Explaining Trades Is More Profitable Than Doing Them

(Bloomberg View) -- Whistle-blowing.

I have found the best trade. Back in 2016, Bank of America Corp. paid $415 million to settle with the Securities and Exchange Commission over charges that its Merrill Lynch unit "misused customer cash to generate profits for the firm." Merrill did derivatives trades, called "leveraged conversions," that had no real economic substance but that did impact its calculation of "customer cash": The leveraged conversions made it look like customers owed Merrill money, even though there were no real loans or credit risk, and those notional customer debts reduced the amount of cash that Merrill needed to keep untouched for regulatory reasons. So the trades freed up customer cash for Merrill to use, without having any other economic effect. (Also everything worked out fine and the customers were never harmed by this abuse of their cash.)

I wrote about the leveraged conversions, rather admiringly, at the time, though to be clear they are not the best trade. After all, the SEC ended up fining Merrill $415 million for them. But one thing I wrote was that "what is most pleasing about this case may be the way that Merrill frog-boiled its regulators into allowing these trades": Merrill actually met with the SEC to get approval for the leveraged conversions, and the SEC approved. Did the SEC know every relevant fact before approving the trades? Did Merrill only do the trades in exactly the form that the SEC approved? Well, perhaps not quite. But the regulators seem to have had a pretty good grasp of the basic mechanics. What they were missing was the intent: The SEC thought, somehow, that the purpose of these non-economic trades was to help Merrill's clients (to finance inventory or whatever), while in fact the purpose of the trades was to free up customer cash for Merrill. Merrill accurately described to the SEC the boxes and arrows of the trades; it just didn't clearly explain why it was doing all the boxes and arrows.

Eventually the SEC figured it out and got hopping mad and fined Merrill $415 million. But more specifically the way it figured it out was that several whistle-blowers at Bank of America told the SEC what was really going on, and the SEC became enlightened, and furious. And yesterday the whistle-blowers received their reward:

The Securities and Exchange Commission on Monday announced its biggest-ever whistleblower awards, with roughly $83 million combined going to three whistleblowers who helped the regulator reach a $415 million settlement with Bank of America Corp., according to an SEC statement and a lawyer representing the whistleblowers.

"Two recipients together were awarded roughly $50 million and another about $33 million." 

Now the SEC and the whistle-blowers' lawyer do not say who they were. But they had to have been fairly closely involved in these trades. After all, the SEC already knew about the trades and didn't have a problem with them. Whoever blew the whistle needed to be familiar with the design of the trades at a deep level: They needed to know not only the mechanics of what Merrill was up to, but also its economic purpose, and the difference between the purpose that Merrill was pursuing and the purpose that the SEC understood it to be pursuing.

It is all suggestive of this, which is the best trade:

  1. Cook up something that regulators shouldn't let you do but that you might be able to confuse them into letting you do.
  2. Confuse them into letting you do it.
  3. Do it.
  4. Get a big bonus.
  5. Go to the regulators and explain it again, but clearly this time.
  6. Have the regulators put a stop to it and impose a big fine.
  7. Get a big whistle-blower award.

I don't think that is exactly what happened here, but I don't think it's exactly not what happened here. To be clear this isn't an easy trade, and the hardest steps are 2 and 5: You have to accurately describe what you're doing both times, but once in a way that makes it sound good, and then later in a way that makes it sound bad. It is a challenge, but a lovely and exciting challenge, and one that is perfectly suited to a derivatives structurer. If you're just building the trades and not later blowing the whistle on them, you are not making things as interesting as you could. And you are leaving money on the table.

The used-car-salesman defense.

We have talked any number of times here about Jesse Litvak, the former Jefferies LLC bond trader who lied to his customers about how much he had paid for bonds. He would buy bonds for, say, 60, and tell the customer he'd paid 65, and sell them to the customer for 65.25, or whatever. Eventually he was charged with a crime for this, and convicted, and appealed, and won on appeal, but then was convicted all over again and sentenced to two years in prison. But in his appeal he argued that lying to customers about the price he paid for bonds was not a crime, because his lies were not material. For one thing, he argued, what mattered to the transaction was not the price that Litvak had paid but the price that the customer was willing to pay.

For another thing, even if the price that he had paid mattered, his lies about it didn't, because no one believed them anyway. "Such statements from sell‐side sales representatives or traders are generally biased, often misleading, and unworthy of consideration in trading decisions" is how the appeals court summarized Litvak's expert's testimony. "It is a used-car-salesman defense, if you will," I wrote at the time:

If it is a widely shared opinion among bond investors, then a salesman's lies about bond prices really can't be fraud, because no reasonable investor would believe them. This is the sense in which "everybody's doing it" really is a defense against fraud charges. To be fraud, lies have to be material, and if lies are so common that they are ignored, then they can't really be material.  

Was that fair to used-car salespeople? I don't know, but here is a story about a used-car dealer who is being accused by a customer of Litvaking him. I mean, fine, he's a "classic" car dealer, but those are used cars too you know:

Mr Tuke claims that, at their December 2009 meeting, Mr Hood agreed to “source” cars for him for a 10 per cent commission on profits.

However, Mr Brannigan claimed that Mr Hood – the owner and “directing mind” of JD Classics – invented fictitious buyers and sellers in order to hoodwink Mr Tuke.

In one example, he claimed Mr Tuke paid £254,000 for what he was told was a “very rare” AC Aceca Bristol Competition car in the belief that he was dealing with a third-party seller through JD Classics, but the court heard JD Classics in fact “owned the car itself”, having paid just £84,000 for it only three weeks earlier.

Mr Hood and JD Classics deny any wrongdoing. Mr Hood also denies he ever agreed to act as Mr Tuke’s “sales agent”, and says that JD Classics was always dealing “on its own account”. 

Man, making up fictitious sellers in order to jack up the price on goods that you have in inventory yourself: It is just like bond trading.

There are some industries where it is obvious that you are dealing with a counterparty. If you go into the supermarket to buy milk, you don't think the supermarket is your agent with a fiduciary duty to get you milk at the lowest price it can find; you understand that the supermarket owns the milk and wants to sell it to you at the highest price it can get. There are other industries where it is obvious that you are dealing with a fiduciary. If you go to a lawyer to write a will, and she writes the will to leave all of your money to herself, and she defends herself by saying "what, I was just an arm's-length counterparty trying to maximize my revenue," she will not persuade anyone.

The financial industry is constantly causing itself and its customers angst because it always seems to be walking a fine line between being a counterparty and being an agent; banks are always trying to get customers to think of them as trusted agents, while reserving the right to act as rapacious counterparties. But the financial industry is not alone in this. Lots of sales industries work the same way. It's not like bond traders invented it. Used-car dealers do it too.

The petro.

Venezuela's "petro" cryptocurrency, which is somehow a fiat commodity cryptocurrency, is pretty dumb even by the low standards of cryptocurrency. It is backed by oil, but not really; it runs on a decentralized blockchain, but it's not clear which one; it can be used to pay Venezuelan taxes, but can't be bought using Venezuelan currency. It's just a way for Venezuela's government, frozen out of international debt markets by sanctions and moral disapproval and its own terrible credit, to raise some international financing by tapping into the bottomless well of incoherent cryptocurrency enthusiasm.

It also seems to have been meant as a way to avoid U.S. sanctions, because of the widespread but baseless belief that if you say the word "blockchain" then no law applies. But in fact that was never going to work, and long before the petro was issued, the U.S. Treasury noted that it "would appear to be an extension of credit to the Venezuelan government," and that petro buyers "may be exposed to U.S. sanctions risk." So it was always going to be illegal to buy it under U.S. law, but now it is extra illegal, because the Trump administration banned it again. "All transactions related to, provision of financing for, and other dealings in, by a United States person or within the United States, any digital currency, digital coin, or digital token, that was issued by, for, or on behalf of the Government of Venezuela on or after January 9, 2018, are prohibited as of the effective date of this order," says President Trump's executive order. Don't buy petros, is I guess the point here, and while that is neither legal advice nor investing advice, it is nonetheless good advice.

Elsewhere in unpopular Venezuelan debt products, here are Ugo Panizza and Mitu Gulati on Venezuela's "Hunger Bond":

The story of the Hunger Bond suggests a new possibility towards establishing a tool that can limit access to credit by despotic regimes. A public ranking of bonds which lists all potential legal problems of individual bonds could lead to price penalties for bonds with legal infirmities -- such as whether the bond was issued without proper legislative approval or whether the promised use of the proceeds had not materialized – and possibly increase the borrowing costs for regimes that, besides being despotic, adopt murky debt management practices. In the presence of such type of public information, few investors could claim to have bought a bond on the secondary market without knowing the illegal origin of the bond. This would depress the price of the bond in the secondary market and, hence, also increase the cost of funds in the primary market. Such a system could also help the opposition parties in countries with potentially despotic regimes announce their future plans regarding likely investigation or even repudiation of those bonds.

Uber killed someone.

It seems a little unfair that an Uber Technologies Inc. autonomous car killed a pedestrian yesterday, just six months into Dara Khosrowshahi's time as Uber's kinder, gentler, more law-abiding chief executive officer. Really I'd have thought that Uber would do its killing during founder Travis Kalanick's more Nietzschean tenure as CEO. I am not alone in thinking that; here, for instance, is an anecdote from last year about Anthony Levandowski, the Alphabet Inc. engineer whom Kalanick hired to run Uber's autonomous-vehicle effort: 

Last summer, after a man died in a Tesla that was using the car’s Autopilot system, which allows for autonomous driving on highways, Levandowski told several Uber engineers that they were not pushing aggressively enough. “I’m pissed we didn’t have the first death,” Levandowski said, according to a person familiar with the conversation. (Levandowski denies saying this.)

"I'm pissed we didn't have the first death" is very much the Old Uber mentality, but the New Uber is the one that actually ... achieved? ... the first pedestrian death.

One obvious and popular reaction here is to say that the Silicon Valley culture of "move fast and break things" is misapplied to life-and-death endeavors like self-driving cars, and that instead Uber should move more slowly and stop breaking things. For instance:

"As always we want the facts, but based on what is being reported this is exactly what we have been concerned about and what could happen if you test self-driving vehicles on city streets," said Jason Levine, executive director of the Center for Auto Safety, a Washington-based advocacy group. "It will set consumer confidence in the technology back years if not decades. We need to slow down."

But I am not sure that's exactly right either. A self-driving Uber killed one person yesterday, but human-driven cars killed about 100 people yesterday in the U.S. If self-driving Ubers fully replaced human-driven cars while still killing only one person -- or 10 people -- a day, then that would represent an enormous improvement in human welfare, even though Uber would be killing people every day. And speeding that adoption up by even a week would save hundreds of lives. Moving fast, here, is actually a good goal. (Though: "Uber CEO’s Commitment to Self-Driving Cars Tested by Fatality.") The problem is that in high-stakes settings, you need to move fast and not break things. And you want a tech firm with a culture that can manage both.

People are worried that people are worried.

Remember how we spent like a year around here talking about how the CBOE Volatility Index -- the VIX -- was historically low, and how people worried that low VIX levels indicated complacency and that people weren't worried enough? Well the good news (?) is that the VIX is higher now and so people are no longer worried that other people are insufficiently worried. But that just means that people can worry that people are too worried:

The burgeoning bludgeoning of large-cap U.S. technology stocks Monday -- largely driven by the Facebook data-misuse controversy -- has traders acutely anxious about the near-term outlook for the S&P 500 Index.

The VIX futures curve, whose contracts track the implied volatility of the benchmark U.S. stock index over time, is in backwardation.

If you had to choose between worrying market signals, would you rather have a market that is "acutely anxious" or one that is "complacent"?

Things happen.

‘I Need to Clear My Name’: Prince Alwaleed on His 83-Day Detention at the Riyadh Ritz. Aramco Scales Back IPO Plan, Eyes Saudi-Only Listing. EU Offers U.K. ‘Improved’ Equivalence for Financial Services. How Facebook Made Its Cambridge Analytica Data Crisis Even Worse. A Q&A with Ed Thorp. Will BlackRock’s algorithms beat the fund managers? Can Jes Staley Fix Barclays Fast Enough? Does the new tax law impose capital gains taxes on baseball trades? Millennial Investors Felt ‘Excitement’ During Stock Selloff. John Paulson’s Merger Arbitrage Fund Plunged at the Start of the Year. China will ban people with poor ‘social credit’ from planes and trains. Gary Cohn wanted to run the CIA. Steve Wynn’s Attorney Reported Alleged Sexual Misconduct Victim To FBI. The Palm is taking down caricatures of sexual harassers. D.C. Councilman Apologizes for Claiming That Jews Control the Weather.

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

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

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

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