Money Stuff

Front-Running and Founder Control

Also active vs. passive, dialysis payments, vast majorities and bank regulation.


I never really worked on a trading desk, but I worked on a desk that looked like a trading desk, which meant in particular that I had (1) no privacy but (2) a turret phone. Sometimes that felt like a fair tradeoff. The turret had dozens of lights that let me see who else on my floor was on the phone, and dozens of buttons that let me pick up their lines to see if anything fun was happening. This resulted in various low-grade hijinks (pick up someone's line while they're on a client call, say weird thing in weird voice, giggle) that I may one day recount in a very boring Wall Street memoir, but it never (that I know of!) led to anything quite like this:

At times certain traders on the Swaps Desk lengthened the amount of time they had to trade ahead by listening in, without announcing their presence, to calls between certain counterparties and the sales staff responsible for handling the counterparty’s trade inquiry.

Reading that, my two near-simultaneous reactions were:

  1. Hahahaha that's bad, and
  2. I can't believe it doesn't happen all the time.

That passage is from this Commodity Futures Trading Commission order against Merrill, Lynch, Pierce, Fenner & Smith Inc. (part of Bank of America Corp.), which on Friday agreed to pay $2.5 million to settle the CFTC's case. Basically the story is that back in 2009 and 2010, the market regulators at CME Group -- which runs exchanges on which Merrill trades interest-rate futures -- launched an investigation of Merrill's swaps desk for allegedly front-running clients' block trades in the futures market. The clients would call up and ask their Merrill salespeople to buy them a lot of interest rates (or whatever, I am simplifying), and the Merrill traders would learn about the client trades, and the Merrill traders would (allegedly) buy some interest-rate futures for their own accounts before doing the big trades for the customers. Then they'd do the client trades, which would push up the price of the futures and make the traders' own trades profitable.

And CME asked the Merrill traders about this, and the Merrill traders allegedly lied about it. ("The traders answered that the electronic trades could have been unrelated to the block trades, or, if the trades were related, the electronic trades likely occurred after execution of the block trade and the reported execution time of the block trades was likely inaccurate.") And that's what the CFTC fined Merrill for on Friday: not for front-running, but for being evasive about front-running. Financial regulation is weird.

But I mostly enjoyed the front-running, and particularly, the mechanism of front-running. I gather that the way things were supposed to work is:

  1. Client calls salesperson and says "buy me 100 futures."
  2. Salesperson says "will do," hangs up, and shouts over to the trader "I need 100 futures."
  3. Trader goes and buys 100 futures and says "you're done on 100 futures."

The trader's clock starts when she hears from the salesperson: If the salesperson said "I need 100 futures" and the trader replied "hang on and let me buy 5 for myself first," that would create obvious awkwardness, because everyone is aware that you're not supposed to front-run customer orders, and because the salesperson feels some sense of loyalty to the customer. But if the trader just listened in to the salesperson's line, bought futures for herself, and then acted cool and nonchalant when the salesperson conveyed the order to her -- well, that is sneaky, though I guess not sneaky enough to avoid the CFTC's attention.

Obviously the big conversation in market structure over the last few years has been about traders using technology to front-run, or "front-run," investors' orders. Sometimes the mechanisms of this front-running seem somewhat far-fetched; often it's like "ooh the computers know what you're going to do before you do." But you don't need fancy low-latency electronic trading for front-running. If you call up a salesperson to do a trade, someone could be front-running you by eavesdropping on your phone call.

Elsewhere in CFTC enforcement: "Regulator Wants Financial Industry to Self-Report Wrongdoing."


It's kind of weird that Facebook Inc. announced its plan to give its co-founder and chief executive officer Mark Zuckerberg perpetual voting control of the company more than a year ago, and still hasn't implemented that plan. After all, Zuckerberg himself controls a majority of the voting stock; he could have voted for it the day after the board announced it, and that would be that. (And in fact he did vote for it, and so it did pass.) But real corporate governance doesn't work that way, and just having enough votes to pass a proposal doesn't mean that it can be done. In this case, lawyers sued Facebook and asked a court to forbid it from implementing the plan, and after some skirmishing, Facebook announced on Friday that it was giving up the plan altogether.

It's not exactly clear why Facebook surrendered, but there are some clues. For one thing, back when Facebook proposed this plan -- which would have involved creating a new non-voting Class C stock and giving some of it to every shareholder, allowing Zuckerberg to sell his non-voting Class C shares while hanging on to his high-voting Class B shares -- entrenching founder control forever was the cool thing to do. Google (now Alphabet Inc.) had already done something similar, and when Zuckerberg had announced that he might sell some stock to give money to charity, Facebook's stock price dropped as shareholders worried that he wouldn't be entrenched forever.

But times have changed. Since Facebook's proposal, Snap Inc. did an initial public offering of non-voting shares, and things went poorly. Fund managers rebelled by demanding that index providers keep companies with non-voting stock out of the indexes, and a couple of big index providers complied. Public -- well, investor -- opinion has shifted decisively against dual-class and triple-class and non-voting and super-voting stock, and while Facebook already has a dual-class voting structure, now's not really the time to go further in that direction. "This really is the death knell for existing companies trying to adopt a non-voting share class," said a governance advocate.

Plus, again, investors sued, and the lawsuit could have been embarrassing. It was supposed to go to trial this week, which would have involved testimony about potential conflicts of interest when the (Zuckerberg-appointed) board approved the plan to give Zuckerberg more control. It also probably would have involved testimony by Zuckerberg himself, which might have been difficult or embarrassing or just conflicted with his schedule. "By dropping the reclassification move, Facebook sidestepped Mr. Zuckerberg’s appearance in court at a time when the company is facing criticism on several fronts."

Plus, the point of this whole plan was to allow Zuckerberg to give away zillions of dollars without losing control of Facebook, and he went and checked his account balance and realized he could do that anyway. "Over the past year and a half," Zuckerberg posted on Facebook, "Facebook's business has performed well and the value of our stock has grown to the point that I can fully fund our philanthropy and retain voting control of Facebook for 20 years or more." The triple-share-class structure would have let him give away more money faster while retaining control for longer, but it was not essential to the basic plan. So when it became annoying, it was scrapped.

So Zuckerberg lost, I guess, but his loss gives you a sense of what real power looks like. His hand-picked board cheerfully agreed to let him control his company forever even with a tiny minority of its stock, but also, when controlling his company forever seemed like it might create an inconvenience for him -- like, he'd have to show up in court and answer some questions -- then he could just drop it and still control the company for decades and remain unfathomably wealthy while also giving away unfathomable amounts of money.

Active management.

Is active management ready for a comeback? That question is often addressed in terms of correlation and dispersion and volatility, which on the face of it is rather odd. A quite well-known and intuitive (though disputed) result in finance is that "before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar" (and after costs it will be worse). The index reflects the performance of all the stocks. (Depending on the index, but you know what I mean.) If some of the stocks do much better than the other stocks -- because of lower correlation, higher dispersion, higher volatility, etc. -- then active managers who own those stocks (and not the other stocks) will outperform the index, and everyone will say "it's a stock-picker's market" and think it's a good time for active managers. But meanwhile active managers who own the other stocks will underperform the index, and on average all the active managers will combine to just match the index, before fees. It will be a good time for good active managers, but relentless arithmetic ensures that the good active managers are balanced by the bad (or unlucky, etc.) ones. And it is hard to know in advance which one is which.

So when people say stuff like this:

“We’ve been in a period where correlations were tight, but that’s breaking up. There are more opportunities to differentiate yourself,” says Tim Armour, chief executive of Capital Group, the $1.5tn asset manager. 

Or this:

“It feels like the market on several fronts is being set up for a sustainably good environment for active investing,” says Brian Hogan, head of Fidelity’s equity division. “It really feels better.”

Or even this:

While muted correlations make the market more fertile for stock pickers, Andrew Acheson, a fund manager at Amundi Pioneer Asset Management, points out that the “dispersion” — the extent of the difference between the good and bad performers — is still subdued. “Making the right decisions aren’t rewarded as much as we’d like,” he says. “Overall, the environment has improved, but not as much as we would like.”

One thing that they are implicitly saying is that they are among the good ones. But that is hard to know even about yourself. What if "there are more opportunities to differentiate yourself" -- and you differentiate yourself in the wrong direction? What if "making the right decisions" is "rewarded as much as we'd like" -- and you make the wrong ones?

The problem is exacerbated by the fact that the bad investors -- particularly, retail investors who pick stocks without knowing what they're doing -- are exactly the ones who are more likely to give up on active management, leaving only the good ones to compete against each other, and ensuring that some of those good ones will, by the continuing operation of arithmetic, become the bad ones:

It certainly makes sense to Bob Landry, chief investment officer for USAA. He points out that most of the money flowing into ETFs has been from the retail investors who used to be the “low-hanging fruit” that the professional money managers could pick off. “With fewer retail investors you have more fund managers going mano-a-mano,” he says.

But, sure, yes, we do seem to be entering a golden age for active management, depending on your standards:

US equity funds have on average returned 18.7 per cent in the 12 months to the end of June, narrowly surpassing the broad S&P 1,500 index’s total returns of 18.1 per cent, according to SPDJ’s flagship Spiva report on active managers.

That translates to 52.5 per cent of all funds beating their benchmarks during that period.


Here is a Southern Investigative Reporting Foundation report about DaVita Inc., a kidney care company that sells expensive dialysis services. Those services are paid for by insurance companies. The patients' insurance premiums are often paid by the American Kidney Fund. The American Kidney Fund is in large part funded by donations from DaVita. So! DaVita isn't exactly paying itself for dialysis services, but you could certainly argue that it is taking advantage of insurance and tax rules to lever its American Kidney Fund donations into profits for itself. 

Interestingly, Berkshire Hathaway Inc. is a big investor in DaVita, and Berkshire's Warren Buffett and Charlie Munger were critics of Valeant Pharmaceuticals International for similar insurance structuring. Or, they were sort of admiring critics:

Charlie Munger, Berkshire’s 93-year old vice-chairman, who has long been a student of what he calls the Psychology of Human Misjudgment, said: “The main thing that Valeant did that was unbelievably clever was to pay the consumers part of the deductible for the drugs they were selling…they paid the consumer share of the deductible and tried to pretend that it was a charitable contribution, when really it was the functional equivalent of bribing the other fellow’s purchasing agent.”

A vast majority.

Here is a Securities and Exchange Commission enforcement action against Aegerion Pharmaceuticals, a "biopharmaceutical company that exaggerated how many new patients actually filled prescriptions for an expensive drug that was its sole source of revenue," and that agreed to pay $4.1 million to settle the case. The problem is that Aegerion told investors and analysts that the "vast majority" of people who were prescribed its expensive cholesterol drug actually went and took (and paid for) that drug. But in fact, as Aegerion's executives knew, "it was actually around 50 percent of prescriptions that resulted in actual drug purchases." Really it seems to have been a bit more than 50 percent -- a majority, but a vast one? "'By no one’s math is 50 percent a vast majority,' said Paul Levenson, Director of the SEC’s Boston Regional Office," and I appreciate him striking a multi-million dollar blow for the notion that language means something.

Bank regulation.

Here is "Optimal Bank Regulation in the Presence of Credit and Run Risk," by Anil Kashyap of the University of Chicago, Dimitrios Tsomocos of Oxford and Alexandros Vardoulakis of the Federal Reserve, who build a model of the banking system with some realistic features, and find sort of what you would realistically expect:

The bank’s choices of both the mix between the level of liquid and illiquid assets and between debt and equity differ from what a social planner would select. The private equilibrium features excessive levels of lending relative to liquid asset holding and more debt financing relative to equity financing. Because of the market incompleteness there is not a unique social planner’s allocation. Instead the preferred allocations will depend on the planner’s weights on the different actors in the economy. Loosely speaking, when the planner favors the savers, she will choose to limit risk while emphasizing liquidity provision for depositors. Alternatively, if the planner is primarily looking out for borrowers, the allocations are arranged to control run risk while increasing lending.

Also bank regulation works kind of like you'd expect: "Capital regulations result in more lending, but in lower liquid asset holdings than it is socially optimal," while liquidity requirements "reduce lending, but leave the level of capital below the social optimum." So you need both.

People are worried that people aren't worried enough.

Here you go: Last week the S&P 500 Index traded within a range of about 12.3 points, or about 0.5 percent, "something the S&P hadn't done since September 1972." And of course people are worried that low volatility today means high volatility tomorrow:

But history has shown that tight trading ranges often get undone in a violent way. So daily moves of 1% or more in coming days are likely, even though they have been a rarity this year.

People are worried about unicorns.

Here is a story about how some men in the technology industry worry that there are not enough men in the technology industry. I know, I know, but it is somehow even weirder than you'd expect:

One radical fringe that is growing is Mgtow, which stands for Men Going Their Own Way and pronounced MIG-tow. Mgtow aims for total male separatism, including forgoing children, avoiding marriage and limiting involvement with women. 


“No eyebrows are going to rise if a woman heads up fashion,” Mr. Parsons said. “But we’re talking about women staffing positions — things like autos — where it cannot be explained other than manipulation.”

James Damore, the guy who was fired from Alphabet Inc. for writing an obtuse memo and who has extended his time in the public eye with a just-hear-me-out-the-KKK-has-some-cool-ideas Twitter presence, features prominently.

Elsewhere: "Uber Tries Compromise With London Regulators."

Things happen.

The European Banking Landscape Has New Powerhouses: French Lenders. Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records. Steve Cohen just took a big step forward in his comeback with a massive new hedge fund. BOE Seeks Brexit Deal for Trillions in Derivative Contracts. Why a BlackRock Legal Victory Could Make It Harder for ETF Investors to Sue. Zynga’s #WTF IPO lock-up. Activist Funds Seek Ouster of Tuesday Morning CEO. Trump Says He Wants 15% Corporate Tax Rate Despite Plan for 20%. Trump Tax Plan Said to Cut Taxes for Wealthy and Whack NY and NJ. Utility company Pepco buys hamster for girl after Petco letter goes astray.

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(Corrects second item to reflect that Facebook shareholders did approve its triple-class stock split, although the company never implemented it.)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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