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Inside Investment: Arbitrage – over the limit

The global financial crisis might mark the beginning of a broader realization that global hyper-capitalism has reached its limits. The failure of the AstraZeneca/Pfizer merger shows that, for good or ill, a backlash has begun.

Practitioners know that finance theory is mostly guff. The efficient market hypothesis and its bedfellow, the capital asset pricing model, have been discredited by recurrent booms, busts and crises. 

Diehard quants might pay lip service to the merits of mean variance optimization, but ones with any credibility accept that neither input can truly be knowable: it is garbage in, garbage out.

The fetish of misapplying science to economics began with Paul Samuelson’s Foundations of Economic Analysis in 1947. But economics remains the dismal science for good reason. Hard science, from Heisenberg’s uncertainty principle through to chaos theory, has long embraced complexity and the near impossibility of full knowledge.


However, one branch of theory had a very good crisis, behavioural finance. In March 1997, Andrei Schleifer and Robert Vishny wrote a paper in the Journal of Finance titled “The limits of arbitrage”. It argued that: “When arbitrage requires capital, arbitrageurs can become most constrained when they have the best opportunities.”

This theorizing was given an empirical boost barely 18 months later. Long Term Capital Management, a hedge fund with two partners, Robert Merton and Myron Scholes, who shared an MIT heritage (and a Nobel Prize in economics) with Samuelson, got into serious trouble and was bailed out by a consortium of banks. LTCM did not collapse because its views were wrong. It failed because it could not fund itself.

Limits of arbitrage

Finance is a complex system. It is adaptive and subject to feedback loops, and extreme events are far more likely than normal distributions allow for. The corollary of their value-at-risk measures telling Wall Street’s dealers to cut positions after the Russian domestic debt default was to demand ever more margin to fund lookalike positions at LTCM.

The precursor to the financial crisis, the August 2007 quant quake, was similar. Supposedly diversified 130/30 funds saw correlations converge on one as they dashed for the exits at the same time. But the biggest vindication of the limits of arbitrage came a year later.

The underlying securities in the structured investment vehicles and conduits funding the global banking system suffered catastrophic mark-to-market losses after the collapse of Lehman Brothers. Many banks were technically insolvent. But those that survived, by hook, crook, or government bailout, saw many of those securities eventually mature at par.

A recent paper by the Federal Reserve Bank of New York shows that even in its darkest hour the banking system performed its market-making role*.

Risk was warehoused and distributed and clients could carry on trading. Corporate bond inventory actually rose. The Volcker Rule and new capital requirements have led this inventory to fall by more than two-thirds. In finance, the limits to arbitrage, already real, have risen.

The banking system took global capitalism to the edge. It is not surprising that policymakers have decided it should be reined in. What is interesting is what this could portend more broadly. Bankers were in the vanguard of global, hyperactive capitalism. Their funding wheezes from Michael Milken to CDOs fuelled a boom in trading, M&A, private equity and LBOs, across borders and around the world.

There has been a pervasive sense that not joining in was akin to being passed by. If a CEO was not on the acquisition trail, not taking those calls from investment bankers desperate for deals and fees he (sorry, it is still mostly a “he”) was regarded as being in dereliction of his duty.

Adderall for finance?

In 1997 a US company called Richwood Pharmaceuticals was taken over by Shire of the UK (currently domiciled for tax reasons in Ireland). Richwood had developed a drug called Adderall. This treats an “illness” that until relatively recently in the history of human malady no one had diagnosed or knew existed, attention deficit hyperactivity disorder (ADHD). In the parlance of the pill pushers, Adderall quickly became a blockbuster drug.

Now another potential trans-Atlantic tie-up of two pharmaceuticals companies is in the news again. But AstraZeneca and Pfizer will not be merging, for the time being at least.

Leaving aside the weasel words of its PRs, it is clear that the real motivation for Pfizer’s approach was an arbitrage.

By a process known as inversion, the $99 billion bid would have secured a UK domicile for the US drugs company and a headline corporate tax rate on earnings of 21% rather than the 27% it is paying in the US. Further, UK companies do not pay taxes on overseas earnings and Pfizer could have taken advantage of a “patent box” scheme, which makes the tax rate on UK-patented products 10% from 2017.

The 30% premium Pfizer offered to AstraZeneca’s shareholders should have been enough to secure its prize. Before the global financial crisis it might well have succeeded. But, having reined in the bankers, policymakers are now suspicious of the hyperactive global capitalism they spawned. Deals driven by tax benefits with little regard to the public good will come under particular scrutiny.

The limits to arbitrage are rising everywhere.

* Jaewon Choi, Or Sachar, “Did liquidity providers become liquidity seekers?” Federal Reserve Bank of New York, Staff Report No. 650, October 2013

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