Insider Dealing or Insiders Scheming?

In the early 1990s, when Britain was in deep recession and banks and investment banks were under nasty financial pressures, the new Chairman of the Securities and Investments Board started a crusade against insider dealing. We all thought his obsession bizarre as London was then widely regarded as being the cleanest securities market in the world. Largely institutional, dominated by 25 or so market makers and fewer than 200 significant fund and pension managers, abnormal conduct was easily detected and brutally sanctioned. Since the average trade size in the cross-border market exceeded $270,000 and in UK stocks exceeded $80,000, it was very difficult for anyone to undertake a pattern of activity that went unscrutinised by their peers. NatWest (Blue Arrow) and Goldman Sachs (rigging the FTSE 100 options expiry) found to their cost at the time that their market counterparties and clients were very unforgiving of misconduct. A director of Goldman Sachs complained to me then that London was their least profitable operation globally.

Nonetheless, the SIB Chairman instigated a crusade, rallied the government, demanded tougher investigative powers and tougher penalties, and carried on as if London were a cesspool of corruption. We scratched our heads and wondered at it. He was and is a good man, even if we thought his efforts then over the top.

While insider dealing prosecutions never picked up much, he succeeded in imposing strict new transparency rules on the London Stock Exchange which quickly eroded its global dominance of equity markets. Transparency made market making impossible, as market makers need time to work a large order to quote a fine spread in institutional size from their own capital. Market making on the basis of quotes was gradually abandoned in favour of electronic order routing systems that transacted thousands of small orders dribbled out piecemeal into automated execution systems instead of finely priced large orders in size. From over 85 percent of global cross-border equity trading going through the London Stock Exchange at the peak in 1991, London’s market share collapsed as trading fragmented to smaller, more opaque markets elsewhere and to derivatives. Goldman Sachs profitability soared as the London Stock Exchange declined.

In this week’s announcement that the SEC will remove insider dealing enforcement from exchanges and concentrate it in two mega systems policed by NYSE and FINRA, I get an echo of this earlier era. I hope I am wrong, but it would not surprise me if once again police powers of regulatory authorities are used – with or without their conscious collaboration – to rig the market in favour of preferred models of interaction and preferred intermediaries.

Insider dealing is no more a threat to market integrity now than it was five years ago, ten years ago, or twenty years ago. If anything, insider dealing is more rampant in bull markets than bear markets.

On the other hand, it is true that insider dealing was much easier to detect when all dealing in securities was concentrated on exchanges rather than fragmented to multiple automated systems, dark pools and cross trading networks. It is also true that insider dealing was easier to detect before half the market volume fragmented to 8,000 unregulated hedge funds.

My concerns may have started with an echo of the UK in the 1990s, but they are aggravated by the pattern of state control and abuse of information observed over the past twenty years in the USA. George H.W. Bush created the “War on Drugs” in 1981 as vice-president of the United States to gain federal authority to monitor bank transactions and telecommunications and to seize property from anyone targeted by his special squads of DEA agents who were empowered to act outside normal due process and judicial review. Reagan then declared the “War on Terror” which Bush intensified as president later that decade, arrogating to himself and US intelligence agencies even broader powers beyond the review of democratic checks and balances. That morphed into the “War on Terror” under George W. Bush, who gained even more powers for the state to spy on its citizens and treat everyone as guilty until proven innocent, extrajudicially arrest and detain citizens and non-citizens alike, render them for torture globally, and otherwise abuse government powers.

It all started with sweeping up huge streams of data into unreviewable hands weilding huge power to seize and redistribute wealth. Forgive me then if I am sceptical when the SEC wants to protect investors by further concentrating both information and police powers.

The imposition of huge data sweeps in the name of “anti-money-laundering” in the banking sector and combating “insider dealing” in securities markets reeks of the same tactics and objectives as telecoms or internet search engine sweeps to the NSA.

Ronald Reagan once quipped that the biggest lie was, “I’m from the government and I’m here to help you.” Given the pattern of abuse in his administration, and the subsequent treatment of US workers and taxpayers, he may have been more truthful than he knew. So what should we think when we hear, “I’m from the SEC and I’m here to protect you”?

Needless to say, the more data collection and police powers are concentrated in a single authority, the more difficult it becomes for anyone to contest an investigation or enforcement action by that authority. Without objective protections, alternative sources of confirmatory data, guarantees of judicial review and due process, it becomes impossible to challenge the arbitrary use of authority or the deliberate misuse of authority.

Think of just one scenario: a target firm becomes the subject of a very public investigation and charges. Its share price collapses, and investors flee. Enter a well-funded vulture fund who takes out the very best assets and a very well-connected competitor who sweeps up the choicest clients.

I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.

I would like to see more substantiation of the rationale for centralising data collection and enforcement, and more controls on the abuse of information and powers, before trusting that the regulators are acting in the interests of investors and of the greater economy as a whole.

Why not have an open database of anonymised transaction data that is reviewable and searchable by all market intermediaries and investors?  That would allow anyone to investigage suspect patterns of transactions for reporting.  But then that might catch the wrong people in the net and expose too many to scrutiny.

It has taken me many years to understand my discomfort with reforms in the early 1990s recession. I am worried that the proper function of markets in the intermediation of capital investment so critical to the prosperity of any economy may be further distorted and eroded. If competition is so good for capitalism, then surely markets should have to compete to demonstrate their ability to uphold efficient price discovery and market integrity. Regulators too should have to compete if only to promote vigilence in each other by maintaining reputation risk.

Harmonisation of market structure and regulation may be harmful if it tends toward sub-optimal choices. Without competition and independent data collection, we may never be able to prove that the choices our regulators make for us are not in our best interest.

7 Responses to "Insider Dealing or Insiders Scheming?"

  1. John M.   August 15, 2008 at 7:58 am

    Thanks for a very important post.

  2. Diane DeSanders   August 15, 2008 at 5:39 pm

    This is a great article!Oh what a tangled web they weave in order to continue to deceive.To mix metaphors, the fraudulent system is like a virus that must work its way through every mechanism and molecule of the organism in order to perpetuate itself or die. The stronger the organism, the longer the process of turning every healthy cell to its uses can continue.It’s a Night of the Living Dead nightmare kind of thing! To further mix metaphors!

  3. Guest   August 16, 2008 at 3:53 am

    “Without competition and independent data collection, we may never be able to prove that the choices our regulators make for us are not in our best interest.”@ LBI am in my late ’60’s and my Grandfather – a wise man – told me “Son, never trust the government or a Banker.”You can be assured that temptation will always be taken up and it has always been, that temptation is always placed in the control of the “regulators”.I have also spent a large part of my life as a “company doctor” where my first rule is to look for the scam. There are always internal scams, and the largest ones are run by Board members.Give me a company and I will find you a scam – without exception.Ho hum

  4. suecris   August 16, 2008 at 5:46 pm

    I’m confused, and it may be (probably) because I’m not understanding your post completely. First you say that GS suffered and complained of unprofitability in London when caught in misconduct in the very transparent London market of the early 90s. Then there was a crackdown (however unmerited). GS’s profitability (presumably in the U.S. and other outside of London markets) soared. You seem to be saying that the SIB chairman in those days was (perhaps unconsciously) helping GS to succeed. “I get an echo of this earlier era. I hope I am wrong, but it would not surprise me if once again police powers of regulatory authorities are used – with or without their conscious collaboration – to rig the market in favour of preferred models of interaction and preferred intermediaries.”And yet you still say he was/is a good man?Will someone in 10-15 years say that Paulsen was a good man for consciously or unconsciously helping GS with these new regs and regulatory models?I know I’m missing something.p.s. – did you decide not to cross-post your RGE writings to your blog? I check that fairly often since it’s easier to find your postings than in the RGE maze.

  5. Free Tibet   August 17, 2008 at 8:13 am

    Vacationing, can’t respond adequately to this very important post.Brought this with me to read on the beach:The Shock DoctrineBy Naomi KleinISBN: 978-0-312-42799-3Suppose I shouldn’t comment too extensively until I’m finished with it, but it bears directly on the fears you express above.

  6. Clam Amity   August 17, 2008 at 4:01 pm

    Getting grimer and grimer in grim town. We’ve (United Statesans) become our pet bogey-men through time. Wars of oppression waged because of lies…er intelligence errors. Exploitation of the innocent and naive, and those still clinging to the ideas of meritocracy, equality, true opportunity. The USA (and by the spread of its culture epidemically) and the world are becoming the sort of people expelled or refused formerly by good society (or London social clubs). Gain by any cost, prevailing in competition by any means, disrespect for integrity, speculation preceding investment, pawnshops as paydirt, paper trading surmounts sweat & tears production. These days of history are where dreams fade from rich techicolor to grayscale. Where the lively diversity of men’s grand dreams and creations collapse into a dull, common sameness; where everyman wears the same dull, common languishing look of desperation subdued. We live in a time where capitalists made war on socialist/communists only to find (after presumptive victory) that they seeded their own institutions and palaces with the very same tendency.Freedom, the real sort–the sort hedged about with high conduct and instinctive morality, is vanishing. It has been hunted about and extinguished by man’s perennial baseness and his making claim on his fellow man. Son on father, father on son, neighbor on neighbor each presumes a due–the collecting of which has bankrupted us. The compleat man, the unsullied man, the blameless man is nevermore. Extinct. Now is where we have defaults and failure to deliver upon the invisible forms of mankind’s honor. No true north in any moral compass. No longer absolutes. Everything must be discounted, debased, mitigated, confounded, contrived, and alloyed. Our financial system and mankind’s means of producing and distributing and underwriting is infiltrated by an insidious plague. It has infected and riddled all its hosts. And none are spared. Calamity.

  7. Guest   August 17, 2008 at 4:46 pm

    @LB” I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.’When you link the facts together in the US, aren’t we already under a single authority? Fact number one: the New York Federal Reserve has a permanent seat in the Federal Reserve System. Why is that? Fact number two: noboby gets nominated for US president without the approval of one specific bank – Goldman Sachs. It is obvious why the presidents are only picking Goldman Sachs people or Sachs’ approved people for the Treasury, either former or future Goldman Sachs people.Wlhen Bernanke has to make big decisions, his records have shown he calls Goldman Sachs.The president of the World Bank, headquartered in New York City, is from Goldman Sachs.The Secretary of the Treasury is from Goldman Sachs.Goldman Sachs gives regular analyses of companies, buy and sell recommendations. It has been involved in scandal since the 1930s but always manages to come out unscathed. The major beneficiary of the Mexican bailout orchestrated by U.S. treasurer Robert Rubin in opposition to Congress, according to Pat Buchanan, was Goldman Sachs – which shows you who really controls taxpayer money.Said Buchanan: “The career of Robert Rubin is instructive. As lead pony at Goldman Sachs, he led that investment bank into plunging billions into Mexican bonds. As head of the White House Economic Security Council, he failed to see the Mexican default barreling up the tracks. But as treasury secretary, he was able to shovel billions of U.S. dollars down Mexico way, thus saving the Goldman Sachs investments.”( are the foreign countries Goldman Sachs is dealing with, going through the World Bank? The fact that Wolfowitz could be appointed to the World Bank with his background connection to the Department of Defense and Project for the New American Century makes it ludicrous to think Rumsfeld was in charge of anything at the Department of Defense.As the New York Times said in November of 2007 in its commendatory article “Goldman’s Shadow Extends Far Past Wall St.”:As John A. Thain prepares to take the reins of Merrill Lynch, he is only the latest example of a tradition borne out across Wall Street, in Washington and around the world. He is a Goldman Sachs alumnus who has reached the top elsewhere.For decades, one investment bank in Lower Manhattan has churned out a golden list of corporate executives and statesmen, wealthy financiers and nonprofit managers.In many ways, Goldman Sachs is seen as the financial world’s equivalent of General Electric, the corporate powerhouse…Goldman claims among its alumni Henry M. Paulson Jr., the current Treasury secretary; Robert E. Rubin, a Treasury secretary under President Bill Clinton and now Citigroup’s chairman; and Mario Draghi, the Bank of Italy’s governor. Jon S. Corzine, New Jersey’s governor, led Goldman for several years. Joshua B. Bolten, the current White House chief of staff, is a Goldman alum.Mr. Thain, who left Goldman as president and chief operating officer to take over the troubled New York Stock Exchange and now Merrill, falls squarely in that tradition.To insiders, all this is a result of Goldman’s elite culture, a sense of close-knit partnership that has endured despite the firm’s decision in 1999 to turn itself into a publicly owned corporation. To detractors, the firm is alternately a cult or a secretive fraternity like Skull and Bones at Yale, one focused on profits and power.The bottom line on Goldman is that it is stocked with bright people who practically mint money. Even as the implosion of the subprime mortgage market forced many of its rivals to take multibillion-dollar write-downs this summer, to cite just the most recent example, Goldman reported a 79 percent increase in profit… (And we all know the story of how Goldman Sachs was chief bundler of the toxic waste and shorted it before it all blew…)“It’s a partnership culture that truly ruthlessly weeds out people,” said Brad Hintz, a research analyst at Sanford C. Bernstein who has worked for two Goldman rivals, Morgan Stanley and Lehman Brothers. “It’s the most elite group.”Goldman is a perennial leader in the lucrative practice of advising on mergers and acquisitions. Its few recent mistakes, including troubles at several internal hedge funds, are subsumed by its eye-popping financial results…Goldman is also known for its insularity. Roy C. Smith, a professor of finance at the Stern School of Business at New York University and a former Goldman executive, noted that relatively few employees defect to rivals… (End Times’ excerpts)Here are some excerpts from “The Long and Short of It at Goldman Sachs” by Ben Stein from the New York Times on December 2, 2007: that mentions a former Goldman Sachs scandal from the Great Depression:…More thoughts came to me as I read a recent piece in Fortune by my colleague Allan Sloan, a veteran financial writer. Mr. Sloan traces the life and death throes of a Goldman Sachs-arranged collateralized mortgage obligation. He shows how truly toxic waste was sold to overly eager investors who now have major charge-offs, and he also points out that some parts of the C.M.O. were indeed safe and were either current or had been paid off.But what leaps out at me from this story is that Goldman Sachs was injecting dangerous financial products into the world’s commercial bloodstream for years.My pal, colleague and alter ego, the financial manager Phil DeMuth, culled data from a financial Web site, (for “asset-backed alert”), that Goldman Sachs was one of the top 10 sellers of C.M.O.’s for the last two and a half years. From the evidence I see, Goldman was doing this for years. It might have sold very roughly $100 billion of the stuff in that period, according to ABAlert. Goldman was doing it on a scale of billions even when Henry M. Paulson Jr., the current Treasury secretary, led the firm.The Goldman spokesman would not comment on this except to note that other firms sold C.M.O.’s too.The point to bear in mind, as Mr. Sloan brilliantly makes clear, is that as Goldman was peddling C.M.O.’s, it was also shorting the junk on a titanic scale through index sales — showing, at least to me, how horrible a product it believed it was selling.The Goldman Sachs spokesman said that the company routinely shorts the securities it underwrites and said that this is disclosed. He noted candidly that Goldman is much more short in this sector than usual.From what I have observed over the years, Goldman has a fascinating culture. It is sort of like what I imagine the culture of the K.G.B. to be. You always put the firm first. The long-ago scandal of the Goldman Sachs Trading Corp., which raised hundreds of millions just before the crash of 1929 to create a mutual fund, then used the fund’s money to prop up the stocks it owned and underwrote, was a particularly sad example. The fund, of course, went bust…Here is a query, as we used to say in law school: Should Henry M. Paulson Jr., who formerly ran a firm that engaged in this kind of conduct, be serving as Treasury secretary? Should there not be some inquiry into what the invisible government of Goldman (and the rest of Wall Street) did to create this disaster, which has caught up with some Wall Street firms but not the nimble Goldman…? (End)And now Congress has given Paulson full bailout czar power to use the US trasury, with no oversight, to bail Fannie and Freddie and unspecified others.All this is because Goldman Sachs people are the most brilliant in the industry. Right?