Regulators are belatedly showing signs that they are thinking about potential market abuses from first principles. The broadening of the Libor investigations into the role played by interdealer brokers, a case against Nymex and two employees for divulging flow information and the pursuit of insider-trading allegations against employees of hedge fund SAC are all examples of regulators tackling potential abuse from the important principle that if it looks like a duck, swims like a duck and quacks like a duck, it may well be a duck.
This phrase gained popularity during the Red Scare witch-hunts in the US in the 1940s and 1950s, which is a useful reminder that allegations of impropriety have to be backed with evidence and that there is always a presumption of innocence.
But an understanding of motivation is nevertheless key to helping regulators to minimize abuses, especially in opaque sectors of the markets.
The potential involvement of interdealer brokers in the Libor scandal was obvious once the scale of the rate-fixing began to emerge. The continuing sturdiness of interdealer voice-broking revenues in markets such as rate derivatives is a puzzle that might exercise a free-market economist with limited experience of the City of London or Wall Street.
Online systems have been in place for many years that can be used to facilitate trades in swaps or bonds and save on brokerage fees. The traditional role of the broker in providing hospitality of many different forms has also been eroded by new rules on accepting gifts, as well as a trend towards the hiring of duller, more quantitatively oriented employees on the part of banks.
Yet the voice broker endures and is still a reliable source of business in the bars around Liverpool Street in the City of London. The value added by these brokers is often described as providing market colour, as though they are cherished for their views on the likely direction of rates and spreads. The most useful colour comes from tangible information about trading flows by other market participants. This information exchange has obvious potential for conflicts of interest even when it is relatively benign, as brokers will clearly be motivated to give priority to the clients that pay the highest commissions. The vulnerability of brokers who are almost entirely dependent on commissions to pressure to commit outright market abuse was demonstrated in the transcripts provided by the Financial Services Authority and the Commodity Futures Trading Commission in their most recent expansion of the Libor cases. When traders at banks including Barclays, RBS, UBS and others yet to settle with regulators worked to make their rate-fixing more efficient they naturally turned to brokers to help to coordinate quotes. Evidence of noneconomic wash trades to reward brokers for this work has already been presented and more is likely to follow.
One area where regulators do not yet seem to have made progress is investigation of the potential involvement of buy-side firms in rates market abuse. Hedge funds were not directly involved in setting Libor or Euribor, which are interbank rates. But bank dealers have a motivation to keep clients happy that is comparable to the dominant role they play in relation to their own interdealer brokers. And hedge funds, at least in fixed-income trading, are almost entirely staffed by former bank dealers who are well versed in exploiting quirks in market dynamics. Regulators interested in the quacks-like-a-duck approach to malfeasance would be well advised to step up their investigation of funds that employ veterans of banks that were involved in the rate-fixing scandals.
The revival of the leveraged buyout market could also be a fruitful area of enquiry for regulatory investigators. (Will their work ever be done? No.) The SEC was refreshingly quick to react to evidence of a suspicious trade in Heinz call options ahead of the recent announcement of its deal to be acquired by Warren Buffett and 3G. Proceeds of a $90,000 option trade that would have yielded $1.8 million were frozen, and rightly so. Heinz credit default swap spreads also jumped as the deal was announced, going from 45 basis points in the five-year to over 200bp. The return on a well-timed CDS trade was not quite at the level of the stock option, but at well over 400% it still wasnt too shabby. Credit spread movement strongly indicated that leakage of information from banks to hedge funds was rampant during the last LBO boom. Regulators should act quickly to ensure that history does not repeat itself.