Mirror Trades and Two-For-One Rules

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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Deutsche Bank.

Let's start with something light and cheery, Deutsche Bank AG's multibillion-dollar money laundering on behalf of Russian oligarchs:

Deutsche Bank AG was fined $629 million by U.K. and U.S. authorities for compliance failures that saw the bank help wealthy Russians move about $10 billion out of the country using transactions that were likely thinly veiled attempts to cover up financial crime.

"Thinly veiled" is an understatement. The trades here were "mirror trades," in which some Russian entity would buy a chunk of Russian shares from Deutsche Bank's Moscow office for rubles, and an affiliated entity would sell the same shares to Deutsche Bank's London office for U.S. dollars, with the result that the web of entities moved rubles offshore and converted them into dollars. It's a simple transaction, using the stock trades as just a mechanical tool for the money transfer. It doesn't even matter what shares you use, as long as there are enough of them:

For example, typically, it made no difference to the counterparties the particular security to be bought or sold. All that mattered was that there was a matching trade available. In one instance, a counterparty representative, who was buying shares for one counterparty and selling the identical shares for a related counterparty, told a DB-Moscow trader, "I have a billion rouble today .... Will you be able to find a security for this size?"

In another case, a counterparty representative, when told by a DB-Moscow trader there were no Sberbank Russian shares available for a mirror trade, immediately switched the order to Gazprom Russian shares. No rationale for this switch was apparent; no trading hypothesis was offered.

That is from the New York State Department of Financial Services consent order. (The DFS, along with the U.K. Financial Conduct Authority, are the two agencies that have fined Deutsche Bank. So far. "A criminal investigation by the U.S. Justice Department is ongoing.") The problem is that when a customer comes to you and asks to buy a billion rubles worth of stock, and he doesn't care what stock, that is kind of a red flag that he is engaged in something other than legitimate financial-markets activity. If you are a big international bank, you are supposed to notice red flags like that. Deutsche Bank did not notice the red flags.

Or, I mean, it did, but then it got tired. From the FCA order:

In mid-September 2014, the Deutsche Bank AML team contacted DB Moscow’s AML team to request more information about the mirror trading and the two customers. DB Moscow stated in its response that it was “strongly convinced that they are a part of one [money laundering] scheme as there is no economic sense behind these transaction [sic] and the whole flow is organized to facilitate cross-border transfers and in order for them to look legitimate.

Although Deutsche Bank’s AML team took steps to investigate the mirror trading, it did not obtain all of the relevant trading data. When it was informed by Deutsche Bank’s Operations team that “providing a spread-sheet will not be possible as this is done manually by a team member and capturing so many records will be painful”, the AML team did not persist with its enquiries.

I feel you, Deutsche Bank anti-money-laundering team. Sometimes I'll leave my car in a parking spot even though the meter has expired, because it's too much effort to go outside and feed the meter, and it's easier to just risk a ticket. Do you think it was worth it here? Like, maybe the AML team came in to work today, saw the $629 million of fines, and said "yeah, but I mean, we would have had to manually type in so many trading records." Good job dodging that bullet! That's the sort of tempered zeal you want in your anti-money-laundering team.

Huh.

Belgium, as people always used to point out, went a year and a half without a government, and it's still there. In the U.S., so far it seems that Donald Trump's administration is cutting the military out of national security policy, the foreign service out of foreign policy, the lawyers out of legal review, the courts out of judicial review, and the cabinet out of all executive decision-making. I know that Trump was elected to shake up the Washington establishment, but at this rate there'll be nothing left. It's just a reality television host and a website proprietor, on their own, trying to run the country. Maybe it will all work out great! It's the scariest moment in American history that I can remember.

There's always a financial angle! "Wall Street Reassures Employees, Without Wholly Rejecting Travel Ban." "Elisha Wiesel Reflects on Immigrant Ban and Father’s Legacy." "Locked in Trump's America: Immigrant Employees Are Afraid to Travel." (Great for business confidence!) "Frantic Phoning Among C.E.O.s: How to Address Trump Ban?" "Some CEOs 'scared out of their minds about being attacked' by Trump, so they won’t complain about immigration ban." "How to Build an Autocracy." And: "If we’re not going to be a nation of laws, then attitudes toward pieces of paper that carry no weight in the absence of law will have to be rethought." (Those pieces of paper are stocks and bonds.)

Elsewhere, Representative Tom Price, Trump's nominee to run the Department of Health and Human Services, "got a privileged offer to buy a biomedical stock at a discount, the company’s officials said, contrary to his congressional testimony this month." And "Mr Navarro said one of the administration’s trade priorities was unwinding and repatriating the international supply chains on which many US multinational companies rely, taking aim at one of the pillars of the modern global economy." 

Regulation.

All the chaos is worth keeping in mind when you think about President Trump's executive order requiring federal agencies to repeal two regulations for every new regulation that they introduce. It sounds like a radical deregulatory agenda, until you remember that two times zero is zero. Probably some Trump administration agencies will end up being active dismantlers of regulation, but at this point it seems like the default state for the new executive branch will be understaffed demoralized lethargy. "If you want to write 10 new regulations, you need to find 20 old ones to repeal." "Sure, we'll keep that in mind, if it ever comes up."

I guess that's not the classic public-choice way of thinking about these things. The usual model assumes that regulators like to build up their own regulatory clout, by issuing more and more pervasive regulations. If that model accurately describes Trump administration regulators -- and why would it? -- then it's hard to know how powerful the "two for one" rule will be in constraining them. It's not easy to repeal regulations, and there is plenty of room for interpretation about units. (What, after all, is a "regulation"?) The binding constraint in the executive order appears to be that "any new incremental costs associated with new regulations shall, to the extent permitted by law, be offset by the elimination of existing costs associated with at least two prior regulations." Which means that each new regulation can be up to twice as burdensome as the old ones you're getting rid of.

Anyway, one place where there probably will be big changes -- likely driven by Congress rather than the administration -- is in financial regulation. "We’re going to be doing a big number on Dodd-Frank," said Trump, which I guess was meant to sound like a good thing. It is not clear yet what those changes are, though for instance the Volcker Rule seems to be on the chopping block. Goldman Sachs Group Inc. and a few others who waited out the Volcker Rule and kept some stakes in private funds will be rewarded for their persistence, but in many ways the Volcker Rule has done its job even if it's repealed now. Banks have gotten rid of their proprietary trading desks, and their cultures have changed to match their new, less aggressive business. It won't be easy to just turn the switch back on.

Entity betting.

The basic trend in modern financial markets is to provide investors with more tools to express precisely specified views on a whole range of economic variables, from the performance of the broad stock market, through that of a specific sector or factor, down to that of a single loss tranche of a particular mortgage bond. Another way of putting that is: Financial markets keep coming up with new things to bet on, and new ways to bet on them. For reasons of history and prudishness, football games have never really been on the list, but eventually that will have to change. It's starting to:

Sports betting has been one of the few areas where people were legally required to make their own boneheaded decisions. For years, Nevada law forbade any entity from making sports wagers on behalf of investors.

Last year, after the legislature dropped the ban, a handful of these so-called “entity wagering” funds popped up, attracting stakes from a few hundred investors.

For now, you can't bet on games, but you can bet on a fund manager's ability to bet on games. (I mean, you can bet on games, if you're in Nevada, but the entity wagering funds are a way to do Nevada sports betting from out of state.) The industry is small and actively managed. But, you know. What about an index fund? The Underdog Fund, or the Favorites Fund, or the Prop Bet On The Home Team To Win The Coin Toss Fund? And then why not a subsector exchange-traded fund like oh say I don't know the New England Patriots Fund? If there's one thing we've learned from stock betting -- I mean, investing -- it's that actively managed mutual funds are not the final stage.

Dual-class stock.

Sure, sure:

Several of the world’s biggest money managers will push for a ban on dual-class shares, as part of a slew of corporate-governance practices they agreed to endorse.

The campaign, expected to be announced Tuesday, will turn up the heat on many U.S. companies at a time of increased shareholder activism. The coalition’s 16 members manage more than $17 trillion in assets.

The participants include asset-management giants BlackRock Inc., Vanguard Group and State Street Global Advisors as well as big public pension systems in California, Florida and Washington state.

Look, it's actually easy to "ban" dual-class shares from your portfolio; you can just not buy them. And if BlackRock and Vanguard stopped buying dual-class shares, they'd probably disappear. But revealed preferences don't always match corporate-governance advocacy statements. (Also, sure, if you run index funds I suppose it is hard to avoid buying dual-class shares. That is also a revealed preference, though.)

Meanwhile, what conclusions do you draw from this story?

In December, Forest City Realty Trust said it would restructure its stock to cancel the dual-class structure that preserved the control of its famed founders, the Ratners. The move came after activists and other investors pressured the company and said the governance structure was dragging down the stock.

Two days later, activist Jonathan Litt swooped in and nominated three directors, he disclosed Monday in a new letter.

On the one hand, if you are a company with dual-class stock, this shows you that all of your scariest activist-proxy-fight fears are valid. On the other hand, the stock is up almost 19 percent since Forest City announced the end of the dual-class structure in December. In the long run, the way that institutional investors will get rid of dual-class stock is not by public campaigns but by price: If companies can raise more money and be more highly valued with single-class stock, then dual-class stock will be less popular. Right now it is not especially clear that that tradeoff exists, but Forest City provides some evidence that it does.

Blockchain blockchain blockchain.

Given all the interest from central banks in the blockchain, it can't really come as a surprise to anyone to learn that the Federal Reserve Board's computers were used to mine bitcoins. The surprise is that the mining was done illegally by an employee who pleaded guilty to a misdemeanor last week:

According to the plea agreement, Berthaume had access to certain Board computer servers in his role as a Communications Analyst. Berthaume installed unauthorized software on a Board server to connect to an online Bitcoin network in order to earn bitcoins. Bitcoins are earned as compensation when users allow their systems' computing power to be part of the structure that processes, verifies, and records bitcoin transactions. We were unable to conclusively determine the amount of bitcoins earned through the Board's server due to the anonymity of the Bitcoin network.

Yeah, that's just what they want you to think to cover up the fact that the Fed is mining bitcoins.

No, I'm kidding. But if you work at the Fed, you have a lot of career risk tied to fiat currency. If societal trust in fiat currency collapses, not only will you live in a post-economic dystopia where your savings are worthless (like the rest of us), but also you'll probably lose your job at the Fed. Why not do a little bitcoin mining to hedge?

The Park Slope Food Coop.

Somehow I missed last week's best financial news story, about the Park Slope Food Coop's pension fund. The Coop has some full-time employees, with a multimillion-dollar pension fund, and it "had invested the majority of its pension fund in just eight stocks, most of them shares of biotechnology firms." One of those stocks was Neptune Technologies & Bioressources [sic!] Inc., a micro-cap Antarctic-krill omega-3-oil company whose biggest shareholder was also a trustee of the Coop's pension fund. (He was also "a former managing director at Lehman Bros.," who "managed the fund as his work shift, instead of stocking shelves or helping carry groceries.") I suppose that's all potentially controversial, but it being the Coop, the presentation exposing the potential conflicts was also controversial:

“It was a bunch of Wall Streeters who came up and made this presentation, and 40 years ago you could never imagine Wall Streeters being part of the coop,” said Mr. Thomas, who works as a fundraiser for a new-music nonprofit.

The Wall Streeters were “perfectly nice gentleman,” Mr. Thomas added, but rubbed “the crunchy people in the front row” the wrong way. They used a complicated Powerpoint, a rarity at coop meetings. “It was, like, graphs and stuff,” he added.

Every annual-meeting season, there are amused stories about nuns showing up at shareholder meetings to push management for socially responsible changes. I try to imagine the Park Slope Food Coop -- famous for its long and emotional debates about plastic bags and hummus boycotts -- sending representatives to shareholder meetings to advocate for its values in corporate America. If nothing else, it would revolutionize financial journalism. I think a lot of financial journalists are Coop members. (Disclosure: not me.) There are synergies here. Someone should make this happen.

People are worried about unicorns.

The current round of unicorn worrying seems to be about how tech companies will walk the tightrope of convincing their customers and employees that they are opposing Trump, while convincing Trump that they aren't. Here is my Bloomberg View colleague Timothy O'Brien on Uber's efforts in that vein, and here is a story about Elon Musk's (fine: not a unicorn) approach. Elsewhere, Snap Inc. plans to list on the New York Stock Exchange when it goes public this year. And here is a food-stamp startup.

People are worried about bond market liquidity.

Here are Stephen Morris, Ilhyock Shim and Hyun Song Shin on cash hoarding:

Open-end mutual funds face redemptions by investors, but the sale of the underlying assets depends on the portfolio decision of asset managers. If asset managers use their cash holding as a buffer to meet redemptions, they can mitigate fire sales of the underlying asset. If they hoard cash in anticipation of redemptions, they will amplify fire sales. We present a global game model of investor runs and identify conditions under which asset managers hoard cash. In an empirical investigation of global bond mutual funds, we find that cash hoarding is the rule rather than the exception, and that less liquid bond funds display a greater tendency toward cash hoarding.

The more general idea here is that, unless you are very careful, most financial-stability protections have a tendency to be pro-cyclical. So you think: "If people redeem from my fund, I want to have cash to give them, so I don't have to sell too many bonds when everyone is redeeming." Great idea! Good for stability. But then people start redeeming from your fund, and you start giving them your cash, and you have less cash. What do you do? A plausible answer is "nothing; this was the point of having the cash around." But in the moment, that answer sounds very stupid and risky. Instead, you think: "Investors have drawn down my cash, and more might be coming, and the only way to feel safe is to increase my cash buffer." So you sell more bonds to raise cash than you would have if you'd just been selling bonds to meet redemptions. Financial stability isn't as easy as it looks.

Things happen.

The $2 Trillion Woman Who’s Turning Around Pimco. Microsoft Sets 2017 High With $17 Billion Bond Sale. What the World’s Biggest Banks Say About Fleeing Brexit-Britain. Trend-following funds need to find their footing in 2017. Court Orders Justice Dept. to Release Fannie Mae and Freddie Mac Documents. Walgreens and Rite Aid Cut Price of Merger. Tempur Sealy Shares Drop After Mattress Firm Contracts Terminated. Investors Press Arconic to Oust CEO Klaus Kleinfeld, Months After Alcoa Separation. Jay Newman is retiring from Elliott Management. A Former Goldman Employee’s Long, Strange Legal Odyssey. Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital. How do Quasi-Random Option Grants Affect CEO Risk-Taking? "It is particularly dangerous to take a selfie while swimming, or while standing on a cliff." Mini-horse chase. Particle-accelerated weasel.

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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