The Man Who Made CDS Interesting
Also an insider-trading roundup, crypto, and circular art.
Akshay Shah, a former managing director in Blackstone Group LP’s GSO Capital Partners debt-trading unit who seems to deserve most of the credit for inventing the concept of a “manufactured default” on credit-default swaps, sounds like the kind of guy I’d like to have a beer with:
People familiar with his trading style say he pores over hundreds of pages of bond or loan documents, trying to find tiny details that others in the market might miss. Once he identifies chinks in the wording of particular clauses he plots a way to construct trades using derivatives on whether a company will default on its debts, which would lure rivals to take the other side.
That’s from this Financial Times profile of Shah and the world he has created, which we have discussed many times recently. (Particularly in reference to the Hovnanian trade, which GSO did after Shah left but which was patterned on his approach.) I am serious about the beer thing. Perhaps I am weird, but I can think of few more interesting topics of conversation than how to construct credit-derivative trades to exploit contract wording for profit. It’d be like discussing painting with Picasso.
Also, read that description of what Shah does, and then imagine doing distressed-debt trading a different way. “Oh I don't read the loan documents, I just figure they will work the way I expect them to.” “Oh I don’t spend any time thinking about how bond clauses can be exploited, I just figure no one will bother.” “Oh I assume the rest of the market knows what they say so I don’t have to put in the effort myself.” Shah’s approach is self-evidently correct, and if he puts one over on his competitors, then they are the ones who should be embarrassed and ashamed. Someone writes those documents for a reason! You gotta read them.
This, I realize, is a minority view, and for some understandable reasons. Yes: The documents really should work the way everyone expects them to, and if they regularly don’t, then that is a problem with the documents—though not, I think, a problem with Shah’s approach to them. You might also worry about insider-trading risks, about a loss of confidence in CDS markets, etc.
But there is also a very popular and very wrong objection to the clever exploitation of CDS that I want to address here. From the FT profile:
“I compare it to sports gambling,” says Aitan Goelman, former head of the US Commodity Futures Trading Commission’s enforcement division, about manufactured defaults. “If gamblers went out and paid players to throw games, everyone would intuitively know that was fraudulent. Highly sophisticated and not particularly upstanding actors are looking for any edge they can get: if they see areas of the law that are vague or poorly defined, they see this as an opportunity.”
Goelman is not alone; people are constantly comparing CDS trading to sports gambling. CDS traders are betting on whether a company will default or not, and if they work with the company to influence that outcome, they are cheating just as simply as they would be if sports gamblers paid a team to influence the outcome of a game.
This is a terrible analogy. The purpose of CDS markets can’t be just to provide a venue for zero-sum bets by disinterested bystanders. CDS was invented as a way for banks to hedge their credit risk of making loans to companies. Its paradigmatic use case is as a hedge for lenders, or bondholders, or trade creditors, or derivatives counterparties, or anyone who has an actual exposure to a company. And people who are actual creditors of companies regularly negotiate with those companies about debt exchanges, restructurings, etc., particularly but not exclusively when the companies are in distress. That is normal and desirable; a world where distressed debtors couldn't negotiate with their creditors would be worse than our actual world. You want companies who run into trouble to be able to go to their lenders and try to work something out, rather than just shut down.
You could imagine a world where CDS was limited to disinterested bystanders, where you weren’t allowed to trade CDS if you had a relationship with the reference issuer. But, why? If you took away “hedging actual credit exposure” as a purpose of CDS, what is left? “Fun gambling”?
Consider the wheat futures market. Big wheat growers, and big industrial users of wheat, are among the big users of the futures market. All of those people have some inside information and some ability to influence the production of or demand for wheat. You could imagine someone coming along and saying “well that is unfair, that is like rigged sports gambling, we should ban that.” And then the wheat futures market would be left to pure disinterested punters, and would be a pure betting product rather than a hedging product. But that would be obviously worse, and in fact you much more often see calls to ban disinterested speculators from the wheat futures market, and to limit it to “real” participants.
You see the same thing in CDS too, in Europe’s ban on “naked” sovereign CDS trading. The idea there is that you should only be able to buy CDS if you have some hedgeable interest—roughly, some creditor relationship—with the issuer. That is precisely the opposite of how sports gambling works.
Or you could imagine a world in which CDS traders who do have a creditor relationship with an issuer aren’t allowed to negotiate with the issuer. But again that is worse, because it makes it harder for distressed issuers to work out their problems. If banks regularly hedge their loans with CDS, then companies that run into trouble won’t be able to work it out by negotiating with their banks, and there will be more unnecessary defaults. “Our financing solutions were determined in competitive processes and provided the most favourable terms and crucial financial support to businesses with thousands of employees,” says Blackstone about its default-manufacturing operation.
By the way it’s not just manufacturing defaults; sometimes GSO will be on the other side and will manufacture non-defaults. The FT mentions the Norske Skog trade, where GSO’s approach involved “charging other hedge funds large premiums to bet on a company’s rapid demise before doing everything possible to keep it alive for long enough to avoid having to pay anything out.” That is not far off from my hypothetical case of a CDS buyer offering a distressed company favorable financing to get it out of distress.
Yes sure you could find something a bit cynical in some of these particular trades; Norske Skog was bankrupt 18 months after it avoided default under its CDS. But to have a general rule that CDS traders shouldn’t be able to negotiate with issuers seems to miss the point of credit markets, or of derivatives, or both. If derivatives are pure speculative bets, hermetically sealed off from having any effect on events in the real world, then what is the point of them?
Elsewhere, here is a profile of Mark Brodsky of Aurelius Capital Management, who also reads the documents, and uses them against distressed (often sovereign) issuers. “Many think of Aurelius as a suppository for the distressed industry,” says one critic.
On Friday, about an hour before the monthly jobs report came out, Donald Trump tweeted an enthusiastic preview, which caused financial markets to move as they anticipated the jobs numbers. A bunch of people tweeted at me variations on “is this insider trading ha ha,” which strikes me as a boring question to which the answer is “of course not”: Few things in the universe are more "public” than Donald Trump’s tweets, and if you traded on them I think you have a pretty ironclad case that you were using only public information.
A related question is, did Trump violate any rules by tweeting about the jobs report before it came out? There I am not an expert, but it seems like the answer is (1) sure, a little, but also (2) there is a case—made frequently by him and his lawyers!—that no rules apply to him so, you know, whatever.
But here is a possibly interesting related hypothetical. Trump got the job numbers a day before they came out, and it seems like he spends his evenings chatting on the phone with his rich buddies: If he told any of them about the jobs report, and they traded on that information, is that illegal insider trading? (It seems unlikely to me that this happened but one can’t rule it out.) Assume that they received material nonpublic information and traded on it; the classic questions for insider-trading law would then be:
- Did Trump have a duty to keep the information confidential, and
- Did he receive some “personal benefit” for breaching that duty?
Question 1 strikes me as difficult: There are rules against early commentary on unreleased jobs numbers but, again, the position of the White House’s lawyers is that no rules apply to the President, and I think it is plausible to argue that he can waive executive-branch rules for himself. (Can he do it … just to enrich his cronies? I … hope not … and yet … ?)
Question 2 is mostly factual: If he gave out information to his cronies with the expectation that they’d do more business deals with his family, or that they would say nice things about him on television, then that would presumably be enough of a personal benefit to count as insider trading. But what if he did it just to brag, because he enjoyed bragging? I think that before the Second Circuit’s Newman decision most courts would have said “sure, knock yourself out, bragging for personal enjoyment is enough of a personal benefit to count as insider trading.” Newman definitively rejected that approach—but then the Supreme Court partially rejected Newman, and now the law of personal benefit is somewhat unsettled. If you came to me and said “a corporate executive just bragged to me that his upcoming quarter will be better than expected, just because bragging makes him feel good, can I trade on that,” I am not sure what I would tell you. I mean I would never tell you anything because I do not give legal advice, but even if I sometimes did, I would abstain here.
Elsewhere in insider trading, here is an utterly bizarre story about Heartland Payment Systems LLC’s lawsuit against its former chief executive officer, accusing him of insider trading in Heartland’s stock. The accusation is that the CEO, Robert Carr, told his girlfriend, Kathie Hanratty, to buy a bunch of Heartland stock just before it was acquired by Global Payments Inc., and Heartland’s complaint is full of emails from Carr to Hanratty disclosing important nonpublic details of the acquisition talks. (Also, after the acquisition, he emailed her to say “We need to chat tonight – about FINRA. FINRA is researching stock purchases prior to Dec 15th,” to which she replied “What is Finra?”) It is all a bit brazen, but not that unusual. What is so bizarre is the response from Carr’s lawyer:
"What Global characterizes as a ’scheme’ by Bob Carr to profit illegally, was in fact a planned sale of Heartland stock, ahead of the Global acquisition, that resulted in a significant tax liability that exceeded the profit from Ms. Hanratty’s lawful investment," McGovern said. "Also, Global officials are fully aware that Mr. Carr sought and received prior authorization from Heartland’s chief legal officer for all of his stock transactions.”
I … can you do that? Like, if you have a pre-planned sale of stock ahead of an upcoming acquisition, and if you’ll miss out on the acquisition premium because of the planned sale—and have to pay taxes!—can you just have your girlfriend insider trade on the acquisition to make up for it? That might not be my advice, but like I always say, I don't give legal advice, and apparently a lawyer did give this guy that advice?
Oh and here’s a story about a former Goldman Sachs Group Inc. vice president who allegedly “gambled his career on a series of trades using inside information about the bank’s clients, including one that netted him $362,” which, come on man. (“In total, Jung is accused of making $140,000 in illegal profits by trading through an alias brokerage account tied to a friend in South Korea.”) Honestly every time people who work at big banks and law firms get caught insider trading, they always seem to have made amounts of money that are pretty piddling by the standards of their careers. Like, sure, throw away your banking career for one $20 million score, be my guest. (Not legal advice!) But if you are constructing a trade that, on the downside, might get you fired, banned from the industry and sent to prison, and on the upside might net you $362, then … well, then perhaps you shouldn’t be in the financial industry, is one conclusion.
Last week cryptocurrency trading platform “Poloniex LLC suspended trading and withdrawals until clients upload new documentation required to verify accounts, spurring concern among some users that they won’t be able to recover their funds.” This is no doubt a natural part of cryptocurrency platforms growing up and becoming more careful about compliance (Poloniex was recently bought by Circle Internet Financial Ltd., which is backed by Goldman Sachs), and will probably work out fine for Poloniex’s legitimate customers, but it also suggests a really sweet scam:
- Open a cryptocurrency trading platform with minimal compliance and know-your-customer procedures.
- Watch every shady money launderer, sanctions violator, drug dealer, etc., flock to your light-touch platform.
- Pivot to legitimacy and demand a high standard of KYC documentation.
- Watch all those money launderers, etc., be unable to get their money out.
The good news is that all the money launderers, etc., probably aren’t going to sue you, or get a sympathetic hearing if they complain to the regulators. The bad news is that they might have other enforcement mechanisms available.
Elsewhere, block.one’s EOS token offering “has raised more than $4bn in a year-long auction, topping nearly all initial public offerings this year in the latest testament to demand for ways to participate in cryptocurrency,” but also hackers are stealing a lot of it by emailing buyers with an offer “to ‘claim’ EOS’s ‘unsold tokens’ during the last 48 hours of the ICO”:
The button takes you to a website that is identical in color, background, font and other design elements to the EOS homepage. The only problem is the scam site’s web address is “eȯs.com,” a nearly imperceptible dot above the o—a diacritic mark only found in the dead language of Livonian, once spoken in parts of Latvia.
And then you enter your private key, and it steals all your cryptocurrencies, and the future of money and finance is great.
Oh and here’s a paper about initial coin offerings by Leonard Kostovetsky and Hugo Benedetti of Boston College, who find that they’re a great deal, buy all that you can:
Initial coin offerings (ICOs), sales of cryptocurrency tokens to the general public, have recently been used as a source of crowdfunding for startups in the technology and blockchain industries. We create a dataset on 4,003 executed and planned ICOs, which raised a total of $12 billion in capital, nearly all since January 2017. We find evidence of significant ICO underpricing, with average returns of 179% from the ICO price to the first day’s opening market price, over a holding period that averages just 16 days. Even after imputing returns of -100% to ICOs that don’t list their tokens within 60 days and adjusting for the returns of the asset class, the representative ICO investor earns 82%. After trading begins, tokens continue to appreciate in price, generating average buy-and-hold abnormal returns of 48% in the first 30 trading days. We also study the determinants of ICO underpricing and relate cryptocurrency prices to Twitter followers and activity. While our results could be an indication of bubbles, they are also consistent with high compensation for risk for investing in unproven pre-revenue platforms through unregulated offerings.
Also consistent with high compensation for the risk that your tokens will be stolen I guess. An 82 percent return on the tokens doesn’t mean an 82 percent return for the investors, if the hackers are the ones who end up with all the tokens.
I don’t know much about art but I know when it’s round.
Here’s Steve Cohen contrasting the artistic tastes of his Point72 Asset Management LP employees and his own tastes:
“They like the art that’s square or rectangular,” the hedge fund billionaire said. “Anything circular they hate.”
“He’s being cryptic,” art adviser Sandy Heller interjected as they dined on pan-seared chicken with sweet pea pesto. “He means geometric abstraction.”
“No, I’m serious,” Cohen said. “They don’t like circles. I like circular things.”
This sent me down a deep rabbit-hole of imagining Steve Cohen as an art connoisseur:
Adviser: Here we have the de Brécy tondo, a controversial work sometimes attributed to Raphael.
Art historian: The attribution to Raphael is based largely on stylistic similarities to the Sistine Madonna that is securely attributed to him.
Chemist: The attribution is further buttressed by chemical analysis of the pigments and glue, which can date the painting prior to the 1700s, despite the presence of 18th-century Prussian blue in some touch-up work.
Adviser: Or you could buy like three hundred Damien Hirst spot paintings.
Also the story opens with an anecdote about how Cohen doesn’t know what artwork is hanging on his office wall because “he’s ‘way too busy’ to look.” He’s way too busy to look at the art that he spends hundreds of millions of dollars collecting. Must be …. nice?
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