Mirror Trades and Tax Tricks

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.
Read More.
a | A

Deutsche mirrors.

I like a good scandal as much as anyone, but the Deutsche Bank mirror-trading scandal leaves me pretty blah. Some Russians had money in Russia, and they preferred to have it elsewhere. That seems understandable? So they bought some stocks in Russia, and sold the same stocks (from the accounts of related offshore entities) in London, usually running both legs through a Deutsche Bank trading desk. The result was that they had less money in Russia and more in London, although if you do the accounting it would seem that they’d also be building up a large stock position in Russia and an offsetting short position in London. I’m a little curious how they closed out their short positions in London. Did they, like, fly bags of stock certificates from Moscow? Doing the mirror trades solves the problem of moving cash from Moscow to London, but would seem to leave a residual problem of moving stock.

The big new New Yorker article about the mirror-trading scandal doesn’t answer that admittedly odd question. Nor does it quite explain what laws were broken by the mirror trades; presumably they evaded Russian capital controls, and there is a strong suggestion that some of the mirror traders were oligarchs subject to U.S. sanctions, who could not have moved money in more straightforward ways. But for the other ones, it's hard to tell if this was regular banal tax avoidance -- analogous to the dividend-arbitrage strategy that is legal in a lot of places, though roundly disliked everywhere -- or something more nefarious. On the one hand, there's a certain baseline level of shadiness that is just expected from global banks in Russia. "If you wanted to be competitive, you had to do a lot of things that were not done in the developed world, because it was Russia," says a guy. On the other hand, the former head of Deutsche's Moscow equities desk, a 37-year-old American who is apparently living in Bali these days, is compared to both Jason Bourne and Edward Snowden, so perhaps he got up to something genuinely juicy. 

Meanwhile, the Russian broker who brought in the trades "wasn’t a great trader, but he was a good fisherman," which is exactly what you want in your broker.

Amazon taxes.

A core basic trick of international tax is:

  1. Build some intellectual property -- patents, technology, whatever.
  2. Put the IP in a subsidiary in a low-tax jurisdiction, say Luxembourg.
  3. Have all your subsidiaries in higher-tax jurisdiction pay the Luxembourg subsidiary a licensing fee for the IP.
  4. Make the licensing fee equal to your revenue.

And by magic, you have moved all your taxable income from the high-tax jurisdictions where it is actually earned, to the low-tax jurisdiction where your IP sits. (The classic example is pharmaceuticals: If it costs you $1 to manufacture a pill that sells in the U.S. for $1,000, you have $999 in taxable income in the U.S. But if it costs you $1 to manufacture it, and you pay $998 in licensing fees to your Irish subsidiary, then you have only $1 in taxable income in the U.S., and $998 in Ireland, where hopefully your taxes are lower.) 

One problem with this trick is that step 2 -- "put the IP in a subsidiary in a low-tax jurisdiction" -- isn't quite as simple as I made it sound. You can't just "put" intellectual property somewhere. You have to sell it, or license it. So if you build the intellectual property in the U.S., and then move it to a subsidiary in Luxembourg, the Luxembourg subsidiary has to pay licensing fees right back to the U.S. one, eliminating the tax savings from the licensing payments that the high-tax subsidiaries are paying to the Luxembourg one. Unless of course those payments are different. If the U.S. company licenses the technology to the Luxembourg one for $1 a year, and then licenses it right back for $100 a year, it can still take a nice $99 tax deduction. But how could you justify that?

Regulators in Europe and the U.S. say that the value Amazon places on the technology behind that experience varies radically depending on which side of the Atlantic it’s on -- and which appraisal will lower its tax bill.

In Europe, the e-commerce giant tells authorities that the intellectual property behind its web shopping platform is immensely valuable, justifying the billions in tax-free revenue it has collected there since moving its technology assets to tax-friendly Luxembourg a decade ago. In the U.S., however, it plays down the value of those same assets to explain why it pays so little in taxes for licensing them.

I mean, I'm sure it's all fine! (Amazon "said that the IP was perishable given the high failure rate of tech companies," and argued that U.S. authorities "had drastically underestimated the amount of research and development costs that should be attributed to" its Luxembourg subsidiary.) But do you kind of get why the Deutsche Bank mirror trades leave me cold? Like, moving money from one jurisdiction to another while minimizing taxes is just ... I don't want to say that it's the point of the international financial system, but it's point of an international financial system, anyway. 

Robots.

This Bloomberg headline is "How This Hedge Fund Robot Outsmarted Its Human Master," and I so hoped that it was going to be a charming story about how the robot tricked the human into, like, buying it ice cream, or shutting down the firewall that prevents it from enslaving humanity under the yoke of our inevitable robot overlords. But no, it's not "outsmart" in the sense of "trick," it's just "outsmart" in the sense of "be smarter than":

It was the hedge fund manager’s self-learning computer program that had placed the bet, selling Japanese stock-index futures before a sizable market advance. Nomura had anticipated a rally, but decided not to interfere, and his fund was paying the price.

Then, in an instant, everything changed. When new vote counts signaled Britain was going to leave the European Union, a burst of selling sent Japanese shares to their biggest drop in five years. By luck or design, Nomura’s Simplex Equity Futures Strategy Fund ended the day with a 3.4 percent gain, one of its best results in three months of trading. 

“The machine was right after all,’’ said Nomura.

Hey that's super, good job computer. There's this quote from Paul Tudor Jones that has been making the rounds recently, in which he told his team that "No man is better than a machine, and no machine is better than a man with a machine." Spoken like a man! It seems to be true about chess, but I am not sure it is a priori true of every human activity. (There are those who think that self-driving cars will be safer without steering wheels.) In a man/machine trading combination, the machine brings vast knowledge of data, light-speed calculation, and cold perfect rationality. The human brings ... gut instinct? Cognitive biases? Greed and fear? Fundraising soft skills, I suppose, but the point here is that Yoshinori Nomura is pretty happy that he just left his machine alone to do its thing. The question is whether the paradigm for the future is more like Jones's idea of human and computer working together in a way that complements them both, or Nomura's idea of sitting quietly in the corner while his computer outsmarts him.

Put writing.

Implied volatility is near its all-time lows, and so of course public pension funds are selling volatility:

Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing. In a typical trade, the investor sells a contract, known as a put, to someone who owns stocks and is willing to pay up for protection in case they decline. If, within a certain time, the shares fall below a given price, the investor buys the stocks at that price, or covers their lost value.

The upside for the pension funds, which are writing options on the S&P 500 index, is that they earn regular income. The strategy aims to work like a volatility dampener. If stocks fall, the income the funds have collected on the options contracts should help cushion any hit they take on the puts and their own separate stockholdings.

That is ... not how puts work? Selling puts increases the funds' downside risk if stocks fall; if they want to protect against a stock drop, they should buy puts. But of course they don't want to protect against a stock drop; they want a little extra income in a low-yield environment. "There comes a point where you might be picking up pennies in front of a steamroller," says a guy, because this is an article about volatility-selling strategies and that's just what you say. People sometimes think that the VIX volatility index is a "fear index," a measure of how traders feel about the future, but really it is just a measure of the prices of options on the S&P 500 stock index, and those prices are determined by supply and demand more than they are by a single definable emotion. And right now part of the supply -- some of the fear antidote -- is from yield-hungry public pensions.

Capital.

One obvious arithmetic point is: If you run a bank at, like, a 25-to-1 leverage ratio, where you have $100 in assets for every $4 in equity, then every asset that you own, every business that you're in, is going to look alarmingly large relative to your capital. If you own $2 worth of creepy securities, that's just 2 percent of your business, practically an afterthought -- but it's also half of your capital. If those $2 of creepy securities were wiped out, you'd be in bad trouble. Anyway:

Eight years after the financial crisis, Europe’s biggest investment banks are holding illiquid assets amounting to more than half their combined shareholders’ equity, underlining concerns about capital.

Deutsche Bank AG, Credit Suisse Group AG and Barclays Plc say their hardest-to-value securities -- known as Level 3 assets -- were worth $102.5 billion at the end of June. These include investments that gained notoriety in the financial crisis, from bespoke credit derivatives to mortgage-backed bonds.

Oops!

Look, nobody likes filling out expense reports, but you just can't do this:

The Defense Department’s Inspector General, in a June report, said the Army made $2.8 trillion in wrongful adjustments to accounting entries in one quarter alone in 2015, and $6.5 trillion for the year. Yet the Army lacked receipts and invoices to support those numbers or simply made them up.

I don't ... what?

At first glance adjustments totaling trillions may seem impossible. The amounts dwarf the Defense Department’s entire budget. Making changes to one account also require making changes to multiple levels of sub-accounts, however. That created a domino effect where, essentially, falsifications kept falling down the line. In many instances this daisy-chain was repeated multiple times for the same accounting item.

I still ... what? What ... kind of accounting system do they have over at the Defense Department, anyway? Is it possible that the whole thing is, like, a guy ordered a $20 room-service sandwich on a business trip, and forgot to get a receipt, and so he had to make up a sub-account, and then billions of other sub-accounts automatically cascaded from that, and the sandwich somehow caused $2.8 trillion of gross accounting adjustments? Like:

Only with so many more accounts?

Is performance good?

Here is a story about how Kimberly-Clark Corp. used to be nice and now is tough:

Not long ago, when Kimberly-Clark Corp. employees gathered for interdepartmental meetings, they prefaced their comments with their names and years of service at the company.

These days, “no one cares,” said Scott Boston, vice president of human resources. The attitude in meetings is “‘let’s get moving,’” he said.

Yes I mean good lord yes, there are few things in life that are worse than a meeting where everyone prefaces their comments with their names and years of service at the company. Just imagine the collective centuries of human life wasted listening to Jim from accounting explain that he'll have been at the company 17 years this October. Good job, Kimberly-Clark.

But the more substantive shift is that Kimberly-Clark used to be a place where low performers "could and would hide in the weeds," according to a retiree, but is now focused on "'managing out dead wood,' aided by performance-management software that helps track and evaluate salaried workers’ progress and quickly expose laggards." That sounds ... right? I mean ... I can't argue with it? Good performers probably perform better than bad performers, so you should try to get more of the former and fewer of the latter. And yet weeds can be nice. A few weeds here and there can add a certain rustic charm to a place. And then there is this:

“It’s certainly more challenging” for employees, said Mr. Herbert, the retired sales director. “If you really don’t have the mettle, you’re asked to get on with your life’s work [elsewhere].”

But what if your life's work is putting in minimal effort at an office job? I feel like the ideal place to do that used to be at big American consumer-brand companies. And now they have embraced efficiency. What are you going to do if you are forced out of Kimberly-Clark for lack of mettle? Go work for a startup? Be an entrepreneur? I am optimistic about the trading robots, because I suspect that the value of human emotion and instinct in trading may be overrated. But I am not so sure about the human-resources robots.

People are worried about unicorns.

Uber is of course the alpha unicorn of the Enchanted Forest, but along the way it has had to fight to maintain that position. Against Lyft, for instance, which seems to be battered and gored, its pink mustache ripped off and trampled in the enchanted underbrush. It's been looking for a way out:

The company, which is based in San Francisco, has in recent months held talks or made approaches to sell itself to companies including General Motors, Apple, Google, Amazon, Uber and Didi Chuxing, according to a dozen people who spoke on the condition of anonymity because the discussions were private. One person said it was Lyft who was approached by interested parties.

Lyft’s discussions were most serious with G.M., which is one of the ride-hailing company’s largest investors. 

Meanwhile, outside the Enchanted Forest, tech companies are doing great:

Fueled by three-year rallies in which Microsoft Corp. and Alphabet Inc. doubled, Amazon.com Inc. tripled and Facebook Inc. surged fivefold, computer and software stocks have increased to almost 21 percent of the S&P 500 Index’s value, near a 15-year high. The distance between tech and the next-biggest group, banks, is close to the widest ever.

People are worried about bond market liquidity.

So if you are a big company and you need money to drill for oil or build power plants or whatever, one natural thing to do is to go to a bank and borrow the money, and that is happening in Europe, and it is all very normal except that the bank is the European Central Bank:

In two instances, the ECB has bought bonds directly from European companies through so-called private placements, in which debt is sold to a tight circle of buyers without the formality of a wider auction.

The two private placements are from Repsol SA and Iberdrola SA, and to be fair the ECB seems to have bought a portion of each deal, meaning that private-sector investors presumably took down the rest. So we are not quite at the point where the ECB hires loan officers and conducts its own due diligence on individual corporate borrowers. Still it is weird. Classically, the reason that monetary policy operates through banks -- the reason that central banks increase the money supply by putting more money in the hands of banks rather than humans or companies -- is that the banks are supposed to be good at allocating capital, at deciding which borrowers should get the money. But at some point the central bank could conclude that the answer to the question "which borrowers should get money" is "whoever shows up," at which point it might as well just start lending directly. We're not quite there yet: The ECB is "all but inviting private actors to concoct specific things for them to buy," and "lays out the specifics of its wish list." But if you can meet its criteria, it's a buyer.

Elsewhere, people are worried about JPMorgan getting out of the tri-party repo clearing business.

Things happen.

Donald Trump the Mortgage Broker Was in Trouble From Moment One. Trump’s Empire: A Maze of Debts and Opaque Ties. Pfizer Nears Agreement to Buy Medivation. ChemChina clears hurdle in $44bn takeover of Syngenta. Nomura Back in Hiring Mode for U.S. Bankers After Cost Cuts. Banks Sprint to Meet $493 Trillion Swaps Market Margin Rules. RBS to impose negative rates on some big business customers. Morgan Stanley Neglected Warnings on Broker. Valeant Taps Zoetis Executive for CFO Role. The Impact of the New Restructuring Law on Puerto Rico Creditors. Fed’s Fischer Says Better Fiscal and Regulatory Policies Could Improve Productivity. BOE’s Effort to Beef Up Digital-Currency Research Hits Bump. When REITs Leave, Financial-Sector Funds Could Lose Some Yield. Britons Abroad Already Know What Pound-Euro Parity Feels Like. Liverpool FC owners hire advisers after Chinese approach. Japanese PM Shinzo Abe appears in disguise as Super Mario at Rio Olympics Closing Ceremony. Nine Incredible Superyachts You Can Still Book for a Last-Minute Trip. An Oral History of Titanic.Jezebel.com. Every Joke from ‘Airplane!’ Ranked.

If you'd like to get Money Stuff in handy e-mail form, right in your inbox, please subscribe at this link. Thanks! 

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