Plumbers, Options and Oil Traders

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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Financial plumbing.

The Securities and Exchange Commission's headline on its latest insider trading case is "Investment Banker and Plumber Charged With Insider Trading." Bloomberg's headline is "Barclays Director Accused of Trading Tips for New Bathroom." (The Justice Department's is "Investment Bank Director Charged In Manhattan Federal Court With Insider Trading," which is something of a letdown.) It is about as silly as it sounds. The Barclays director is Steven McClatchey, whose job at Barclays involved keeping track of the mergers and acquisitions pipeline for the "M&A Global Weekly Business Update." So he knew about all of the deals. And then one day, down at the dock, he met Gary Pusey:

McClatchey and Pusey met in 2011 or 2012 at the Yachtsmen’s Cove marina in Freeport, New York, where they had identical-model fishing boats that they kept in adjacent slips, according to the SEC. McClatchey and Pusey became close friends, spending most Saturdays at the marina or, in cold weather, playing pool and watching sports in McClatchey’s renovated garage. McClatchey frequently told the plumber to "keep an eye on" particular companies that would soon have good news, warning him not to tell anyone, not even family, about the tips, the government said.

The SEC complaint says that Pusey insider traded in 10 different companies, making total profits of $76,000, which just does not seem worth the risk of prison to me. In exchange, allegedly, "Pusey paid McClatchey cash by placing hundreds of dollars at a time in McClatchey’s gym bag, usually at the marina where they kept their boats, or sometimes handing the cash directly to McClatchey in McClatchey’s garage. In another instance, Pusey provided McClatchey with free services to remodel McClatchey’s bathroom." I suppose I'll leave it to the reader to decide whether a free bathroom remodel is worth the risk of prison. It is hard to get a good plumber.

We have talked before about the difficulties, after U.S. v. Newman, of prosecuting golf-buddy insider trading cases. The same applies to boat-buddy cases. If McClatchey and Pusey had just hung out on their boats, talking about boats, or fish, or bathrooms, or whatever, and if McClatchey had occasionally also described in great detail Barclays's M&A pipeline, and Pusey had traded on it, and he hadn't handed over gym bags full of cash or done any free plumbing, then I'm not sure there'd be a case here. (Obviously not legal advice! And prosecutors also charged them with wire fraud, perhaps on the theory that proving wire fraud doesn't require the "personal benefit" component of insider trading.) For all I know, marinas, like golf courses, are places for people to get together and swap stock tips in the open air, just out of the sheer joy of being out in nature with their moneyed friends. "I have a boat, you have a boat, here's some inside information." Without the kickback element, that might be legal, which is maybe a bit weird.

But once you put cash in a gym bag you are going to get charged with insider trading! Come on. If you are stuffing cash in a gym bag, or receiving a gym bag stuffed with cash, something has gone wrong in your life. And their lives were so good! They had boats. I don't really understand why people insider trade.

Elsewhere in insider trading, here's an infographic on the Southern District's big insider trading crackdown over the past few years. Also: "Visium Considers Sale Amid Investigation Into Alleged Insider Trading."

Elsewhere in enforcement.

Here's an SEC enforcement action against a firm that managed hedge funds and charged a 20 percent incentive fee on realized monthly profits. There were losses. How do you change losses into realized profits? According to the SEC, by trading options on S&P 500 E-Mini futures over month end:

These Scheme Trades often involved (1) selling call or put options on futures that would expire at the end of the current month (“first leg option”) and simultaneously (2) buying call or put options on futures for the same quantity at the same “strike price” that would expire early the next month (“second leg option”).

These options would typically be deep “in the money,” meaning they were very likely to be exercised or assigned.

The sale of the first leg options would result in significant proceeds (referred to as “premium”) being paid to the respective Fund, which was realized as a gain for the current month when the first leg option expired.

When the first leg is exercised, you have an unrealized loss, but a realized gain on the premium, so you can charge fees on that. The next month you get out of the position and your loss becomes realized, but you've already gotten your fees. Then at the end of the next month you do it again. This is obviously not allowed, and it's not really all that clever, but it is kind of cute.

Elsewhere here is an alleged Ponzi that "purported to specialize in serving middle-class investors and securing exorbitant returns by investing in hot pre-IPO stocks." Oh and the Trump University sales pitches are out!

"Objection: I don't like using my credit cards and going into debt OR I just paid my credit cards off," the playbook explains in one hypothetical scenario.

The playbook then directs the Trump University rep to respond with the following script:

"I see, do you like living paycheck to paycheck? Do you like just getting by in life? Do you enjoy seeing everyone else but yourself in their dream house and driving their cars with huge checking accounts? Those people saw an opportunity, and didn't make excuses, like what you're doing now. Most wealthy people made their money in real estate and it usually started with a decision to get the knowledge and skills to be successful. You need to look at what this small investment will fix in your life. … You're here today because you're sick and tired of being sick and tired and you want to chance that — you're not alone. I'm going to help you take your first step to create the life you've dreamed of. Follow me and let's get you enrolled. Congratulations!"

Hey that's super. ("I believe that Trump University was a fraudulent scheme," wrote one former sales manager.) Donald Trump has objected, in terrifying terms, to the unsealing of these documents, but New York Attorney General Eric Schneiderman has a pretty good response: "You are not allowed to protect the trade secrets of a three card Monte game."

Vitol has fun.

Here is a Bloomberg Markets profile of Vitol Group, the energy-trading firm. Vitol is a private company, which is perhaps why Chief Executive Officer Ian Taylor is not quite as on-script as a typical public company CEO:

Trading margins keep shrinking as the minute-by-minute movements of the global oil industry are disseminated on the internet. Possession of market information that others don’t have—once Vitol’s edge—is fast disappearing. So what will Vitol do?

As quick-witted as he usually is, Taylor struggles a bit to answer the question over his breakfast at St. Pancras. “You will be surprised,” he finally says. “I don’t know the answer.”

After mulling things over, he says Vitol will benefit from “natural market growth.”

I feel like, for all the talk about public markets' short-termism, they do like to hear that their managers have long-term plans. But actually the rest of the article kind of undermines this concern. My takeaway here was: Oil trading is a tough business! The opening anecdote is about Taylor flying into Benghazi in 2011 to strike a deal to fuel the Libyan rebels. Vitol is not just in the business of sitting at computers and moving electronic assets around; it actually owns ships and terminals and refineries and other messy stuff, and uses them to actually move oil to and from difficult places. (Also yes sure there are bribes here and there, or as they're apparently called, "surcharges.") Technology is really good at equalizing access to information and reducing the costs, and margins, of trading abstract entitlements like stocks and bonds and money. But trading businesses that involve doing hard complicated dangerous physical work will be harder to replace with algorithms.

How does e-mail even work.

I guess I qualify as a skeptic of the idea that innovations in, like, cryptography will allow new technology players to come in and supersede the legacy banks entirely. Banking is a complicated business with lots of regulatory and operational requirements; you can't just mumble the word "blockchain" and replace the banks. On the other hand, I mean, this is embarrassing:

After an email went out with 90,000 recipients on Friday, some Wells Fargo employees began hitting “reply-all,” according to an internal report obtained by the Observer. “This has caused the email server queues to back up,” the report said.

The bank’s servers had a backlog of 4 million email messages to process at one point, according to another internal document.

I feel like you need to either hire and train employees who won't constantly reply "take me off this list" to a list of 90,000 people, or have an e-mail system that can handle it if they do, or ideally both. Maybe get a blockchain up in there.

Elsewhere in e-mail faux pas:

Five research analysts who lost their jobs in Nomura’s April restructuring now face losing some of their severance packages for allegedly breaching the bank’s email policies.The Japanese giant, which shut its European equities research division as part of a wider restructuring last month, believes three of the analysts forwarded materials to their personal accounts immediately before they were let go, while two others sent materials right after they were put on notice, reports Laura Noonan in London.

I sympathize with this temptation way more than I do with the insider trading one. You worked so hard on that model! Now your loser replacement will take it over, and if you do get a new research job you will have to start all over again on the model. It is a grim prospect. Still, rebuilding your model from scratch seems like it would be way more fun than being sued by your former employer for taking stuff on your way out the door. And, you know, they check.

The euthanasia of the rentiers.

When interest rates are high, you can invest all your money in bonds and get a high return. When interest rates are low, you can invest all your money in bonds and get a low return. That is just what an interest rate is. But people who invest in bonds like getting high returns, and don't like getting low returns, so here is a lot of complaining from them about the fact that interest rates are low.

“Not nearly enough attention has been paid to the toll these low rates—and now negative rates—are taking on the ability of investors to save and plan for the future,” BlackRock Inc. Chief Executive Officer Laurence Fink said in a recent letter to shareholders.

And:

“We know the Federal Reserve is trying to trick us—we’re dealing with distortions,” said Mr. Villa, referring to how low rates have historically encouraged investors to take on more risk. “They want us to invest in building new things, but what [investors are] doing is trading existing assets at higher and higher prices.”

I am not sure they have anything especially new to say, but the bond investors need an opportunity to vent every now and then.

People are worried about non-GAAP accounting.

Apparently the SEC is worried, and "is forming an internal task force to closely review the use of 'non-GAAP' numbers," with a focus "on companies that use non-GAAP metrics to tell a misleading story, that give too much prominence to non-GAAP numbers, or promote non-GAAP metrics that exclude relevant, recurring costs." 

People are worried about unicorns.

Uber, the Ubercorn, is a special sort of unicorn, not only in that it is the biggest unicorn but also in that it is an ... evil unicorn? I mean, I like Uber fine, but the whole Ayn-Rand-and-surge-pricing thing seems almost intended to give off an evil vibe. "Aside from companies like Uber," a startup public relations guy asked Nellie Bowles, "what companies in our world are doing bad things?" If it is not actually evil, it is at least the bad-boy punk unicorn, with a pierced horn and a mohawked mane.

Anyway it's now leasing cars to its drivers at terms that some people think are predatory. They sound pretty rough to me -- $155 per week for a Toyota Corolla -- though they include maintenance and, you know, Uber is taking some credit risk. The money is deducted directly from your Uber earnings. 

This is a company that argues that its drivers are not employees and so are not entitled to employee benefits like health insurance or overtime or mileage pay. They are just independent contractors; Uber is just an app that connects them with potential customers and takes a cut of their pay. But also Uber owns (some of) their cars, and deducts payments for them directly from their earnings.

A lot of what is going on in financial technology these days involves rethinking basic assumptions about what it means to, for instance, own a company. There's nothing magic about the word "shareholder" that automatically implies, say, an equal vote in the company's affairs. Now you can tease out all the relationships that shareholders have with their companies, pick the ones you like, discard the ones you don't, and write contracts that define exactly the relationships you want and no others. Or so a lot of people think. The concern, sometimes, is that the traditional relationships that entrepreneurs want to discard tend to be the ones that protect shareholders, the voting rights and fiduciary duties and liquid markets. Maybe this is fine. The market is efficient, and shareholders can price these protections and decide whether to give them up. 

Similarly there's nothing inherently magical about the word "employee." You can tease out all the relationships that workers have with their companies, pick the ones you like, discard the ones you don't, and write contracts that define exactly the relationships you want and no others. Or so Uber thinks. The concern, sometimes, is that the traditional relationships that Uber wants to discard tend to be the ones that protect workers, all the magic that the law has, over time, incorporated into the word "employee." Maybe this is also fine, though I have less confidence that Uber's drivers can price those protections and decide whether it's worth it to give them up.

Elsewhere in unicorns, and innovations, and worrying:

Last year, Elizabeth Holmes topped the FORBES list of America’s Richest Self-Made Women with a net worth of $4.5 billion. Today, FORBES is lowering our estimate of her net worth to nothing. Theranos had no comment.

How much would you pay for a share of Theranos stock right now? If you told me that there's a very high likelihood that Theranos ends up being worth nothing, I would have a hard time disagreeing. But is it really 100 percent? Or is the problem that the distribution of Holmes's possible Theranos outcomes is not floored at zero? 

People are worried about bond market liquidity.

Here's a bond market liquidity paper:

We use a comprehensive sample of U.S. corporate bond trades from 2003 to 2014 that includes dealer identifiers to assess liquidity and dealers’ capital commitment. We find that customer trade execution costs have decreased over time, despite a temporary increase during the financial crisis. However, several alternative measures of market quality, including turnover, dealers’ capital commitment, the likelihood that trades are completed on a principal basis, interdealer trading, and dealers’ propensity to hold positions overnight were not only degraded during the financial crisis but failed to return to pre-crisis levels in more recent years. Difference-in-difference analyses of TRACE initiations in 2003-04 and 2014 provide no evidence that public transaction reporting contributed, which leaves regulatory initiatives implemented in the wake of the financial crisis as potential explanations for the changes in bond market liquidity. On balance, the evidence indicates that the role of corporate bond dealers has changed in recent years, as dealers are less inclined to trade on a principal basis, and more inclined to prearrange a customer trades in a search-and-match brokerage role.

The problem with bond market liquidity statistics is that, overgeneralizing somewhat, you only see trade execution costs for the trades that execute. If an investor comes to a dealer and asks to sell bonds, and the dealer buys them onto its balance sheet and then tries to sell them when it gets a chance, it will charge the investor a fairly wide bid-ask spread for providing that risky, balance-sheet-intensive service. If an investor comes to a dealer and asks to sell bonds, and the dealer says "give me a few days to find a buyer," and eventually does, and matches the buyer and seller, it will charge the investors a relatively narrow bid-ask spread for providing that riskless, agency-only service. And the deal will print when it prints -- in fact the dealer's buy and sell will print at nearly the same time -- so the reported statistics will show a narrow bid-ask spread and no obvious fall-off in liquidity. But a dealer who stands ready to buy and sell bonds for its own balance sheet really is providing a different, and more valuable, service from a dealer who is just trying to risklessly match up buyers and sellers.

So who is taking up the slack?

Global fixed-income ETFs, which track bond indexes and trade like stocks, attracted $60 billion of inflows this year through May 25, according to data compiled by BlackRock Inc. That’s the most for the period since the funds were created 14 years ago and on pace to top last year’s record total of $93.5 billion.

The funds are emerging as one of the few winners from worsening trading conditions as dealers pull back from making markets and investors seek cheaper ways to take and hedge credit exposure.

"Bond ETFs have become like whales in the market," says one money manager.

Things happen.

"At one of his first meetings with financial CEOs, in March 2009, Mr. Tarullo said the administration was planning to allow their banks to continue to exist." Icahn Takes ‘Large Position’ in Allergan. Valeant’s Former C.E.O. to Receive $9 Million Severance. Goldman's Cohn defends bank's trading business amid revenue slump. Saudi Arabia lines up banks for $15bn bond sale. Saudis Said to Seek Restoration of OPEC Unity After Doha Failure. The Struggles of Today’s Sumner Redstone. Swiss Investigate Apparent Suicide of Ex-Chief of Zurich Insurance. Obama Retirement-Savings Rule Faces Industry-Led Court Battle. SoftBank cuts Alibaba stake to raise cash. Anbang drops FGL buyout approval from New York regulator. Online Shareholders’ Meetings Lower Costs, but Also Interaction. Analysts Skeptical MSCI Index Will Include China A-Shares. "The younger workers are often off task, engaged on social media, on the internet, texting on phones and other unproductive activities." Financial Weapons of War. "Respondents who have competed in varsity athletics are more likely to work in finance (26 percent to 16 percent), while those who have not are more likely to work in consulting (22 percent to 15 percent)." Jose Canseco Whiffed on His Gold Prediction. Emoji bible. "They’re like the Peyton Mannings or Brett Favres of canines."

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

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

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net