Anyone who has ever spent time on an exchange’s trading floor goes through a progression of observations.
First, is the awe at the commotion. There are the coats of different colors, the trader’s frenzy, the enormity of the closed space, the roar, the clutter of papers and the mix of all types, sizes and colors of people.
Over time, the scene becomes more understandable. An observer soon can discern the various roles, ranks, seniorities and power of the various traders and staff. An observer will then see the actual order of the trading floor, including its bid-offer and order routing process.
But if an observer becomes s regular visitor to any trading floor, they will notice its tenor and temperament. The trading bursts are eclipsed by periods of boredom. The trading comes in ebbs and flows, so there is time for traders on the floor and upstairs in front of computers, to compare notes, speculate on order floors and trading directions, and even go into a corner to devise more novel, untraditional trading strategies designed to obtain a larger, less risky, consistent profit.
As someone who has been on almost every major trading floor in the U.S., stock and futures, I believe the same process applies to all. There may be cultural differences between the trading floors, but the peoples’ motives and profit-seeking focus is universal.
That is why the recent disclosures of bid rigging on the LIBOR (London Interbank Bank Offer Rate) by traders represent the world’s largest bank in the multi-trillion dollar foreign exchange market is breathtaking in its scope and impact, yet mundane in its purpose. The fact is that traders cannot be profitably engaged in daily trading and remain profitable over time unless they are extremely talented or have some inside edge on the other competing market participants.
As Bloomberg news reported:
“The $4.7-trillion-a-day currency market, the biggest in the financial system, is one of the least regulated. The inherent conflict banks face between executing client orders and profiting from their own trades is exacerbated because most currency trading takes place away from exchanges.”
That is to say, the LIBOR scandal is unfolding in an unregulated market, which exists alongside the regulated financial marketplace which has seen an even-increasing number of larger front-running and insider trading scandals. The similarities have to be noticed. While many will deny it, front-running and insider trading are what drives the most profitable banks and trading firms over time. Yes, there are individual trading firms and managers who can post five or ten years of above-index market returns, but their days are statistically numbered. Over time, their performance will revert to the mean, or to the index market averages.
But the front-running model in their various forms can pay off big in the short run for some. But, in the LIBOR case, the bid-rigging has been going on for decades taking an extraordinary amount of money out of the hands of unsuspecting people worldwide.
Again, the Bloomberg story said this has been going on for a least a decade and involved trillions of dollars in loans, including mortgage loans made to unsuspecting U.S. home buyers, tied to the rigged LIBOR rates:
“Employees have been front-running client orders and rigging WM/Reuters rates by pushing through trades before and during the 60-second windows when the benchmarks are set, said the current and former traders, who requested anonymity because the practice is controversial. Dealers colluded with counterparts to boost chances of moving the rates, said two of the people, who worked in the industry for a total of more than 20 years.”
More Common Than You Think
While there are no official statistics on front-running and insider trading aside from legal case data, my bet is that the undetected number of insider trading instances far exceeds the number of individuals caught.
One personal story may provide an example. In the early 1990s, I did some marketing work for a hedge fund in the Bear Stearns building. Hedge funds there received free rent and other perks if they became clients of the Bear Stearns prime brokerage services. (If readers are interested in finding out about the brave new world of hedge fund operations, start reading about prime brokerage services.)
After about six months on the project and working on some delicate, intricate language explain the firm’s investment strategy, the project was finally completed. At our last meeting, the managing partner distilled their strategy: “Basically, we take many, many NYSE specialists to lunch and eventually we can find out what their clients are going to do. That is our trading strategy.”
So with the addition of near-instantaneous trade executions and an army of highly-paid consulting snoops to discover revealed and unrevealed trading plans, insider trading should be considered a permanent feature of trading. Sure this hurts individuals, as well as some less-aggressive institutional investors, but that is only collateral damage. When hundreds of thousands of people per day pay a few dollars more for a loan, there really is no huge cause for concern. Instead, the big returns and bonuses make this game very attractive, even essential, for select trading and investment banking executives who want to maintain their lifestyles.
The only takeaway for individual investors who are not LIBOR-dependent or trading foreign currencies is to accept that big-rigging and insider trading are risks which cannot be avoided. The way to reduce this exposure, at least in the equity markets, is through index funds. Let the active managers and their investors take the price and volatility risks. If they suffer enough fund redemptions or their trading records become even more volatile, some big firm may even ask to call in the regulators.
But that is a remote possibility. After all, the prevailing policy is to let the big boys have their fun, even if untold thousands of bystanders get hurt in the frenzy.