Successful Algorithms and Rude CFOs

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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Virtu.

Here's a fun profile of Virtu, the high-frequency-trading firm that never loses money, except that one time, but that was an accident:

The consistency with which Virtu earns a profit is almost beyond belief. From 2009 to 2014, it lost money on only one day. (The aberration happened when it missed a special dividend payment for a stock, throwing off its model and causing a seven-figure loss.)

You can have two basic theories for how an electronic trading firm could make money every single day:

  1. It has brilliant complicated algorithms that are mysterious and maybe a little evil, or
  2. It has boring simple algorithms and makes up for it in volume.

Virtu seems like the second kind. "What the company wants to do over and over is to sell to buyers and buy from sellers, not take positions of its own, and either hedge its risks at the end of the day or go home with no risk at all." Market-making is a conceptually simple business. The way market-making works is, you buy at the bid, and you sell at the offer, over and over and over again, and the offer is higher than the bid. Market-making is a service -- selling immediacy to customers -- and the customers pay you for the service in the form of the bid-ask spread. In the long run, you're supposed to make money. It's just that if you trade millions of times a day, a day is the long run. Here's Virtu's chief executive officer, Doug Cifu:

Cifu, 51, points to probability theory and the millions of times Virtu trades every day to explain its winning ways. The law of large numbers dictates that the company, seeking only to earn the spread on each transaction and not bet on the direction of markets, will make money close to 50 percent of the time.

Not everyone sees it that way, which hurts Virtu's feelings, though of course not the feelings of its algorithms:

Virtu is built to benefit from more electronic trading, Cifu says. The company doesn’t make money from inefficient markets, he clarifies—just the opposite. “The secret of Virtu is the scale and the efficiency we brought to the market,” he says. “The biggest misconception of this firm is we’re some nefarious quantitative firm with a secret algorithm.” Viola says being cast as a villain was “the most bizarre period of my life.”

Elsewhere: "The New Wall Street: Even Big Banks Want Help Navigating Markets." Like JPMorgan, which is getting help from Virtu in Treasury trading. I think of that as less of a "navigating markets" issue, and more of an "it's hard to disrupt yourself" issue. Like, if you are a bank full of traders, you're probably not going to build the computer that puts all those traders out of work. But someone will. 

Research.

Ahahahahaha:

An earnings briefing in Hong Kong turned heated when the chief financial officer refused to continue with his presentation until an analyst from Macquarie Group Ltd. left the room.

In a video obtained by Bloomberg News, PAX Global Technology Ltd. CFO Chris Lee can be seen standing over a seated Timothy Lam and ordering him to leave the conference room on Wednesday. Lam initiated coverage on PAX Global’s stock in April with an underweight rating, making him the only analyst out of 17 tracked by Bloomberg to have a bearish recommendation at the time.

This is the dumb cartoon version of a subtle issue that we talk about a lot around here, which is that research analysts have incentives to shade their recommendations toward "Buy," not because those favorable recommendations will help their banks win banking business or whatever, but because the favorable recommendations will help the analysts maintain access to management, and access to management is a key service that the analysts provide. Like, this poor guy didn't even get to hear the earnings briefing because of his sell recommendation. He certainly isn't going to get a cordial welcome at PAX headquarters if he wants to bring a hedge-fund client by to meet with management. Management won't give him helpful hints about where next quarter's earnings are likely to come in. He is cast out into the darkness, wandering in the wilderness far from the warm light of management's favor. It's not a good place to be, if your job is to provide insight about a company.

In the U.S., people have mostly internalized the notion, popularized by the 13-year-old Global Analyst Research Settlement, that analysts are supposed to believe their recommendations, so you don't see too many CFOs physically throwing analysts out of meetings. (It's unusual in Hong Kong too: "On Thursday, Lee said he regretted his behavior, which was a 'one-off' that didn’t reflect the management’s position and he welcomes 'diverse points of view.'") But the quieter versions -- a little less access, a little less help, an unwillingness to take one-on-one meetings -- are probably more important, and hard to do much about. 

Anyway the best part of the story is that Nomura cut its rating on PAX because of it:

Nomura Holdings Inc. cut its rating on Hong Kong-based PAX Global, which makes point-of-sale payment systems, in a report that was titled "CFO conduct disrupts shareholder value." Shares in the company dropped 2.1 percent at the close, their biggest loss in a month, after rallying 5.6 percent the previous day.

"Before the analysts briefing meeting started, the company’s CFO asked a sell-side analyst to leave the conference room," Nomura analysts led by Leping Huang wrote in the note. "While we do not judge this dispute, we think this may hurt PAX Global’s shareholder value."

Bold! Nomura saw the consequences of standing up to PAX management, and did it anyway. Of course this is a repeated game, and if analysts don't want to be abused by managements, they have to stick together. 

Valeant.

You can't be that surprised that "Federal prosecutors are investigating whether Valeant Pharmaceuticals International Inc. defrauded insurers by shrouding its ties to a mail-order pharmacy that boosted sales of its drugs," right? Two useful rules of thumb here are:

  1. Any high-profile scandal will attract an investigation by federal prosecutors, and
  2. Everything is wire fraud.

The potential wire fraud in this case relates to Philidor Rx Services LLC, a pharmacy that had a ... complicated ... relationship with Valeant, and one that Valeant did not perhaps take pains to make perfectly clear:

Prosecutors are investigating whether Philidor, now defunct, made false statements to insurers about its ties to Valeant, that person said. Philidor helped patients get insurance coverage for higher-priced Valeant drugs, for example for toenail fungus or acne treatment, instead of cheaper alternatives. At issue is whether insurers thought Philidor was neutral rather than in the service of Valeant, the person said.

I said recently that "drug companies, like, do research to find new drugs, but mostly I think of them as laboratories for principal-agent problems," but of course Valeant's famous innovation involved not doing much research to find new drugs, so it could concentrate on the principal-agent problems. The central principal-agent problem is that patients take the drugs, and insurance companies pay for the drugs, but doctors and pharmacists are the ones choosing the drugs. They don't exactly have a ton of skin in the game. And so there is a complex dance of insurance companies trying not to pay for expensive drugs recommended by pharmacies affiliated with the manufacturer, and the pharmacies trying to slip one by them. From a previous story about Philidor:

Employees were to first submit paperwork with Philidor’s national provider identifier, or NPI, and if that didn’t work were to then try with the NPIs of partner pharmacies, according to a Philidor training manual.  “We have a couple of different ‘back door’ approaches to receive payment from the insurance company,” said the manual, dated October 2014.

This isn't legal advice or anything, but when prosecutors are leafing through your employee manual, if they find the phrase "'back door' approaches to receive payment," they're gonna highlight that, and put a little Post-it flag on the page, and high-five each other. That's the good stuff, for prosecutors.

Whistle-blowers.

Here's a weird little Securities and Exchange Commission case against BlueLinx Holdings, a building-products company that made employees sign confidentiality agreements when they were leaving the company and getting severance pay. Some of the agreements said this:

Employee further acknowledges and agrees that nothing in this Agreement prevents Employee from filing a charge with…the Equal Employment Opportunity Commission, the National Labor Relations Board, the Occupational Safety and Health Administration, the Securities and Exchange Commission or any other administrative agency if applicable law requires that Employee be permitted to do so; however, Employee understands and agrees that Employee is waiving the right to any monetary recovery in connection with any such complaint or charge that Employee may file with an administrative agency. 

That is: If you go to the SEC to blow the whistle on BlueLinx, and the SEC sues and gets a big penalty and gives you a whistle-blower reward, you can't take it. (You have to give it to BlueLinx, I guess? Or just turn it down?)

That's cheating! SEC Rule 21F-17 says it's illegal "to impede an individual from communicating directly with the Commission staff about a possible securities law violation," and obviously the reason for the SEC's whistle-blower program is to give people an incentive to blow the whistle on their employers. If they can't keep the money, the incentive goes away. You can see why the SEC dislikes it, though I can't quite see how it violates the letter of the rule. I mean, if you signed that agreement, you can talk to the SEC to your heart's content. You just can't get any money for it. But the rule doesn't mention the money.

Anyway BlueLinx settled for $265,000. There's no allegation that it violated any other securities law, or that any potential whistle-blowers were actually deterred, though I wonder a little if someone blew the whistle on these confi agreements and will get a few thousand bucks for his troubles.

Bridgewater.

Speaking of severance arrangements, the guy who sued Bridgewater for sexual harassment has settled. He has taken a new job at KKR & Co. and "is dropping any claims he has against Bridgewater, and the hedge fund agreed to waive his employment restrictions, allowing him to move to his new job." That's the whole settlement: He's leaving, they're letting him leave, and he's dropping his case. A "spokesman for Bridgewater added that Mr. Tarui 'did not receive any payment of compensation in connection with his decision to withdraw his claims.'"

When we last talked about Christopher Tarui's claims against Bridgewater, I pointed to some aspects of Bridgewater's culture that might make reporting sexual harassment awkward. Like for instance Bridgewater's policy of recording meetings and making them available for employees to listen to, or its Principle No. 11:

Never say anything about a person you wouldn't say to him directly. If you do, you are a slimy weasel.

It doesn't seem like that would foster confidential resolution of sensitive issues, though Bridgewater notes that it has "an Employee Relations team charged with being a closed, confidential outlet outside of the management chain for handling issues of a personal nature." But then there are the non-competes! Imagine being sexually harassed at work and being unable to quit, because you've signed a non-compete that won't let you take another job in finance. It doesn't give you much choice but to fight the issue out directly, by going to employee relations or by suing to, in effect, get the non-compete lifted. I guess forcing open confrontation is kind of Bridgewater's thing.

Cavalier.

Look, I am aware that former Philadelphia Eagles player Merrill Robertson Jr. also formerly played football at the University of Virginia, and that UVA's teams are called the "Cavaliers," and that he probably named his investment fund after them. Still, "Cavalier Union Investments LLC" is not a great name for an investment fund. It suggests that you will be cavalier with your investors' money. Which, according to the SEC, they were:

The SEC’s complaint, filed in federal court in Richmond, Virginia, charges Robertson, Sherman C. Vaughn Jr., and the company they co-owned, Cavalier Union Investments LLC.  According to the complaint, the defendants promised to invest in diversified holdings but diverted nearly $6 million of the more than $10 million they raised from investors to pay for personal expenses and used other funds to repay earlier investors.

Et cetera.

People are worried about unicorns.

My basic model for the biggest private tech companies is that they have most of the attributes and advantages of being big public companies, but with a little more room for customization. For instance, they pay employees in stock, and those employees can sell that stock for money, but the companies have more control of those sales than public companies do:

Private companies such as Pinterest and SpaceX are increasingly arriving at the same solution: They are giving employees some controlled opportunities to sell their start-up shares — but in return, workers now must agree to more explicit restrictions on what they can and cannot do with their remaining stock.

"These deals will hopefully help employees get liquidity while giving companies some control over the Wild West market that has developed for employee shares," says a guy, though I don't quite know why free selling of employee shares is the "Wild West." I mean it works fine for Google and Apple and Microsoft and Facebook.

Elsewhere, here is Benedict Evans on the venture capital payoff structure -- a portfolio approach with lots of failures and a few big hits -- and the associated mentality:

This is an interesting intellectual challenge for a VC or, more importantly, an entrepreneur: you need to ask not whether this idea will fail, let alone whether it could fail, but rather, ‘what would it be if it worked?’ You need, in a sense, to ‘suspend disbelief’ - to put aside your normal human risk-aversion and skepticism, accept the probability that it could go to zero, and ask if this could 'put a dent in the world', and if so, how big. 

I guess this is an obvious point, but one reason for Silicon Valley's particular futurism and grandiosity is just the payoff structure of its financial instruments. If your model for investing is finding a bunch of companies that will grow at 10 percent a year, you will end up with a certain plodding realism. If your model for investing is finding 95 dumb ideas that fail and five ideas that change the world, without knowing in advance which are which, then you will end up with an excessive confidence in your ability to change the world, as well as a soft spot for dumb ideas. Silicon Valley's psychology is a superstructure built on the foundations of its preferred investment vehicle.

Elsewhere: "Founder of Google’s venture capital arm stepping down." "VC Funding Is Drying Up for Media Startups." "Why It’s Not Enough Just to Be Disruptive." And "The Typical Home in San Jose Now Costs More Than $1 Million," making it cripplingly expensive to live in the Enchanted Forest. Maybe you could move to Narnia? Wait, no: "WeWork's 'Millennial Office Worker Narnia' Communal Living Concept Is Struggling." 

People are worried about bond market liquidity.

Here's Alexandra Scaggs on government-bond auctions in the U.S. and the U.K., which people are worried about, though in somewhat arcane ways relating to how much information leakage is optimal. It's liquidity-ish. And here is Scaggs on the Bank of England's failed effort to buy gilts for quantitative easing, and the time "that the BoE got its face ripped off (in New York trader parlance) during its first and second rounds of QE in 2009 and 2011-2012." 

Sorry!

The e-mail version of Money Stuff went out late yesterday because I ... forgot to push a button? Sorry about that; we'll try not to let it happen again.

Also, while I am apologizing for yesterday's Money Stuff, I should say that I regret the phrasing, "Improving the efficient frontier of the 60/40 portfolio is a rather lower bar than providing alpha, but there you go." Improving the efficient frontier is providing alpha, really, so it's a bit odd that hedge funds provide negative alpha in aggregate, but that 55 percent of them improve the efficient frontier. My assumption was that those things were measured against different benchmarks, though it's also possible that it's just a difference between mean (negative) and median (positive) performance. Elsewhere: "The Case for Hedge Funds / Creating an Ideal Liquid Alt."

Things happen.

Wall Street bonuses expected to decline for bankers, traders: report. Romantic Relationship With Fannie Mae CEO Prompted Firing of Fifth Third Lawyer. People are worried about risk parity again. Pioneer of smart-beta investing warns strategy is being abusedNew money raised by equity ETFs drops 85%. MIT, NYU, Yale Sued Over Retirement-Plan Fees. "Wrestlers have to cobble enough to live on to train for four or eight years, so winning $250,000 is nice," says Mike Novogratz. "While appealing to politics is ultimately an appeal to morality, not everyone has a thorough understanding of the inherent immorality of global capitalism." A Therapist Who Preps White-Collar Criminals for Prison Time. Millennials can't cook. "Beer soap, bacon beard oil and the marketing of fragrant masculinity." "This is the way the day ends – not with bangers, but with whimpers." Chorks. Remembering When 'Melrose Place' Became a Conceptual Art Project. Trump Supporter Explains Why He Built a Shrine to Harambe. Squirrel GoPro. The Microsoft Office World Championships Feature Blood, Tears, and Very Little Sweat.

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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:
Brooke Sample at bsample1@bloomberg.net