Financial Review
Anna Bernasek
The latest exposé of how some financial players make their money centres on gaining advance knowledge of analyst recommendations. A few well-connected hedge funds appear to have come up with a clever way of front-running the market by finding out when analysts are about to change their opinions on stocks, before they become public.
According to a report in The New York Times, hedge funds controlled by BlackRock, Two Sigma Investments and Marshall Wace created comprehensive surveys for stock analysts to enable those funds to predict upcoming shifts in stock recommendations. The funds were positioned to make quick profits ahead of public disclosure.
It seems to have been something of a shared secret. Analysts across the industry are reported to have participated in these surveys including those at Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch and UBS while the practice grew over recent years. And not without reason. When a well-regarded analyst changes her view on a stock it tends to affect the price. Any hedge fund that knows ahead of time is almost guaranteed a profit.
Front-running is a practice as old as the markets. As much as organised markets offer attractive liquidity and transparency, they also afford unique opportunities for parasitic operators to take advantage of unsuspecting customers and the general public.
According to an internal memo by Barclays, which owned a money management company conducting analyst surveys, the practice was understood: “The results support prior evidence that our signal enables front-running individual analyst recommendations.”
It’s further evidence that what’s behind many a successful Wall Street career is secret information. Fortunes can be made by knowing things others don’t – at least not yet – and exploiting that for gain.
There are growing indications that the basic services of finance, the bread and butter of our economy, aren’t profitable enough to satisfy the lords of finance. After all, who makes money on plain vanilla brokerage or banking any more? When Wall Street pays lip service to transparency and efficiency, be sceptical. A level playing field isn’t what insiders are after. It’s not good for profits.
Hedge funds in particular have spent millions of dollars lobbying to ensure disclosure rules aren’t strengthened. Banks have been no better fighting disclosure on the grounds it will expose crucial information to competitors.
What’s really going on is a process of creating and protecting deep pockets of knowledge not available to the public in order to make windfall profits. Banks know it, hedge funds know it, and regulators ought to know it.
The free market is almost an icon of the developed world. Yet the very notion of a free market open to all depends on maintaining a level playing field. Secret information is antithetical to free markets, undermining confidence and raising costs for broad swaths of society.
You can trace a solid line through the illiquid junk bonds of the 1980s, the over-promoted stocks of the late 1990s and the faulty real estate bonds of the 2000s to the Libor and front-running scandals unfolding today. In each case a highly profitable sector of Wall Street looks less like the free market than a low grade Coney Island scam.
It makes one wonder who’s in charge. Regulators, banks and funds all share a vital long-term interest in the markets. They need to speak up. Wrongdoing should be systematically exposed and rooted out, not allowed to fester and grow in the dark recesses of the markets. Regulated disclosure has to be priority number one.
Which brings us back to Libor. A little disclosure would have done a lot in avoiding the Libor mess. The Libor rate is one of the most important rates in finance. It’s treated as the actual rate at which a typical bank can borrow. You’d think such a benchmark would be calculated based on hard evidence. In fact it is based on an opinion survey. Effectively, regulators ask a few large banks what they guess it would cost to borrow. Some answers are thrown out and the rest are averaged.
What an invitation to mislead! Barclays apparently did this during the financial crisis to make itself seem healthier. Is it too much to ask for banks to disclose their actual borrowing rates? The truth tends to be relatively useful for markets.
If you’re like me and sometimes wonder why financiers have big houses compared with journalists, here’s your answer. Financial players find things out and keep it to themselves. Journalists trot the secrets out for all to see. That’s the difference between a public service and something that’s neither public, nor a service.
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