Tuesday, January 7, 2014

Frontline: To Catch a Trader

Trying something new... I'm watching PBS, writing as I watch, and hoping to have something publishable shortly afterwards.  I'll see what happens.

FRONTLINE is back with a look at insider trading with "To Catch a Trader."  This time, we're looking at hedge funds, specifically SAC Capital.  I'm personally skeptical of hedge funds in general - they appear to be fee structures that if they do make real money, there is so much trading involved that the actual assets one owns at any point is not entirely clear.  In general, I worry about anything that's a black box.  I like to know how my money is making more money. 

With Wall Street, the question is not just about transparency, but legality.  We'll put the ethics on the side for now.  If you want to move first, then you need information about what move to make, and you need to move before everyone else in order to make the most money.  If you make the most money, then you get the largest clients, as people want their money to make the most money possible.  All incentives are to get this information fast, and to act on it, even if doing so is illegal.  Insider trading is not just unethical, or bad manners, but is flat-out illegal.  But if your incentives are contrary to legal compliance, and you perceive that you chance of getting caught is low, then the choice that is most advantageous to a fund is to do that which is illegal.

This isn't about morals.  Companies are amoral.  Not immoral, but without morals.  If your firm's goal is to maximize profits, then the expected benefits should outweigh the expected costs (chance of getting caught * expected fine), and the firm does it.  Possible ways around it are to increase the fines that are collected (unpopular politically, as this gets rolled into your 401(k) management fees) or to increase the likelihood of getting caught (which increases payroll... increasing government expenditures... also unpopular politically).  The business isn't going to police this activity.

Instead, it may come down to the individual trader.  (S)He will be the one on the line for illegal behavior.  At this point, one's salary vs the fine may be more likely to spur legal behavior.  Actual jail time might also incentivize correct behavior in the individual.  But, this only works if you believe that you will get caught.  The last piece of the pie is whether illegal behavior is socially acceptable.  So, if you go to Wharton, do your classmates assume that you will be making money while keeping to the straight and narrow?  Probably not.  FRONTLINE mentioned that one hedge fund relied on their Wharton network to get the insider tips on which the hedge fund business model relied.

So, how does one fix this?  How do you design a system that incentivizes proper behavior?  Is it socialization in business school?  Stricter oversight?  More scrutiny of actual trades?  Or do you expect investors to somehow know that huge returns above market may indicate some funny business on the part of the person you've entrusted with your money?  Considering how pervasive the culture on Wall Street is to make money, it's hard to see how any one fix can overturn an entire system that appears to be corrupt.

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