Poison Pills and Customer Liquidity

(Bloomberg View) -- Poison pills.

What I like about Carl Icahn is his ability to get exaggeratedly and, I think, genuinely offended when anyone tries to stop him from using his billions to tell companies what to do. Corporate managers will politely refuse his demands to buy back more shares, and he will accuse them of being monstrous human-rights abusers, and you get the sense that he means it. I like to think that if I were that rich I would preserve the ability to be that offended. Now he's in a fight with SandRidge Energy Inc., and SandRidge put in place a poison pill to stop him, and he sat down to write a letter:

It is the type of move many companies have used against Mr. Icahn over the years, and that usually leads him to ratchet up his rhetoric. In his letter, SandRidge becomes the latest company to have hit “a new low in corporate governance.” The pill would “make a totalitarian dictator blush,” he wrote.

The thing is, he is not wrong. SandRidge Energy Inc. announced a controversial proposed acquisition of Bonanza Creek Energy Inc., and a couple of large shareholders, including Icahn, expressed their opposition. Icahn's letter describes, emotionally, what happened next:

On November 26, 2017, in direct response to this strong shareholder opposition to the proposed acquisition, you adopted a poison pill that is a complete travesty and represents a new low in corporate governance. The pill contains an especially noxious provision whereby the members of the board may, for whatever undefined reasons you may determine, “deem” large shareholders to be “acting in concert” with other shareholders – even if they have never met or spoken with one another – thereby triggering the massively dilutive consequences of the pill. This provision is patently absurd and we believe unenforceable because it is a transparent attempt to preclude large shareholders from communicating with one another and exercising their rights as shareholders. More specifically, it is clearly designed to prevent large shareholders from campaigning against the Bonanza transaction. 

This is a little intemperate but also correct. Here is SandRidge's poison pill. The pill -- like most pills -- basically provides that if anyone acquires more than 10 percent of SandRidge's stock, then all of the other shareholders (but not the 10 percent acquirer) can buy a lot more shares at a steeply discounted price, diluting away the acquirer's investment and voting rights. Icahn is already over 10 percent -- he owns 13.5 percent of the company -- and is grandfathered into the pill, but if he acquires even one more share then the company can dilute him away. That is pretty rough, but a common defensive mechanism against activists who are trying to gain control. 

What Icahn objects to is that SandRidge's pill kicks in if any investors "acting in concert" with each other acquire more than 10 percent of the stock. So if Icahn -- already over 10 percent -- "acts in concert" with anyone, he will trigger the pill and essentially lose his SandRidge investment. And here is the pill's definition of "Acting in Concert":

A person shall be deemed to be “Acting in Concert” with another Person if such Person knowingly acts (whether or not pursuant to an express agreement, arrangement or understanding) in concert or in parallel with such other Person, or towards a common goal with such other Person, relating to (i) acquiring, holding, voting or disposing of voting securities of the Company or (ii) changing or influencing the control of the Company or in connection with or as a participant in any transaction having that purpose or effect, where (A) each Person is conscious of the other Person’s conduct or intent and this awareness is an element in their decision-making processes and (B) at least one additional factor supports a determination by the Board that such Persons intended to act in concert or in parallel, which such additional factors may include, without limitation, exchanging information, attending meetings, conducting discussions or making or soliciting invitations to act in concert or in parallel. 

If you read that literally, I think it says that if Icahn calls another investor and asks her to vote against SandRidge's transaction, and the investor is persuaded and votes against the transaction, then the board can decide that Icahn and the investor are "acting in concert" and trigger the pill. The pill excludes purely public proxy solicitations -- if Icahn just sends out a proxy statement and gets people to vote with him, they are not deemed to be "acting in concert" -- because it more or less legally has to, but otherwise, any effort by Icahn to persuade other investors of his position seems very risky.

It has to be said that this is only barely an innovation -- other pills can have similar chilling effects without such broad language -- and that the law here is pretty bad. Delaware courts have let companies do pretty much whatever they want to prevent shareholders from talking to each other, short of actually banning proxy solicitations. Shareholder democracy protects the vote, but it's not great on freedom of association. You can see why a democracy activist like Icahn would find that offensive.

People are worried about bond market liquidity.

Here's the central intellectual problem in bond market liquidity. Practitioners -- bond traders and investors -- all go around saying that liquidity in corporate bond trading is bad. If you call up your dealer and ask her to buy a big slug of bonds from you, she will put you on hold and call other customers to see if they're interested in buying those bonds. If they are, she'll buy from you and sell to them; if they're not, there's no trade. In the good old days she'd just buy them herself and deal with the risk of finding buyers later, but now she is too nervous and capital-constrained and Volcker-limited. 

Academics and regulators, meanwhile, look at the data, and they almost invariably say: Meh, corporate bond liquidity looks fine. Volumes are up; bid/ask spreads are tight; price impact is modest. Dealer inventories are down -- dealers really are buying fewer bonds for their own accounts -- but it doesn't seem to be affecting the actual liquidity that anyone experiences in the market.

The practitioners reply: Look, you can't learn anything from the data. The data just shows trades that happened. Of course bid/ask spreads are tight. In a world where dealers buy and sell bonds at their own risk, they will charge a lot for doing it: They'll buy at 99.5 hoping to sell at 100, because there's a risk they might have to sell at 98. In a world where dealers only match customer trades, they don't need to charge as much: They can buy from one customer at 99.5 and sell to another at 99.75 and clip a totally risk-free 0.25. Bid/ask spreads are tighter, but if you actually need to trade a bond, liquidity is worse. An important element of liquidity -- immediacy, the assurance that you can sell a bond whenever you want to -- is gone; you can only sell a bond if the dealer can line up a buyer on the other side. If it can't, then it just won't buy your bond. 

Here is an extremely delightful Federal Reserve Board discussion paper from Jaewon Choi and Yesol Huh called "Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs." They find a neat way to shed light on this question using TRACE data of corporate bond trades, which identifies the dealer involved in each trade. They identify when a dealer buys and sells each bond, and classify trades as "DC-DC" (dealer-customer/dealer-customer, where a dealer buys a bond from one customer and sells it to another customer within 15 minutes, or vice versa), "DC-ID" (where a dealer buys a bond from a customer and sells it in the interdealer market within 15 minutes), or "invt>15min" (where a dealer buys a bond from a customer and holds it for longer than 15 minutes). Their assumption is that DC-DC trades -- where a dealer offloads its risk to another customer immediately -- are more or less what I described in the first paragraph above: The dealer is not taking risk on her own book to buy the bonds, but buys them only because she already has an ultimate buyer lined up. Choi and Huh call this "customer liquidity provision," and they find that the customers who provide liquidity -- the ones who are willing to be lined up as buyers to facilitate the dealers' trades -- get paid for it:

We provide empirical evidence that is consistent with predictions implied by customer liquidity provision. First, we show that customer trades that are matched with other customer trades (i.e., DC-DC trades) have lower average spreads than customer trades that are not matched. We find that DC-DC trades have 20–40% lower bid-ask spreads compared with trades where customers are demanding liquidity, indicating that average bid-ask spreads underestimate trading costs for customers demanding liquidity. We find that 40% of DC-DC trades exhibit negative spreads, higher than that of DC-ID or invt>15min trades. Furthermore, DC-DC trades have lower bid-ask spreads and are more likely to have negative spreads particularly for customer buy trades, which is consistent with our prediction that customers have more capacity to provide liquidity on their long positions. For investment grade bonds, for example, DC-DC trades for customer buys (sells) are on average 42.6 (23.7) bps and 17.17 (6.6) bps lower than DC-ID and invt>15min customer buy (sell) trades, respectively. Also, we find that the bid-ask spreads for DC-DC trades are lower particularly for bonds that trade infrequently, consistent with our customer liquidity provision hypothesis in that liquidity-providing customers are compensated more for bonds with high dealer inventory risk.

This seems like pretty good evidence for the practitioners' argument that dealers are not providing as much liquidity. "Our results indicate that liquidity decreased in corporate bond markets and can help explain why, despite the decrease in dealers’ risk capacity, average bid-ask spread estimates remain low," they write.  

Still, you could ask: So what? You could imagine a market where dealers don't matter much, where bond investors (mutual funds, pensions, insurance companies, etc.) buy and sell from each other, with dealers playing a minor role. (Lots of people imagine this, which is why there are so many all-to-all electronic trading platforms designed to let bond investors buy and sell from each other.) "Since the periods before the 2008 financial crisis, substantial amounts of liquidity provision have moved from the dealer sector to the non-dealer sector," write Choi and Huh. The system works -- the customers provide liquidity to each other -- so why do you need the dealers?

One answer is that investors like immediacy, and customer-to-customer trading is not great at providing it. "Among trades where customers are demanding liquidity" -- where dealers aren't just matching two customers with each other but actually providing immediacy themselves -- "we find that these customers pay 35 to 50 percent higher spreads than before the crisis." Bid/ask spreads have gone up for the dealers' core work of providing liquidity at their own risk, of buying when there is no obvious natural buyer. There is a social role of a bond dealer in providing liquidity, and dealers were optimized to do it, and now they are not. Customers can do it themselves, but they are not optimized to do it -- they are primarily in the business of investing in bonds, not providing liquidity -- and so they are not as good at it.

Bitcoin bitcoin bitcoin.

The celebrations of Bitcoin 10,000 Week continue, which is a little awkward for Dow 24,000. Congrats to the Dow Jones Industrial Average, which reached 24,000 yesterday, but honestly: meh. It took 131 years for the Dow to go from about 40 unitless units to 24,000 of them, which is not even a power of 10. Meanwhile bitcoin was just a white paper nine years ago; now it is worth over 10,000 American dollars. The Dow is the old-economy, plodding, industrial way for a number to turn into a much bigger number. Bitcoin is the cool new cryptographic technologically advanced scalable social global way for a number to turn into a much bigger number, and it should be no surprise that it is faster and more efficient at the job. 

Anyway here's a random hodgepodge of bitcoin news. Coinbase Inc. will have to turn over some of its customer data to the Internal Revenue Service, which finds it intriguing that only 800 to 900 taxpayers have reported taxable bitcoin gains "in a period when more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of bitcoin." 

Elsewhere in the domestication of bitcoin, the U.S. Commodity Futures Trading Commission has approved CME Group Inc.'s and Cboe Global Markets Inc.'s plans to offer bitcoin futures. (Here is the CFTC's statement.) And Nasdaq will introduce bitcoin futures too. Here is Izabella Kaminska on the systemic risks of bitcoin clearing, and I was a bit thrown by this quote:

“Choose a big enough margin, and it’s not an issue,” Craig Pirrong, noted market structure and clearing expert from the University of Houston. “I looked at the data, and found that a 20 per cent initial margin, which is huge, by the way — crude oil is on the order of 4 per cent — would have covered 99 per cent of the price moves in 2016-2017. CME has talked about 25-30 pct. So that should be adequate.”

A classic way to do margin is to have it cover 99th percentile price moves over some period -- five days for CME Group interest-rate swaps, 10 days for best-practice non-centrally-cleared derivatives, something like that. The idea is that if the position moves and the counterparty doesn't post more margin, you can liquidate the position without burning through the margin you already have. Just to do a dumb lazy calculation, bitcoin was up by more than 25 percent in four of the 48 calendar weeks (including this one, so far) this year. (Measuring by Friday-to-Friday closing prices on Bloomberg page XBTUSD BGN Curncy.) You'd blow through a 25 percent margin in five trading days roughly 8 percent of the time. That seems not ideal?

And here is Federal Reserve Vice Chairman Randal Quarles on payment systems and digital currencies. "Without the backing of a central bank asset and institutional support," he says, "it is not clear how a private digital currency at the center of a large-scale payment system would behave, or whether the payment system would be able to function, in times of stress." But he's not that jazzed about central-bank-issued digital currency either, which "would require extensive reviews and consultations about legal issues, as well as a long list of risk issues, including the potential deployment of unproven technology, money laundering, cybersecurity, and privacy to name a few."

And here is Tyler Cowen with a bitcoin pseudo-valuation:

This estimate claims there is $241 trillion of wealth in the world, make of that what you will (there is something nonsensical about such aggregate measures because they are not traded against anything). If you imagine people wish to hold one quarter of one percent of that in crypto form, that gets you to about $600 billion in value. Currently crypto assets (on good days) hover near $300 billion in market capitalization. Is that so crazy? I genuinely don’t know, but that is one way of thinking about market cap in this sector.

The number -- one quarter of one percent -- doesn't sound crazy, if you have already accepted that the form -- "crypto" -- isn't. If you imagine people wish to hold one quarter of one percent of their overall wealth in tulip form, you will probably overpay for tulips.

Finally: "Don’t Understand Bitcoin? This Man Will Mumble An Explanation At You."

Greed and envy.

A word that I hate is "greed." Any time a banker or trader is charged with doing something bad, the prosecutors will get up and say something like "he was motivated by Wall Street greeeeeeeeed," which adds nothing to anyone's understanding. Yes, sure, we live in a society in which most people find it useful to have more money rather than less money. The fact that someone feels that way is rarely helpful in determining whether he insider traded or manipulated accounts or whatever, or in deciding how blameworthy his actions were. It is just emotional hand-waving, a way to say "this guy is rich so let's punish him." 

The head of UBS has lashed out against regulators’ efforts to rein in bankers’ pay, arguing that the push is fuelled by envy among less well paid officials and risked stoking the populist backlash against capitalism.

Sergio Ermotti, chief executive of the Swiss bank, also complained that banking had been singled out for criticism over compensation in a way that other sectors, such as private equity and tech, had not.

“I think this discussion is made by people who are maybe frustrated that they do not make that kind of level of money,” the UBS boss said at the Financial Times annual banking summit on Thursday.

I mean, the second sentence undermines the third, doesn't it? If regulators want to regulate bankers' pay because of envy, why don't they regulate even-more-enviable private equity pay? It's almost like there are some substantive considerations underlying the desire to regulate banker pay, some notion that banking is a uniquely public/private partnership that is legitimately subject to more state intervention than purely private-sector activities like technology or private equity. But it is always easier to attribute other people's actions to greed or envy than to reasonable thought.

People are worried about unicorns.

Here is a story about "HVMN, a San Francisco start-up backed by former Yahoo CEO Marissa Mayer and Andreessen Horowitz," which sells "nootropics" for "biohacking," but which "found that one of its best-selling supplements was less effective in many ways than a cup of coffee." It's more expensive than coffee though. "Any sufficiently advanced technology is indistinguishable from magic," said Arthur C. Clarke, but perhaps a corollary is that any sufficiently advanced technology industry is indistinguishable from a magic industry. Medieval wizards were perfectly capable of selling people potions that don't work. But now that gets venture-capital funding.

Things happen.

The Bloomberg 50. Blankfein isn't planning to die at his desk at Goldman, after all. Chriss Is Shutting His $2 Billion Hutchin Hill Hedge Fund. Brexit May Leave Banks on the Hook for Impossible Contracts. Venezuela Arrests Former Oil Heads as Maduro Widens Purge. Jacob Zuma, the Guptas and the selling of South Africa. China’s Tech Giants Have a Second Job: Helping Beijing Spy on Its People. Uber's use of encrypted messaging may set legal precedents. World’s Biggest Shipbroker Clarkson Hit by Cyberattack. "If you can’t merge that industry expertise and credit paradigm of underwriting like a helix—you got nothing." Buffett's Fruit of the Loom Tries on Subscription Underwear. Barnes & Noble might start selling books. Gunman on the run after robbing Las Vegas casino poker room. Man fined for painting road signs to aid his commute.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen L. Carter is a Bloomberg View columnist. He is a professor of law at Yale University and was a clerk to U.S. Supreme Court Justice Thurgood Marshall. His novels include “The Emperor of Ocean Park” and “Back Channel,” and his nonfiction includes “Civility” and “Integrity.”

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.

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