The Volcker Rule Doesn’t Ban Trading

(Bloomberg Opinion) -- Volcker.

Here’s some stuff that banks do. They call up a big investor and say: “Hey I have an idea. What if I sold you a product that gives you exposure to XYZ stock, but your upside is capped at 120 percent of today’s price, and your downside is floored at 80 percent of today’s price? Also I will lend you most of the money to do this thing.” And the investor says “ugh I don’t know that sounds complicated” and the bank says “no no no it is great trust me you will love it” and the investor says “ugh fine I guess.” And the bank signs this contract with the investor, and lends the investor a bunch of money. And then it goes out and buys some XYZ stock to deliver to the investor, and sells some XYZ stock to hedge its exposure under the structure. And then maybe it buys or sells some XYZ options to hedge its volatility exposure, or some interest-rate swaps to hedge its rates exposure, or some credit-default swaps to hedge its jump risk on XYZ. And then XYZ’s stock goes down and the customer calls and complains “I thought you said this would be great,” and the bank apologizes and offers to make it up to the customer by converting this trade into a series of knock-in options on the Swedish krona that will be more to the customer’s liking, and the customer says “oh fine go ahead,” and the bank does it and goes out and hedges by trading kronor and kronor options and a basket of correlated currencies and, I don’t know, bauxite or something as a hedge. 

This is a stupid and stylized example and please do not email me to be like “actually they’d trade cobalt not bauxite” or whatever. The point is: What is this? Like, what would you call the thing that the bank is doing here? Here are some words that people sometimes use about some stuff that banks do: 

  • “making their own risky bets with their customers’ deposits”;
  • “a bet by the bank on the future directions of markets”;
  • “trading that amounts to speculation”;
  • “using ... derivatives to make speculative bets on the markets”;
  • “trading with depositors’ money.”

All of those words actually come from this article about the Volcker Rule, which forbids banks from doing proprietary trading, and which the Trump Administration is likely to “soften,” “making it easier for giant banks to engage in a wider range of trading that can be highly profitable, but also very risky.”

I do not think that it is any sort of stretch to apply any of those words to the stupid stylized trade that I outlined in the first paragraph. That trade consists of the bank taking risky positions, with its own money, in various markets. Some of those positions more or less cancel each other out—it sells stock exposure to the customer and then hedges it by buying the stock or whatever—but the bank is likely to retain some greater or lesser residual risk, or at least, to make market-based choices about which risks to retain and how to hedge the ones it gets rid of. And it’s hard to say that that trade is just responding to customer demand, since in my story the bank called the customer up and badgered it into doing the trade.

And yet this trade is not only not proprietary trading, it is obviously not proprietary trading; it is at the very core of the thing that banks do that is not proprietary trading. It is trading on behalf of customers; it is offering a service—the service of, call it, risk management, or liquidity provision, or trading facilitation, or something—to customers. What is confusing about it is that:

  1. The service is sold, not bought: The bank comes up with a service that it would like to provide, and thinks it can provide profitably, and then goes out and markets that service to potential customers.
  2. The service involves taking market risk: The bank’s essential function is this trade is not just bringing together buyers of XYZ stock and sellers of XYZ stock and clipping a commission, but rather providing the customer with one exposure and hedging it by taking a slightly different set of exposures in another market. The bank doesn’t just purchase and resell the exposure that it gives to the client; it manufactures the exposure out of its component parts. The bank’s advantage—its business—is that it is good at manufacturing financial exposures.

This is all absolutely normal and what happens in every industry. Apple Inc. doesn’t just buy iPhones from a supplier and sell them to customers; it makes the iPhones from parts. And it doesn’t just sit by the phone waiting for customers to call it up and say “hey could you invent an iPhone”; it designs products itself and then markets them to find buyers. Manufacturing products out of raw materials, and then manufacturing demand for those products via marketing, is just the way business works. 

Some businesses are plausibly bad. You might think that it is bad that cigarette companies turn tobacco into cigarettes and market them to smokers; you could if you want think that it is bad that banks manufacture financial products out of raw materials and then market them to clients. You could say that it is bad because the products are bad for the clients, or you could say that it is bad because the products are bad for the banks (risking customer deposits!), or I suppose you could even coherently say both things at once. (Perhaps they are just bad speculation, and speculation is bad for the people on both sides.) 

But I find discussions of the Volcker Rule very tiring because no one ever quite says that. Critics of weakening the Volcker Rule sort of vaguely accept the Volcker Rule’s central distinction—that “proprietary trading” is bad while “customer facilitation” trading and “hedging” are good—without really believing it in their hearts. The point of the Volcker Rule, on this view, is to prevent banks from taking market risk in their trading businesses. But taking market risks is the main thing that the trading businesses do.

If you think that banks shouldn’t do that, well, that is a totally plausible position! That used to be the rule! Investment banks used to do securities trading and take market risk; commercial banks used to take deposits and make loans; keeping those businesses separate seemed like a good idea to a lot of people for a very long time. But the Volcker Rule is not really a way to express that position, and any plausible version of the Volcker Rule will still allow banks to do a lot of their core trading businesses, in ways that will still annoy people whose real concern is that those businesses are bad. And if that is your concern, then you will object to any “weakening” of the Volcker Rule—any clarification that makes it easier for banks to do their customer-facilitation and hedging businesses—not because it doesn’t make sense in the context of the Volcker Rule, but because the Volcker Rule itself isn’t really what you want.

Dumb beta.

This is just pleasing as a matter of, like, set theory:

To test the genius of the smart-beta industry, Deluard spent Nov. 7, 2016 -- the night before the presidential election -- concocting an experiment. He created what he called a “basket of deplorables,” an index made up of the outcasts of the smart-beta world, which he named DUMB. To do it, he put together a market-capitalization weighted index with about 200 companies that are in the S&P 500 Index but didn’t make the cut for these five factor-based funds: 

iShares Edge MSCI USA Quality Factor ETF (QUAL)

ProShares S&P 500 Dividend Aristocrat ETF (NOBL)

iShares Edge MSCI USA Min Vol USA ETF (USMV)

iShares Select Dividend ETF (DVY)

iShares Edge MSCI USA Momentum Factor ETF (MTUM

He then combined those five smart-beta funds to create an equal-weighted portfolio that he named SMART. From the experiment’s start through April, the most recent period for which the data is available, DUMB beat SMART by more than 2 percent. Deluard says he remains bullish on the “DUMB beta” index, in part because he expects rates to rise and most smart-beta funds have a negative correlation to yields, he said.

It’s the set of objects that are not the members of any set! The index of stocks that aren’t in an index! The barber who shaves the people who don’t shave themselves! It’s the factor of not being selected by any factors. Also: It kind of works? The theory is that factor investing is pretty picked-over at this point, and that once you have identified and named a factor, and picked stocks based on that factor, then the stocks that are over-indexed by that factor will be overvalued. (“If everyone’s doing it, it’s not going to work anymore,” says Vincent Deluard, DUMB’s inventor.) The having-no-factors factor is a sort of meta-value factor for identifying cheap and unloved stocks. 

Obviously one objection is that his comparison mashup of factor indexes doesn’t actually give you any smart beta; it just gives you a mush: “Equally weighting five different smart-beta ETFs doesn’t really mimic the reality of what the industry is trying to do,” notes Bloomberg’s Sarah Ponczek. “The point of the strategy is that different factors work in different market environments, so an investor probably wouldn’t want equal exposure to these characteristics at the same time.” And so in fact some of the component smart-beta portfolios outperformed DUMB: Some real factors have done better (in this very short sample) than the no-factors factor. Though of course that doesn’t tell you how to pick which portfolios will outperform in the future. But the no-factors factor arguably gives you a general sense of cheapness: Momentum, or quality, or whatever, may outperform for some fundamental reason, but the idea is that anything selected by any popular factor will be relatively expensive, which gives DUMB a little lift.

Unless people actually use it! Then it will be overbought like (in this theory) all the other factors. Then you’d need a new factor, the not-selected-by-any-factor-not-even-the-not-selected-by-any-factor-factor factor. I might preemptively launch that exchange-traded fund just in case.

Elsewhere in ETFs: “With ETFs About to Be Easier to Build, Aspiring Money Managers Go Solo.”

Icahn v. AmTrust.

Here is a neat trick. AmTrust Financial Services Inc., an insurance company, announced in March that it would be taken private by its chief executive officer and his family, who are the company’s largest shareholders. Carl Icahn, who enjoys messing with companies, saw the announcement and decided that the takeover looked like a sweetheart deal for the controlling family. So he set about buying shares to vote against the deal and see if he couldn’t get something better. And then, after he had bought a bunch of shares, AmTrust said: Sorry Carl Icahn, you are too late. Specifically it announced on May 4 that the shareholder meeting to vote on the deal will be held on June 4, and that the record date for the meeting—the date on which you needed to own shares in order to vote at the meeting—was April 5. Icahn’s purchases started on April 26 and continued through last week; he owns about 9.4 percent of the company (including through forward contracts where he still hasn’t gotten the shares) but can’t vote. (To be fair the majority of his purchases were after the company announced the April 5 record date, and he launched his proxy fight on May 17.) 

Yesterday he sued AmTrust on a theory of oh come on. From his complaint (the “KZ Group” is how he refers to the controlling Karfunkel-Zyskind family and its private-equity backers):

Through a manipulation of the record date for the meeting, the KZ Group has created a situation in which a large percentage of the “public stockholders” voting will actually be former public stockholders or public stockholders who retain some shares but will be voting far more.

In short, the KZ Group is attempting to use what are called “empty votes” to gain the approval of what it will claim was a majority of the minority.

The deal was signed on March 1, 2018. The parties filed a preliminary proxy statement on April 9, 2018, which had a blank inserted for the record date. The plain implication was that the record date had not been chosen yet. On May 4, 2018, though, the final merger proxy statement was issued, announcing that the meeting date would be June 4, 2018, while the record date was set for April 5, 2018. In other words, since record dates cannot be set retroactively, the board of directors must have set that date on or before April 5th, and the Company must have consciously decided not to include that fact when it filed its preliminary proxy statement. ...

The setting of the record and meeting dates thus was a manipulation, and it was a manipulation with consequences. As discussed hereafter, it effectively disenfranchised the holders of tens of millions of shares bought between April 4 and May 5, 2018 when the purchasers had no idea that the shares they bought could not vote. In addition, it means that many of the votes of the public shares will be “empty” votes, cast by holders who have either no or a diminished economic interest in the outcome of the vote.

I have to say that as a human I find this complaint convincing: If a company declares that it is going to get up to some questionable stuff, a common remedy for that is for someone like Carl Icahn to show up and lead a campaign to stop it, and if the company waits a while and then says “oh ha no actually you needed to own shares a month ago to vote against this stuff” then that seems unsporting. Also the entire notion of declaring a record date in the distant past seems pretty antiquated: Back in the olden days companies probably did need weeks to delve into their handwritten shareholder registries and determine whom to mail proxies to, but there are computers now, and it doesn’t actually take two months to figure out who is entitled to vote. As a matter of practical modern technology, here in 2018, living as we do in the shadow of the blockchain, you really could have a shareholder meeting where everyone who owns shares, like, the day before the meeting gets to vote. 

On the other hand Icahn doesn’t cite much law, and record dates are normally scheduled well in advance of shareholder meetings—Delaware law requires them to be at least 10 and at most 60 days before the meeting—so this seems like the sort of stuff the company can likely get away with. (“This type of stuff happens all the time—record date playing,” tweeted Steven Davidoff Solomon.) To the naked eye it looks like lame trickery to protect the board’s prerogatives against pesky shareholders, but in fact boards have a lot of lame tricks they can use to protect their prerogatives against pesky shareholders. (Though many of them don’t work as well in conflicted going-private transactions, and Icahn’s argument to the company is that the record-date game-playing will increase a court’s scrutiny of the fairness of the takeover.)

We talked a lot last week about CBS Corp.’s directors’ utterly goofball attempt to get rid of CBS’s controlling shareholder because they don’t like her and worried she might fire them. On the simplest theory of corporate governance—the one in which the shareholders own the corporation—this is plainly ridiculous: The whole point of being the controlling shareholder is that you can fire the board if you don’t like them, so it is completely backwards for the board to fire the shareholder first. And by Thursday a Delaware chancellor said more or less that. But if you hold that simplest theory of governance you run into some difficulties. Most of the time directors really can do a lot to keep shareholders from bothering them. Sometimes, if things line up right, they can even make sure a shareholder they don’t like doesn’t get to vote.

It could be worse.

Sure Carl Icahn bought a bunch of shares in a company to run a proxy fight and then found out that he couldn’t vote, but Blue Lion Capital has had a much worse time of it in its proxy fight with HomeStreet Inc.:

The Texas-based investment fund—which originally sought to replace two directors at regional bank HomeStreet Inc. but had to resort to urging shareholders to register protest votes against incumbents after a judge said it botched its nomination papers—has hit another snag in the fight.

Blue Lion failed to get approval from Washington state bank regulators to run its campaign to withhold votes from two HomeStreet directors, a stumble that would likely make the investment fund’s proxy ballots invalid, HomeStreet said Monday.

I mean, Blue Lion was trying to run a meaningless protest vote against two of the company’s nine directors. Even if it had won, nothing would have happened. But it won’t even get the chance to lose: Not only did it fill out some forms wrong in trying to run meaningful proxy fight, but it didn’t even fill out the right forms to run the meaningless protest vote.

One lesson here is that the central skill of running an activist fund is not “making correct arguments about how to run a business” but rather “knowing how to fill out the forms”; the activist’s role is to correctly manage the process of expressing what shareholders think, rather than to tell the shareholders what to think. Another lesson might be that banks are a public trust and don’t really belong to their shareholders: Just because shareholders want to change the board, or even express vague displeasure with the board, that doesn’t mean that they get to. The banking regulators are the more important stakeholders.

Things happen.

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