HedgeFundLive.com — WOW! The FBI has just arrested two more people for alleged insider trading, and this is a big one, replete with burnt cash, prepaid cell phone destruction, wiretaps and all. All that is missing is a great nickname like “Octopussy”.
According to CNBC, a trader named Garrett Bauer is alleged to have made over $32 million trading on tips recieved from Matthew Kluger, a lawyer who has worked at some of the worlds most pretigious law firms over a seventeen year legal career. According to US Attorney Paul Fishman, Mr. Kluger, currently a Washington, D.C. based mergers and acquisiton lawyer with Wilson Sonsini Goodrich & Rosatii PC, allegedly “stole trusted secrets” and passed along the stolen information to an unknown tippee, who passed the information on to Mr. Bauer. Kluger allegedly obtained the prized deal information by seaching the law firms’ computer systems. According to Mr. Fishman, before Wilson Sonsini, Mr. Kluger previously stole and passed along inside information from two of the world’s most prestigious mergers and acquisition law firms: Skadden, Arps, Slate, Meagher and Flom, and Cravath, Swaine & Moore.
If this is all true, Kluger and Bauer (hey, isn’t that a great name for a law firm?) are big-time criminals, and certainly deserve to rot in prison. Time will tell with these two guys. I ask myself, is this just the tip of the iceberg? Sure seems that way if you believe what you see on televison and read in the papers. Can there be any doubt that we will soon here about another expert network arrest, or the unwinding of another big hedge fund unable to survive investor redemption requests after being raided by the F.B.I? All of this begs the question: Why are so many hedge funds managers and traders being arrested for insider trading?
In my opinion, this battle to clean up Wall Street is being led by S.E.C. Chairman Mary Schapiro and her Director of Enforcement Robert Khuzami. To win the propaganda war, and to secure the necessary funding it needs for further enforcement actions, the average Joe on Main Street needs to believe this scourge of Wall Street is rampant, and believe that it somehow threatens his livelihood. Enter U.S. Attorney for the Southern District of New York, Preet Bharara, who is continuing to wage war against traders, hedge funds and other proprietary trading shops. According to Mr. Bharara (derisively referred to as “Tweet Piranha” by those who believe that his trademark tenacity and seeming voracious appetite for Wall Street trader meat has gone a bit too far), “illegal insider trading is rampant and may even be on the rise”. Consequently, Mr. Bharara is on a self-professed mission to catch all those modern day Gordon Gekko’s, and prove to the world that, in fact, “sometimes, greed is not good.”
I simply cannot agree with Mr. Bhahara’s contention that insider trading is rampant and on the rise, notwithstanding today’s arrests. To me, that is a specious claim which both defies logic and smacks of politics. As a simple matter of supply and demand, there are substantially less traders today, and the demand for all kinds of trading-related information has decreased as a result of both increased enforcement and vague laws. Moreover, legislation emanating from the financial crisis of 2008 has made it much more difficult for firms to deploy capital and engage in proprietary trading, though as Michael Lewis has pointed out, poor drafting and loopholes in the Dodd-Frank bill have allowed the big banks to skirt the legislative intent, and continue to make their massive bets on the markets. While big banks such as Goldman Sachs and Morgan Stanley may be able to figure out ways to continue to make enormous and risky bets, the legislation and increased scrutiny of trading has dramatically affected the livelihood of smaller proprietary traders and hedge funds (eg, the guys being arrested for insider trading).
The fact is, the short term proprietary stock trading business is rapidly going the way of the dinosaur. Over the past three years, scores of traders have left the business, unable to compete with the black boxes and unable to gather the requisite market information (ie, material public information) needed to make a living trading. Many traders have been fired for losing money, and now count themselves amongst the structurally unemployed. The harsh reality of the proprietary trading business was driven home last year by Steven Schonfeld, a pioneer in the day trading industry (and a billionaire with his own “personal” not “private” golf course). His firm fired the majority of his proprietary traders because it was “getting much tougher for traders to make a living…” and he noted that “the direct competition from black boxes, stat arb (sic) and high frequency trading which continue to grow at exponential rates is here to stay”. Trust me on this one Mr. Bharara, for most short-term proprietary day traders, day trading is truly dead.
With respect to the hedge funds, market data clearly demonstrates that stock picking as an investment strategy is rapidly declining, and that traditional long/short equity funds, while still popular, have had difficulty generating excess returns without additional risk. This makes perfect sense, since without the free flow of information it is that much more difficult for markets to react to changes in underlying fundamentals. In sum, markets are less efficient.
The end result for traders who work hard and spend a great deal of time and money following markets is that there is no “edge”, and generating alpha (ie, making money) has become nearly impossible. As a consequence, many of the biggest hedge funds have decided that they are better off focusing their time and capital on the global macro investment arena, where there is most definitely still a discernable “edge”. In this investment space, hedge fund managers are free to make leveraged bets on all aspects of the global macro economy using a wide variety of instruments including currencies, commodities, interest rates and derivatives.
In sum, the practical result of stepped up enforcement, together with notoriously ambiguous insider trading laws themselves (which regulators refuse to adequately define) is that most equity traders are petrified to exchange any information whatsoever. This has made a difficult and stressful profession even harder. We are scared (or prevented by our compliance departments) to exchange tidbits of information that historically was the lifeblood of the trading arena. We don’t send as many instant messages about the goings on of the marketplace, we don’t gather as much research, we don’t talk to as many people (heaven forbid we had a contact who was part of the dreaded “expert networks”), we don’t even share funny YouTube videos or sexy Barstool Sports pictures anymore for fear that somebody in those videos or pictures may have some connection to a company or a stock we might trade, and we might find ourselves woken up early one morning by a team of FBI agents eager for some fresh Wall Street meat.
The end result is that the proprietary trading business is not only less profitable, it is also much less fun than it used to be. In fact, it really stinks. Traders are, for the most part, miserable. While prosecutors like Mr. Bharara and Mr. Fishman occasionally arrest notorious and flagrant insider traders like Raj Rajaratnam and Garrett Bauer, they are certainly guilty of selectively enforcing the insider trading laws. If they continue to view all traders as criminals, and round up all those traders who dance along the grey area of extremely vague statutes, one day all that will be left are high frequency trading shops obsessed with capturing fleeting price discrepancies using collocation and other arguable illegal trading strategies –think FLASH CRASH. The Government may be winning the public-relations battle, but may ultimately lose the war.
This blog originally appeared in Clearandpresent.com
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