves: I promise you 5 percent of my winnings, and in exchange you promise me 5 percent of your winnings. This makes perfect sense from a finance perspective (hedging, diversification, etc.), though it raises some obvious conflicts of interest (you couldn't do it in baseball!), and would make those index-funds-are-an-antitrust-violation people furious.

Weirder, though, is the fact that some players -- including the guy who finished third at the World Series of Poker Main Event in 2012 -- sell stakes in themselves for cash, and that the going rate seems to be an X percent equity stake for X percent of the buy-in fee. So the WSOP Main Event costs $10,000 to enter, and if I stake you $1,000 of your entrance fee, I get 10 percent of your winnings. Doesn't that seem ... wrong? On the one hand, the expected value of a WSOP entry, especially for a player who can't pay his own fee, is probably below $10,000, so the investors are probably overpaying. On the other hand, isn't it weird to implicitly allocate 100 percent of the value of the entry to capital, and zero percent to labor? I mean, the player himself puts up at least some of the entry fee, but if he puts up 20 percent he gets paid the same as any other 20 percent investor, even though he has to do all the work, and any profits turn on his own skill and luck. I suppose your model could be that his labor (and skill) compensation is non-pecuniary: He gets to play poker and, if he does well, be on television and get famous and stuff. (The investors get only a Planet Money episode years later.) The incentives are pretty well aligned. Still it seems like a strange financing market.

Trump and Deutsche Bank.

In 2005, Donald Trump borrowed $640 million from Deutsche Bank and other banks to build a building in Chicago. In 2008, he didn't want to pay it back:

In 2008, Mr. Trump failed to pay $334 million he owed on the Chicago loan because of lackluster sales of the building’s units. He then sued Deutsche Bank. His argument was that the economic crisis constituted a “force majeure”—an unforeseen event such as war or natural disaster—that should excuse the repayment until conditions improved.

Fine, okay. That is not a good argument -- the court rejected it, and he eventually had to pay -- but it is, like, recognizably an argument. It is a thing you might say if you didn't want to pay back a loan. But then there is this:

Mr. Trump also attacked Deutsche Bank’s lending practices and said that as a big bank, it was partially responsible for causing the financial crisis. He sought $3 billion in damages.

He sued Deutsche Bank for $3 billion for lending him $640 million! Come on. That is pure, classical chutzpah, "that quality enshrined in a man who, having killed his mother and father, throws himself on the mercy of the court because he is an orphan."

People are worried about unicorns.

"Don’t mourn the unicorn," says Gideon Lichfield; "there are more interesting animals in Silicon Valley." Hippogriffs? Manticores? Krakens? Beholders? Shambling Mounds? Dragon Turtles? I think he just means, like, Google though.

People are worried about stock buybacks.

I assume that, deep down, the proposed bill to ban hedge-fund "wolf packs" is driven by worries about stock buybacks. Or just worries about the name "wolf packs"? (They should call themselves Shambling Mound Packs.) "We cannot allow our economy to be hijacked by a small group of investors who seek only to enrich themselves at the expense of workers, taxpayers and communities," says Senator Tammy Baldwin, one of its sponsors. I have never fully understood the analytical basis for trying to ban shareholder activism, and I certainly don't understand the efforts to do it by tweaking the Schedule 13D disclosure requirements and "group" definition, but there you go.

People are worried about bond market liquidity.

The best thing about bond-market liquidity worrying is that it is unfalsifiable: Any fact, or its opposite, can be taken as proof that bond market liquidity is in trouble. Dealer inventories of bonds are down? That means dealers can't provide liquidity. Dealer inventories of bonds are up? That means that markets can't provide liquidity:

Strategists say there are signs that the buildup of Treasuries held by dealers is having a ripple effect, mucking up the plumbing of the financial system. While the holdings show they did their job by soaking up the supply from central banks raising cash to support their currencies, it’s adding to questions about the resilience of the world’s most important market. The Treasury Department is already looking into whether the market isn’t operating as smoothly as it should.

“This was a lot of dealers doing what they are supposed to do -- provide liquidity,” said Scott Buchta, head of fixed-income strategy at Brean Capital LLC in New York. “But the liquidity providers right now are getting the short end of the stick. It’s harder for dealers to offload these securities because the market depth just isn’t there.”

Whatever happens, you have to worry about liquidity. Elsewhere:

We present evidence on the evolution of liquidity in the UK corporate bond market for the period 2008–2014. On the basis of a series of widely accepted liquidity measures, we document that there is no evidence that liquidity outcomes have deteriorated in the market, despite the decline in inventory of dealers in this period. If anything, the market appears to have become more liquid in recent years.

Congrats to Mark Spitznagel's goats!

In June 2014 I wrote:

Mark Spitznagel, who runs black-swan-protection hedge fund Universa with the advice of Nassim Taleb, is going to let loose a bunch of adorable baby goats (there are pictures) to graze in Detroit, where they will provide jobs for unemployed residents and keep the vacant lots from becoming too unkempt. Then, at the end of the summer, he's going to kill them. This will teach the goats about black-swan risk.

That ended up not working out, but Spitznagel still has a bunch of goats on "200 acres of rolling, chemical-free pastures in northern Michigan," and he makes cheese, and the cheese just won some awards at the 2016 World Championship Cheese Contest:

"We are honored to receive this recognition by some of the world's leading experts in the cheese industry," said Mark Spitznagel, who along with his wife Amy owns the farm which they founded in 2010. Mark is also the founder and Chief Investment Officer of the hedge fund management firm Universa Investments, based in Miami. "At Idyll Farms we can coordinate and manage all of the symbiotically moving parts in our production process, from pastures to goats to creamery, and this is precisely how we make some of the best cheese in the world."

As I've also said before, the best black-swan hedge is isolated farmland. And, sure, goats.

Things happen.

Sherwin-Williams to Buy Valspar for $9.3 Billion. Hedge Fund Priest's Trades Probed by Wall Street Cop. Leveraged buyout financing is drying up. Coal financing is drying up. Valeant’s Focus Shifts to Talks With DebtholdersJamie Dimon successfully bought the dip. Banks urged to beef up bonus clawbacks. Low rates have been tough on life insurers. The Fed Keeps Talking, and Bond Traders Just Get More Confused. How the herd mentality hurts hedge funds. Housing inventory is tight. At J.P. Morgan, $9 Million in Assets Isn’t Rich Enough. Taste for Bacon Spurs Investor Feast as U.S. Hog Prices Advance. Bitcoin is still a mess. Happy birthday Twitter! Instagram Pope. Monkey selfie appeal. Easter bunny brawl. The 2016 Name of the Year Bracket. Boaty McBoatface.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Matt Levine at

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