Different Rules for Different Brokers

(Bloomberg) -- Bond markups.

Last week, when former bond trader Jesse Litvak had his fraud conviction overturned again, I quoted extensively from the U.S. Court of Appeals for the Second Circuit’s description of how the bond market operates. Let’s quote some of that again:

The broker-dealer acts solely in its own interest as a principal. The broker-dealer continually tracks potential buyers and sellers, their interests in particular kinds of RMBS, and their ongoing acceptable price ranges. It seeks to profit from transactions in the securities by buying low and selling high. …

A broker-dealer is not, therefore, an agent for its counterparties in these trades and owes them no special or fiduciary duty. In a sale by a counterparty to a broker-dealer, the counterparty has no legitimate expectation that the broker-dealer will resell the bond at the price paid to the counterparty. Similarly, in a purchase, the counterparty has no legitimate expectation of purchasing a bond at the price paid by the broker-dealer. Rather, the broker-dealer and counterparty each have their own price ranges in which they will consummate their ends of the transactions. The final price is determined in an arms-length negotiation and, if agreed upon, will be somewhere in the overlap of price ranges.

If you are an institutional bond investor, and you ask a dealer to sell you a bond, and the dealer says “sure that’ll be $95,” then all you know about the price of the bond is that the dealer wants to sell it to you at $95. Perhaps the dealer paid $94.75 for it a minute ago. Perhaps she paid $92 last week. Perhaps she paid $70, last month, or a minute ago. Perhaps she paid $97. You could ask, though if you do she is not obligated to tell you. (She probably shouldn’t lie to you, though after the Litvak decision that is in a little bit of doubt.) You should pay a price for the bond that you are willing to pay for the bond. If you are willing to pay $95 and the dealer is willing to take $95 then you have a trade. But the dealer is not your agent, is not working on your behalf, has no duty to make sure that you are paying the correct price. The dealer is trying to make as much money as she can, consistent with her desire to do repeat business, and her knowledge that customers can always price-check with other dealers. Her markup is her business.

On the other hand, if you are a retail bond investor, the rule will soon be the opposite:

Starting next week, mom-and-pop investors will learn how much their broker made selling them bonds.

The change in practice is due to a new rule meant to curb abusive sales practices. Beginning Monday, brokers will have to say how much they pocket when they buy corporate and municipal bonds and sell them to retail investors later that day.

There are limits—this rule applies to same-day transactions, that is, essentially, transactions where the dealer goes out and finds bonds to fill a customer order, rather than transactions out of the dealer’s aged inventory—but still it is a different norm.

The norms are diverging more generally. We talked last month about the Securities and Exchange Commission’s new “best interests” rules, in which retail brokers will have to “act in the best interest of the retail customer” when recommending investments. This rule would be absurd in the institutional market. “A broker-dealer is not … an agent for its counterparties in these trades and owes them no special or fiduciary duty.” If you are in the business of buying low and selling high, it is hard to also be in the business of looking out for the best interests of the people you’re buying from and selling to. After all, it’s in their interest that you buy high and sell low.

There is nothing surprising about any of this. The rule for institutions—caveat emptor, arm’s-length counterparties looking out for their own interests—seems correct, for institutions. If you are a big bond fund you probably have your own view on value, and you have data feeds that can give you a sense of the fair price, and you can check prices with multiple dealer, and if one dealer is ripping you off you can put her in the penalty box, and anyway you are probably playing the dealers against each other so that you can rip them off. The rule for individuals—in which brokers are supposed to look out for their customers’ interests—also seems correct, for individuals. If you are a retail investor you probably have one broker and have to rely on what she tells you. Retail investors expect their broker-dealers to be advisers, institutional investors expect their broker-dealers to be dealers, and the rules really ought to let both sets of investors get what they expect.

Of course there are gray areas; some institutions might be the sorts of innocents whom we want to protect from the big bad dealers, while some individuals are sophisticated sharks. Some sorts of big-bad-dealer behavior are borderline in the caveat-emptor institutional world; some sorts of conflict-of-interest management are borderline in the best-interests retail world.

But it seems to me that a bigger problem is the risk of reasoning by analogy from one world to another. “Don’t banks have fiduciary duties to their customers,” politicians will ask, because that seems like the sort of thing that would be true of retail customers, so why shouldn’t it be true of institutions? “Our markup is our business, caveat emptor,” retail brokers will say, because that seems to be true for their institutional cousins, so why shouldn’t it be true for them? The point, though, is that you shouldn’t assume that retail brokers should be able to do what institutional brokers can do, or that institutional brokers should be required to do what retail brokers must do. Retail and institutional brokerage are, in important ways, opposite sorts of businesses.

Ah, shareholder democracy.

What should you do, as a shareholder, if you think guns are bad? Well, you could buy shares in big retailers and then encourage those retailers not to sell guns. You could buy shares in banks and encourage them not to finance gun manufacturers. You could refuse to buy shares in gun manufacturers, thereby driving up those manufacturers’ cost of capital and reducing the production of guns. These all seem like plausible, though incremental, approaches.

Or you could buy shares in gun manufacturers and lobby them to stop manufacturing guns. This is a more extreme approach, and I am not convinced that there is a coherent way to do it. For one thing, if you buy shares in a gun manufacturer and tell it to shut down its business, and it does, then you will probably lose your whole investment. (You could tell it to pivot to manufacturing ball bearings or whatever, but presumably the pivot would have substantial costs; presumably gun manufacturers are better suited to manufacturing guns than ball bearings.) Given that obvious problem, you’ll have a hard time getting management to agree to your plan, and you will need to run a proxy fight to replace management; for the same reason, you’ll have a hard time getting other shareholders to vote for your plan. If you have limitless money you could perhaps do it anyway—just buy 51 percent of all the gun manufacturers and shut them down—but even that might not work. Presumably people would just start up new gun manufacturers, and you’d have to pay a premium to acquire them to shut them down, and you’d just keep paying premiums to gun manufacturers and end up subsidizing the gun business.

Anyway that concludes my weird hypothetical in which shareholders actually influence the actions of the companies they own. Here meanwhile is real life:

Sturm, Ruger & Co. will prepare a report on risks related to the company’s business, following a shareholder vote during the firearms manufacturer’s annual meeting on Wednesday afternoon. The vote does not require the company to change the products it manufactures. 

“The proposal requires Ruger to prepare a report. That's it: a report,” said chief executive officer Christopher John Killoy. “The shareholders have spoken and we will follow through on our obligation to prepare that report in due course. What the proposal does not and cannot do is force us to change our business, which is lawful and constitutionally protected.”

The lead filer of the proposal was Colleen Scanlon of Catholic Health Initiatives, who was joined by a variety of other investors, many affiliated with religious groups.

Imagine being so concerned about gun violence that you … buy shares in a gun manufacturer and … vote for it to … produce a report … about manufacturing guns? You could just not own gun manufacturers, you know? I wrote yesterday that embarrassment “seems to be the principal mechanism of corporate governance,” but I cannot see how this report would embarrass Sturm Ruger into changing its business. (As the CEO said!) Really the shareholders should be embarrassed here.

Oh you know.

I don’t want to tell you how to live your life, and I don’t hold myself out as an expert on the Foreign Corrupt Practices Act or anything, but if you are doing business in a country in the developing world, and your business is politically sensitive and depends on the goodwill of the country’s president, and you decide to start paying $100,000 a month to some guy with nebulous skills and no knowledge of your industry who happens to have a close business and personal relationship with that president, and this comes out, and people ask you what those payments were for—I hope you have a better answer than “access”? “Access” is the bad answer! I mean, of course the payments were for access. But you are not supposed to say that. You might as well just say “bribes, it was bribes.”

When Michael Cohen approached the global health care company Novartis AG to hire him shortly after his longtime boss and client Donald Trump arrived at the White House, Cohen promised one thing: access, a company spokesman told ABC News.

“He promised access to the new administration,” Eric Althoff, a spokesman for the company said. “Keep in mind – it was a whole new environment and the usual players were no longer in [their] role.”

For that access, the company paid Cohen $1.2 million, Althoff said. … 

He said the company soon became convinced that Cohen would not be able “to provide the services that Novartis had anticipated related to U.S. healthcare policy matters and the decision was taken not to engage further.”

Yet, the company said it continued to pay Cohen because the contract could be terminated only for cause.

“Basically the company did not feel that he could provide the access [he claimed]," Althoff said.

AT&T Inc. also threw some money Cohen’s way, though it at least had the good taste to say it was paying for “insights” rather than “access.”

I mean, again, this is not legal advice. “You can pay money to get access to politics and curry favor -- you just can’t pay money to get an official action,” says a former federal prosecutor. It is certainly unseemly, but I guess that is a silly thing to worry about these days. “One of the great arbitrages in finance—in life—is being immune to embarrassment,” I wrote, yesterday. It serves me right. 

It could be worse. For instance: This is worse.

The Avenatti memo also said Korea Aerospace Industries Ltd. made a $150,000 payment to Mr. Cohen in November 2017. Korea Aerospace said it hired Essential for legal counseling regarding U.S. accounting standards.

Hahaha no. No. No.

The crypto.

The nice thing about Bitcoin is that since transactions occur on the blockchain, settlement is instantaneous; you are not beholden to the slow archaic money-transfer processes of the traditional banking system. No just kidding here’s how you spend your Bitcoins if you rely on Xapo, Wences Casares’s startup, to keep them safe:

At Xapo, retrieving Bitcoin from the vault takes about two days. The company verifies a client’s identity and authenticates the request before manually signing the transactions with private keys from multiple vault locations. Approval from three separate vaults is required for any transactions to be authorized.

There are literal underground vaults—“including one in a decommissioned Swiss military bunker”—to demonstrate how seriously they take security for this entirely digital currency, and how much you should trust them to hold your trustless currency. 

Elsewhere here is Davis Polk & Wardwell LLP on the problem of Bitcoin fungibility, in which the relative ease of tracing Bitcoin transactions creates a risk that some Bitcoins (stolen ones, ones that have previously been used for illicit purposes or been owned by sanctioned actors, etc.) might be worth less than others:

A possible future for bitcoin is one in which the old banknote lists return in 21st-century form—bitcoin from a particular address would be graded based on its transaction history and relative distance from flagged transactions or blacklisted addresses. For example, as generally described by JP Koning, Grade A bitcoin would be “fresh” bitcoin, purchased directly from a miner and would trade at a premium. Grade D bitcoin, meanwhile, may have passed through a blacklisted address and trade at a significant discount. In between are bitcoin that are not closely associated with a blacklisted address or that have been “cleaned” by passing through a bitcoin mixing service that makes tracing more difficult. Such grading schemes could easily become enormously complex given that bitcoin easily moves across borders, and various jurisdictions could have overlapping or inconsistent blacklists, tort laws, AML/KYC requirements, and laws particular to digital assets. This type of regime could lead to a market where any large bitcoin transaction would require a bespoke appraisal. Further, because bitcoin do not go out of circulation, bitcoin will “age,” becoming less valuable over time as each transaction makes it more likely that it will pass through a tainted address. All told, fungibility issues could easily become a substantial limiting factor on bitcoin’s usefulness as a currency.

I find this extremely improbable, since the problem theoretically exists now—you can trace Bitcoins and see if they come from bad places—but everyone just treats them as fungible anyway. If Bitcoin is widely used, it seems like a no-brainer for law and custom to continue that norm.  

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

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