the idea of investing is to get a return - this shouldn't be ONLY a matter of returns if you have any [ethical] issues with certain activities (e.g., [slavery], [drugs](substances), etc) - it's better to first know what you believe morally, then invest within those domains - without that framework of thought, you'll likely find yourself investing in [evil] activities without realizing it The measure of the stock market's success is not whether stock prices are rising. It's whether stock prices are right. It's harder for the market to get prices right when there is so little money on the short side. The psychology of investors: - sometimes herd, preferring the safety of the company of others to make independent decisions. - too much credence to recent and high-profile news while underestimating the longer-lasting trends or less dramatic events - (in the same way people worry about being killed in a plane crash while not paying attention to their high cholesterol) - fooled by randomness, believing money managers who have had a few good quarters have figured out the trick of beating the market - find losses twice as painful as they find gains pleasurable, so hold on to stocks longer than they should, believing as long as they haven't sold it, they haven't suffered any losses - above all, overconfident, which means they trade more than they should and end up costing themselves money as a result - (from 1991-1996 the market returned 17.9%. active investors earned just 11.4%. They would have done better had they just sat on their hands.) The idea of the wisdom of crowds is not that a group will always give you the right answer, but that on average it will consistently come up with a better answer than any individual could provide. That's why the fact that only a fraction of investors consistently do better than the market remains the most powerful piece of evidence that the market is efficient. The healthiest markets are those that are animated by both fear and greed at the same time. Any time you sell a stock, the person who's buying it thinks differently about the future prospects of that stock. You think it's going down, he thinks it's going up. One of you will be right, but the important thing is that it's only through the interaction of those differing attitudes that the market is able to do a good job of allocating capital. If groups on the whole are relatively intelligent (as we know they are), there's a good chance that a stock price is actually right. Problem is that once everyone starts piggybacking on the wisdom of the group, then no one is doing anything to add to the wisdom of the group. Lending money in a world of lenders leaves you dependent on who you lend to - that risk should have a contingency at all times for wiriting off as bad debt Make sure the information all your trades are on "public information" - this information must be accessible to everyone - the information may be your [trade-specific] expertise, but it's still something anyone else can theoretically research - however, if it's enough money, expect lawsuits about it the only difference between gambling and investing is [knowledge] clarify the meaning of close-to-the-money versus out-of-the-money index funds are safe, but they also oddly unethical - it's bsaically holding an entire industry, meaning that the stakeholding of any individual company is not aas well-considered as the stakeholding of the mutual fund's basket IF IT SEEMS TOO GOOD TO BE TRUE, IT MAY BE A LAUNDERING OR [MLM] SCHEME 3 TIMELESS IDEAS FOR INVESTING: 1. Look at stocks as part-ownership of a business 2. Look at market fluctuations as your friend by profiting from folly rather than participating in it. 3. Margin of safety. It seems like a waste to get a PhD in Economics and have it all come back to that. There's a tendency to overlook anything that simple and important. Read the annual reports of Berkshire Hathaway at http://www.berkshirehathaway.com - and subscribe to Outstanding Investor Digest at http://www.oid.com [Takeaways from the Jane Street bond prospectus | Hacker News](https://news.ycombinator.com/item?id=40220722) [Jane Street is big. Like, really, really big](https://www.ft.com/content/54671865-4c7f-4692-a879-867ef68f0bde) [Cryptowatch to sunset: Kraken Pro to integrate Cryptowatch features - Kraken Blog Kraken Blog](https://blog.kraken.com/product/cryptowatch-to-sunset-kraken-pro-to-integrate-cryptowatch-features) [Money laundering and AML compliance](https://www.bitsaboutmoney.com/archive/money-laundering-and-aml-compliance/?ref=bits-about-money-newsletter) ## Banks [Bank Regulators Issue Warnings on Fintech and Banking as Disasters Pile Up](https://wallstreetonparade.com/2024/07/federal-bank-regulators-issue-warnings-on-fintech-and-banking-as-disasters-pile-up/) ## Ben Bryan Over the last few years, anti-Christian activists have influenced asset managers and are pushing ungodly agendas. If you invest in Mutual Funds or ETFs, your Fund Managers may be voting on your behalf, against your values. I wonder if Christian shareholders are aware their votes are pushing Marxist, social gospel resolutions. If we voted in a bloc for board members based on Biblical values, perhaps the blatant ungodliness we've seen at Bud Lite, Target, Ford, Disney, etc., would not even exist at all. Proverbs 27:23 LSB - Know well the condition of your flocks, and pay attention to your herds. Over the last five years, as I learned this was becoming a larger issue, I've been thinking of some good ways to invest from a Christian perspective. Doing a quick search reveals Faith-Based funds. The Timothy Plan, Global X by SEI, and Inspire. These funds try to avoid "sin" stocks by screening out companies that promote abortion, homosexuality, cross-dressing, alcohol (which is not even a sin), tobacco (again..), etc. But I'm less interested in avoiding "sin" stocks. My investment strategy is to own the market. What I want to know is, for the funds you hold, are the fund managers using your proxy vote to support Biblical or ESG values? I couldn't find a lot of information on this until earlier this year. Pension Politics recently released a report on how Fund Companies Proxy Vote. The report grades Fund Managers on how they vote from A to F. The closer to A, the more the fund managers voted against ESG policies, and the companies rated closer to F voted for the ESG policies. Looking through the report, I took note of some of the larger players: PRIMECAP - A (perfect voting score) Dimensional - A Vanguard - A (of the largest three fund managers, Vanguard has the highest grade) Fidelity - A Blackrock - C (for all the bad press Blackrock gets, they aren't the worst) JP Morgan - C (no surprise there) Charles Schwab - D (Chuck, what happened?!) State Street - D Remember the "Christian" Faith-Based funds I mentioned earlier? The Timothy Plan got an F. SEI, which runs the Global X Catholic Values fund, got a D-. Dave Ramsey, who is promoted in many churches, recommends SmartVestor Pro advisors, which sells Alger funds. Alger got the worst possible grade, voting for every single woke proposal. F-. As an aside, many of the Alger funds have enormous fees; if you are ever tempted to buy such a fund, you may want to read Where Are the Customers' Yachts? by Fred Schwed Jr. and Enough by John C. Bogle. So, while Faith-Based investing funds appear to be pious in their avoidance of "sin" stocks, they vote to turn the stocks they do hold into social justice companies. There is one exception. That's Inspire, which got an A grade with a perfect voting record. They aim to be Biblically responsible, and they do vote according to Biblical values. If the 0.35% net ER were a bit lower, I'd consider holding their BIBL fund. Next time you're about to invest, read the report from Pension Politics to see how your fund manager votes. In the past, I've preferred to hold index funds from Vanguard, Schwab, Fidelity, State Street, and Blackrock without considering how they vote on my behalf; I have adjusted my IPS to prefer fund managers that are more likely to vote in the way I would. Finally, while it is wise and good stewardship to verify your fund managers are representing your values, the fact that woke resolutions can even be successful is a symptom of a much larger problem, and that is simply that people are ungodly. Unless the hearts of men change towards God, which is only possible through the Gospel, any other form of resistance to ungodly shareholder resolutions is futile. I've made the assumption that the reader already understands the dangers of Wokism and ESG; this has been well-defended and documented elsewhere, so I didn't triple the size of this post to do that. But if you are interested, see MacArthur's article on The Injustice of Social Justice and listen to A Biblical Theology of Climate Change at the Just Thinking podcast. The post Investing as a Christian in a World of Woke Proxy Voting appeared first on b3n.org. [Beating Inflation Portfolio Retrospect - 3-Year - b3n.org](https://b3n.org/beating-inflation/) ## fintech [The future of kdb+? | Hacker News](https://news.ycombinator.com/item?id=41143764) [The Future of kdb+? »](https://www.timestored.com/b/the-future-of-kdb/) ## fund managers [Nevada’s public employee pension fund invests passively and beats peers (2016) | Hacker News](https://news.ycombinator.com/item?id=40957656) [wsj.com](https://www.wsj.com/articles/what-does-nevadas-35-billion-fund-manager-do-all-day-nothing-1476887420) ## stock market [Stock Market Volatility](https://themeasureofaplan.com/visualizing-stock-market-volatility/) ## Peak pod - Matt Levine The most basic [move](https://www.bloomberg.com/opinion/articles/2021-10-07/matt-levine-s-money-stuff-looking-for-tether-s-money) in [finance](https://www.bloomberg.com/opinion/articles/2022-11-28/ftx-s-blockfi-rescue-didn-t-work) is the [slicing](https://www.bloomberg.com/opinion/articles/2023-01-18/slicing-cash-flows-for-better-ratings) of cash flows. You have a thing with some uncertain payoff: It will surely be worth at least $X, but it could be worth as much as $Y. You put the thing in a box and sell claims on the box to different people who want different things. You sell $X worth of senior claims to people who want safety, promising to pay them back first: The box will surely be worth at least $X, so their claims are very safe. And then you sell some junior claims to other people who want risk: The box could be worth as much as $Y, in which case you'd pay off the $X of senior claims and have money left over for the junior claims. Those claims are risky (they could go to zero), but also more lucrative (they could be worth a lot); they promise a higher expected return in exchange for taking more risk. And of course you could slice more finely: Issue one set of super-safe senior claims, another set of pretty safe mezzanine claims, a set of risky junior claims, etc. And an important way to come up with new financial businesses is to notice some financial thing with some fluctuating value and decompose it into a safe part and a risky part. One way to think about multi-manager, multi-strategy [hedge funds](https://www.bloomberg.com/opinion/articles/2023-11-08/the-coffee-futures-got-stale) (or "pod shops") is that they are a way to turn _investing skill_ into this sort of tractable, tranche-able financial asset. The rough theory is: 1. Some people can, with hard work and native skill, identify which stocks (bonds, commodities, etc.) are better and which are worse, within some narrow sector, with some reasonably high success rate. Not through any sort of magic market intuition but through deep study and specialization: If you spend your life studying the biotech industry, you might have somewhat better-than-chance odds of picking which biotech stocks will outperform and which will underperform. 2. If they just went out and bought the five stocks they thought were the best, they'd have a good chance of making a lot of money, but there'd be risks too. Perhaps there would be a general stock market crash, or a collapse in the biotech industry; they might have accurately picked the best stocks but those stocks would still go down. 3. But you can hire them and isolate their skill: Make them buy the best stocks in their sector, short the worst stocks in their sector, and keep a neutral exposure to the stock market, the sector and other factors, so that they only make (or lose) money if their favorite stocks outperform (or underperform) their least-favorite stocks due to their pure stock-picking skill. 4. And you can also hire other specialists in other sectors, and other asset classes, and make all of them hedge, so that you have a diversified portfolio that has no exposure to the broad stock market, to individual sectors, to factors, etc., but is exposed only to their collective investing skill. 5. And you fire the ones who mess up, so the overall skill level remains high. 6. And then you decompose what they are doing into (1) a very large, very boring, very safe portfolio and (2) a smaller and more volatile stream of payoffs for their investing skill. If you do this right, you can have them build a very large portfolio with not very much risk. They can bet on a lot of things, and bet against a lot of other things, and those things are highly correlated with each other. Like, they make $1 billion of bets that blue widgets will go up, and they make $1 billion of bets that green widgets will go down, and historically blue and green widget prices have moved in lockstep. That's a total of $2 billion of bets, but they cancel each other out. If blue widgets go down 20% (and they lose $200 million on their long bet), then probably green widgets will also go down 20% (and they make $200 million on their short bet), so there's still $2 billion. But the idea is that they know something the market doesn't, and actually blue widgets will go up by 5 percentage points more (or down by 5 percentage points less) than green widgets, and so they'll make $50 million on this bet. Of course they could be wrong; maybe blue widgets will _underperform_ green ones and the bet will lose money. Not the whole $2 billion amount of the bet - blue and green widgets are pretty fungible - but, you know, maybe $50 million. And you can kind of abstractly do some math like "this bet requires $2 billion, and we hope it will pay back like $2.05 billion, but even if we're wrong it should pay back $2 billion, or $1.95 billion at absolute worst." And then you can go out and sell, say, $1.9 billion of senior claims on this bet, saying "we'll pay you back the $1.9 billion no matter what." And then you raise, say, $100 million of junior claims on this bet, saying "we hope to pay you back $150 million on your $100 million investment, but if we're wrong you eat the losses." Traditionally the people buying the senior claims are prime brokerage desks at big investment banks, and they can check all of this: They can look at the actual trades that you're doing and say "ah yes, historically, blue and green widget prices have been highly correlated, so the chances of losing much of this $2 billion is slim, and the chances of eating into our $1.9 billion are close to zero." And they can check your track record, too, and say "yeah these guys usually make money and always pay back their senior claims so it's fine." Also they hold your collateral - the blue widgets you're long, the green widgets you're short - and if the trade does start to collapse they can probably shut it down before you lose too much money (and, thus, before _they_ lose any money). And then traditionally the people buying the junior claims are your hedge fund investors, who are betting that you really do have all this investing skill, that you really can turn their $100 million into $150 million much more often than you turn it into $50 million. And then traditionally you yourself, and your employees, have some sort of super-junior claim, where you get paid a big chunk of the upside if the bets pay off. Now, another important move in finance is to worry about this slicing of cash flows. The traditional worries are: 1. The safe senior claims: Are they really that safe? Do we really _know_ that this trade can't lose a lot of money and cut into the $1.9 billion senior claim? What if blue widgets fall 10% and green widgets go up 10%? Then this strategy loses $200 million, the junior claims are wiped out and the lenders lose money. 2. The risky junior claims: Boy, they sure look risky! In the example above, the total portfolio lost 10% of its value, but the junior claims lost 100% of their value. Seems risky. 3. The interplay between them: If you have a $2 billion portfolio and it loses 10% of its value for some temporary reason, you might just hold onto it until the prices recover. But if you have a $2 billion portfolio with 95% leverage and it loses 10% of its value, your lender - a bank prime brokerage - will seize the collateral and sell it as quickly as possible, which means (1) you permanently lose all of your equity and also (2) your lender's sale might further drive down prices and cause more problems. Here's a [Bloomberg News story about "peak pod"](https://www.bloomberg.com/news/articles/2023-11-30/ken-griffin-s-citadel-hedge-fund-rivals-draw-scrutiny-over-crowding-leverage): > Multimanager funds like [Ken] Griffin's Citadel have come to dominate the hedge fund industry, riding a steady run of outperformance to oversee more than $1 trillion, including a healthy dose of leverage. But the explosive growth has led the industry giants to pile into many of the same trades. > > That has built unease among regulators, investors and traders over these so-called pod shops. … > > Overcrowding in some bets, increased market volatility, an expensive talent war and lower returns this year have prompted market participants to question whether the world of high finance is approaching peak pod. ... > > "There's some overcrowding and concern about the amount of leverage at individual firms and collectively," John Jackson, head of hedge fund research at investment consultant Mercer, said during a recent Capital Allocators podcast. And because they typically cut risk very quickly "we are worried about the potential snowball effect." … > > Clients are now fixated on leverage and the risk of "platform de-grossing" - or stampede selling - Goldman Sachs said in an earlier report. … > > Much of the increased regulatory focus has been in Treasury markets, where leverage tends to be the highest. Hedge funds in aggregate had estimated leverage of 56-to-1 on $553 billion of Treasury repo borrowing as of December 2022, according to a September research note by Federal Reserve staffers Ayelen Banegas and Phillip Monin. > > That's why many of the big firms incurred larger-than-expected losses during the early days of the Covid-19 pandemic. They were caught in the so-called basis trade, which is designed to profit from small differences between Treasury futures and the cash market. Considered a safe arbitrage bet if held to maturity, it can occasionally go haywire, as it did in March 2020. If you are [long $1 billion of Treasury bonds and short $1 billion of Treasury futures](https://www.bloomberg.com/opinion/articles/2023-09-14/people-are-worried-about-the-basis-trade), your chances of losing even 2% of your money are low enough - because Treasury bonds and Treasury futures are almost the same thing - that a bank will lend you 98% of the money you need to do that trade. But they are not zero! Sometimes bad stuff happens. But the other problem is the crowded trades. "Of the $90.7 billion that Citadel held in US stocks at the end of September, 93% was in shares Millennium also holds," says the article. The essential bet of the multi-manager pod shops is that investing skill is (1) real, repeatable and identifiable and (2) not correlated to broad markets: Picking the better things and shorting the worse things should work whether the stock market is up and down. But the risk is that investing skill might be _correlated with everyone else's investing skill._ If you hire people who are really good at knowing which stocks are good and which are bad, and then your four biggest competitors hire similarly skilled people, they might all pick the same good stocks and short the same bad stocks. And then if their bets blow up, they all blow up at once. ## First-loss funds - Matt Levine Here's another way to [slice the returns from hedge-fund skill](https://www.bloomberg.com/news/articles/2023-11-30/hedge-fund-to-back-traders-who-risk-their-own-money-if-bets-fail): > Andrew Lubin, previously the chief executive officer of the London unit of SAC Capital Advisors, and Tim Pearey, former CEO of Odey Asset Management, said they have started a hedge fund that provides capital to traders if they put in their own cash and agree to lose their money first when bets fail. > > Such arrangements, known as first-loss funds, are a niche part of the $4 trillion hedge fund industry and offer traders an opportunity to hold on to more of their profits in exchange for taking on the bulk of the risk. Traders signing up for Lubin and Pearey's London-based AB Asset Scale could keep as much as 60% of the profits they generate, higher than traditional industry payouts of 20% at major multi-strategy hedge funds. ... > > Such platforms frequently hire and fire traders whose performance has dropped or when a trading strategy they run falls out of favour. Lubin and Pearey said they are looking to pick talented traders affected by this churn. > > The first-loss funds provide as much as nine times the capital of a hedge fund or a trader, with their money being housed in a separately managed account. The arrangement, which provides a significant boost to assets under management, requires any losses to accrue to the trader's own invested capital first. … > > Losses of up to 10% will be absorbed by the trader's own capital with the fund aiming to liquidate their bets when declines hit 8.5%, according to an investor document seen by Bloomberg. I like it. The traditional way to get fired from a multi-manager fund is to have too big a drawdown, to lose, say, 5% or 10% of your allocated capital. If you work at a big multi-strategy fund and then are "affected by this churn," the natural inferences to draw are: 1. You have investing skill (that's why the pod shop hired you), but 2. You sometimes lose 10% of your capital (that's why they fired you). So someone else should be willing to hire you to run their money, but only if you take the risk of losing 10% of your capital. ## Factors - Matt Levine If you invest in stocks, your returns will come from roughly three sources: 1. The broad stock market goes up or down. 2. You can get paid (or lose money) for taking on some particular systematic risk: Small companies' stocks tend to outperform large stocks, and cheap stocks (by price-to-book value) tend to outperform expensive ones. 3. You can be idiosyncratically good at picking stocks. The first thing is generally pretty easy to measure; there are widely used broad market indexes. The second thing is less obvious; someone needs to identify the systematic factors and measure the data. The third thing - alpha, investing skill - is generally what's left over after the first two things. This means that identifying and measuring factors - Thing 2 - is very important. For one thing, those factors are part of a popular investment approach: There are funds that try to capture factor premia by, say, buying cheap stocks and avoiding expensive ones, and you want to know how well that strategy works. For another thing, lots of people _really_ want to know how much investment skill their managers have - how much alpha they create - and since that is the residue after subtracting factor returns, you need to know what those are. For many academic and other uses, the main factor model is the [Fama-French three-factor model](https://corporatefinanceinstitute.com/resources/valuation/fama-french-three-factor-model/), where the three factors are market returns, size ("small minus big") and value ("high minus low," that is, high book-to-price ratio minus low book-to-price ratio). And the main source of historical data on the factors is [Kenneth French's website](https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). And here is a fun [Bloomberg Markets story](https://www.bloomberg.com/news/features/2024-03-11/a-fight-over-factor-investing-tests-a-pillar-of-modern-finance) by Mary Childs and Justina Lee about how sometimes that historical data … changes? > In 2021, three professors then based at the University of Toronto noticed something strange and potentially unsettling. The numbers were "noisy" - that is, they changed in significant ways depending on when they were downloaded from the site. Pat Akey, Adriana Robertson and Mikhail Simutin wrote up their puzzling findings in two working papers. ... The authors noted that changes in the numbers seemed to improve the historical record of the value investment strategy-that is, of buying cheap stocks-and wrote that a "lack of transparency" made it impossible to know what to make of that. > > Fama and French's November article confirms that the numbers were changing and lays out the reasons. Among them: Corrections in historical stock market records and adjustments related to accounting rule changes that affected how some stocks are categorized. French's Dartmouth website now contains an archive of earlier versions of the data, so researchers can compare them. "Everything is seating charts," I [sometimes](https://www.bloomberg.com/opinion/articles/2019-01-11/direct-listings-are-a-thing-now) [say](https://www.bloomberg.com/opinion/articles/2021-06-14/morgan-stanley-s-ted-pick-matched-wits-with-goldman-s-blankfein) [around](https://www.bloomberg.com/opinion/articles/2024-02-22/put-the-money-in-the-boxx), about how informal networks of friendship and influence are often the most important incentives in business. In academia, I suppose the equivalent is that everything is the acknowledgments section of working papers? After Akey, Robertson and Simutin questioned the Fama-French data, Fama and French circulated another paper explaining their methodology and the changes, and they were mad: > Two days before the paper hit SSRN, a PDF of it landed in the email inboxes of some of the country's top economists and legal scholars. The accompanying message from Fama made it clear why he and French had written the article-and also that he was annoyed. "Most of you are in the acknowledgements of two papers," he wrote. "There is lots of strong language in those papers about the effects of updates in the Fama-French factors. ... Our view is that their results are not surprising for those with experience in asset pricing research." Fama added: "For us, the whole experience is a great example of the old saw: No good deed goes unpunished." "Most of you are in the acknowledgements" of critical papers is I suppose how academics say "traitors!" ## Yellow - Matt Levine You could have a model like this: 1. Every company has a capital structure with an order of seniority. Secured debt generally gets paid first, followed by unsecured debt, followed by preferred stock, followed by common stock, etc. 2. Every so often, some weird event flips some part of the seniority, so that people who would normally get paid back first get pushed to the back of the line, and people who would normally be at the back of the line move up. 3. You should try to (1) anticipate (or cause!) those events, (2) buy the stuff that will move up and (3) avoid the stuff that will move down. Probably the most notable recent case is [Credit Suisse Group AG's additional tier 1 capital securities](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDMtMjAvdWJzLWdvdC1jcmVkaXQtc3Vpc3NlLWZvci1hbG1vc3Qtbm90aGluZz9jbXBpZD1CQkQwMzIwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDAzMjAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bd6800fc1). These AT1s were a form of subordinated debt that ranked senior to common stock in the capital structure, as Credit Suisse's disclosures and presentations frequently said. But they had provisions saying that in certain circumstances - regulatory capital falling below a trigger, or certain national bailouts - they would be _disappear_, and it was not _necessarily_ true that the common stock would disappear in those circumstances. And in fact, when Credit Suisse was acquired by UBS Group AG last year in a regulator-driven shotgun marriage, (1) the common stock got something and (2) the AT1s got nothing. If you had owned the senior AT1s a day before the merger, you would have been smart to sell them and swap into the junior common stock, because that got paid and the AT1s didn't. This turned out to be very controversial, a lot of people still disagree that the AT1s should have been zeroed, and there are lawsuits. This is a pretty normal feature of this model: Seniority is rarely flipped in some clean, obvious and noncontroversial way; somebody will always sue. (Some other recent examples share that feature: Generically, there's a company, it has debt, and some new or junior creditors [strike a deal with the company](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjItMDUtMTAvY3JlZGl0LW1hcmtldC1jbGFzaGVzLWFyZS1nZXR0aW5nLXVnbGllci1kaXJ0aWVyLW1vcmUtY29tbW9uP2NtcGlkPUJCRDAzMjAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDMyMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B698b43e9) to give it new money in exchange for being made more senior than the previously senior creditors. The creditors left out of the deal [sue](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjItMDQtMDcvZGlzdHJlc3NlZC1kZWJ0LWRlYWwtbWFrZXMtcGVvcGxlLW1hZD9jbXBpZD1CQkQwMzIwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDAzMjAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bb2323af7), claiming that this is not allowed.) Last year, Yellow Corp., the trucking company, filed for bankruptcy. A week before the bankruptcy, an investment firm called MFN Partners paid something like $23 million to buy a ton of Yellow stock, which [seemed like a weird choice](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDgtMDcvaXJsLXMtdXNlcnMtd2VyZS1ub3QtaXJsP2NtcGlkPUJCRDAzMjAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDMyMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B591d4e59): Yellow's bankruptcy was _extremely_ well telegraphed, and generally when a company goes bankrupt its stock becomes worthless. But [in fact](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDgtMTAveW91LWNhbi1zZWxsLXRoZS1iaXRjb2lucy15b3UtZG9uLXQtbWluZT9jbXBpZD1CQkQwMzIwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDAzMjAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bac479e80) Yellow's assets (largely a real estate portfolio) turned out to be more valuable than its debt, there is money left over, and shareholders could get hundreds of millions of dollars back, making this a good trade for MFN. Or not. Bloomberg's [Steven Church reports](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL25ld3NsZXR0ZXJzLzIwMjQtMDMtMTkvbWZuLXBhcnRuZXJzLWZpZ2h0cy13aXRoLXllbGxvdy10cnVja2luZy1wZW5zaW9ucy1hbmQtcGJnYz9jbXBpZD1CQkQwMzIwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDAzMjAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B6038212c): > MFN Partners is the single biggest stockholder of Yellow, which filed bankruptcy last year after failing to win concessions from its union drivers. The company has been liquidating its valuable portfolio of real estate under court oversight and that process has brought in more than initially expected. > > The way things are going, MFN and other shareholders including the US government could share a surplus in the range of hundreds of millions of dollars. But they'll first need to step over pension funds, which have argued they should get the cash because Yellow ditched its retirement obligations in bankruptcy. … > > The pension funds claim that because the trucker shut down and fired tens of thousands of unionized workers, Yellow must kick in at least $582 million to cover future retirement payments, according to court papers. They claim the fight should be handled in private arbitration; the hedge fund says it should play out quickly and in open court, which would get everyone paid faster. One way to think about this is my model above: Ordinarily, when it is a going concern operating its business normally, a company has to pay its pension obligations. Those pension obligations are senior to the common stock; the shareholders only get the profits after the pension obligations are paid. But in bankruptcy, perhaps, that flips: Perhaps Yellow can walk away from its pension obligations for $0, leaving enough money to pay shareholders. On that model, buying the stock a week before the bankruptcy was a good trade: The stock was junior to the debt and pensions and so worth roughly nothing, but _in bankruptcy_ it could ditch the pensions and become worth more. This is not the only model, though, and the pension funds and the US Pension Benefit Guarantee Corp. hotly dispute it. The dispute is actually kind of weird. Yellow's unionized drivers are members of various large, union, multiemployer pensions; those pensions are underfunded; and Yellow had contractual obligations to contribute to those pensions. If it stopped doing so and withdrew from the pensions, it would have to put in additional money to cover the underfunded pension liabilities, and those withdrawal liabilities could be as much as $6.5 billion, [Yellow itself estimated](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cuc2VjLmdvdi9BcmNoaXZlcy9lZGdhci9kYXRhLzcxNjAwNi8wMDAwOTUwMTcwMjMwNDIwNzEveWVsbC0yMDIzMDYzMC5odG0jbm90ZXNfdG9fY29uc29saWRhdGVkX2ZpbmFuY2lhbF9zdGF0ZW1lbg/60e87ce39a995a4b1a2deb96B4a029eed). It went bankrupt in large part because of a dispute with its unions over these pensions, so it stopped contributing in bankruptcy and the pensions filed claims for the withdrawal liability. But in 2021, the US government [bailed out the pension funds](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly93d3cud2hpdGVob3VzZS5nb3YvYnJpZWZpbmctcm9vbS9zdGF0ZW1lbnRzLXJlbGVhc2VzLzIwMjIvMTIvMDgvZmFjdC1zaGVldC1wcmVzaWRlbnQtYmlkZW4tYW5ub3VuY2VzLWhpc3RvcmljLXJlbGllZi10by1wcm90ZWN0LWhhcmQtZWFybmVkLXBlbnNpb25zLW9mLWh1bmRyZWRzLW9mLXRob3VzYW5kcy1vZi11bmlvbi13b3JrZXJzLWFuZC1yZXRpcmVlcy8/60e87ce39a995a4b1a2deb96Bfee842aa) as part of the American Rescue Plan. Now they have plenty of money, so [Yellow argues](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly9kb2N1bWVudC5lcGlxMTEuY29tL2RvY3VtZW50L2dldGRvY3VtZW50c2J5ZG9ja2V0Lz9kb2NrZXRJZD0xMDQ3NTY3JnByb2plY3RDb2RlPVlSQyZkb2NrZXROdW1iZXI9MTMyMiZzb3VyY2U9RE0/60e87ce39a995a4b1a2deb96B91466635) that they are not underfunded, so it should have no withdrawal liability: "[The pensions] cannot ignore the [ARP bailout] or feign a need to allocate to the Debtors an attributable share of [unfunded vested benefits] that do not exist, at the expense of the Debtors' unsecured creditors and equity holders." The [pensions](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly9kb2N1bWVudC5lcGlxMTEuY29tL2RvY3VtZW50L2dldGRvY3VtZW50c2J5ZG9ja2V0Lz9kb2NrZXRJZD0xMDUzNTAwJnByb2plY3RDb2RlPVlSQyZkb2NrZXROdW1iZXI9MTY2NSZzb3VyY2U9RE0/60e87ce39a995a4b1a2deb96C7723b1c7), and the [PBGC](https://link.mail.bloombergbusiness.com/click/34754866.259831/aHR0cHM6Ly9kb2N1bWVudC5lcGlxMTEuY29tL2RvY3VtZW50L2dldGRvY3VtZW50c2J5ZG9ja2V0Lz9kb2NrZXRJZD0xMDY3Nzg0JnByb2plY3RDb2RlPVlSQyZkb2NrZXROdW1iZXI9MjY0MCZzb3VyY2U9RE0/60e87ce39a995a4b1a2deb96Dcecb3c7a) - the government agency that insures pensions - argue, in effect, "oh come on it could not possibly work that way, you can't get out of your pension obligations because of a government bailout of those pensions." But it's worth a shot! ## Banks borrowing short and lending long - Matt Levine ### Banks are where the money isn’t I don’t know, man, it’s all very simple. Here’s what a mortgage is: 1. A company gives me $100,000 to buy a house. 2. I pay the company back $665 per month for 30 years. [[3]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E7174#footnote-3) And here is what an annuity is: 1. You give a company $100,000. 2. The company pays you back $665 per month for the next 30 years. I mean, _probably_ the annuity is more like “the company pays you back $665 per month for the rest of your life, which it actuarially expects to be 30 years,” but it _could_ be a fixed term. The point is that these trades are _pretty_ similar. They both involve a large upfront payment, followed by fixed amortizing payments over an expected term of decades. [[4]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E7174#footnote-4) In the right circumstances, we could cut out the middlemen — you could just give me your $100,000, and I could pay you back over 30 years — but that would require a lot of work. Here is what a bank account is: 1. You give a bank some money. 2. The bank pays you a little interest each month, and lets you take out your money (or put more back in) at any time. Just a different trade. Nothing wrong with it, but different. On first principles, if you were trying to set up a financial system, which of these things would you pair with each other? Like: There are people who need to borrow money to buy houses. They’ll need the money for decades, and they’ll make monthly payments to amortize the loans. And there are people who need to fund their retirement, who’ll sock away a lot of money at the start of retirement so they can get monthly payments for decades. And then there are some other people who need access to liquid cash, so they’ll put away some money that they might need at any moment. Which source of money — the people who need to put away money for decades in exchange for fixed payments, or the people who need to put away money to pay rent next week — should provide the funding for the people who need loans? Historically the answer is “the people who need their money next week fund the 30-year mortgages”: The banking system matches short-term savers with long-term borrowers, funding itself with demand deposits and using those deposits to make mortgages. This system [has some big benefits](https://link.mail.bloombergbusiness.com/click/36079366.223888/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDMtMTcvYmlnLWJhbmtzLXRydXN0LWZpcnN0LXJlcHVibGljLXdpdGgtdGhlaXItbW9uZXk_Y21waWQ9QkJEMDcxNjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNzE2JnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B72c720f9) in terms of spurring economic activity, but it also has extremely well-known problems: _It’s a Wonderful Life_, “[the money’s not here, well your money’s in Joe’s house](https://link.mail.bloombergbusiness.com/click/36079366.223888/aHR0cHM6Ly93d3cueW91dHViZS5jb20vd2F0Y2g_dj1pUGtKSDZCVDdkTQ/60e87ce39a995a4b1a2deb96Bf0521134),” etc. Much of modern banking regulation is about tempering those problems, at the cost of restricting the activity. But I [want](https://link.mail.bloombergbusiness.com/click/36079366.223888/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMTEtMDIvdGhlLWJhbmtzLWFyZS13aGVyZS10aGUtbW9uZXktaXNuLXQ_Y21waWQ9QkJEMDcxNjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNzE2JnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B88ed71f0) to [suggest](https://link.mail.bloombergbusiness.com/click/36079366.223888/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDUtMDEvYmFua3MtYXJlLXN0aWxsLXdoZXJlLXRoZS1tb25leS1pc24tdD9jbXBpZD1CQkQwNzE2MjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MTYmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Be913e437) that the much more intuitive answer is “the people who want annuities should fund the mortgages, because they are after all opposite sides of the same trade so they match up very nicely.” You put away a big slug of money for a long time, and I get it; I make steady payments every month, and you get them; a single intermediary sits between us to evaluate my credit and your lifespan and to do the administrative work of forwarding the payments. All very tidy. Bloomberg’s [Scott Carpenter reports](https://link.mail.bloombergbusiness.com/click/36079366.223888/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDctMTYvaW5zdXJlcnMtdGllZC10by1hcG9sbG8ta2tyLWJ1eS1tb3J0Z2FnZXMtb3V0cmlnaHQtaW4tbmV3LXR3aXN0P2NtcGlkPUJCRDA3MTYyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDcxNiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B740f638d): > Yield-hungry insurance firms are adopting an unconventional strategy: they’re skipping mortgage-backed bonds and buying the underlying whole loans outright. > > It’s a trend that’s picked up pace over the last few years. Last year alone, insurers increased their holdings of residential mortgage loans by a whopping 45%, or about $20 billion, according to an analysis by Ellington Management Group. > > The loans typically don’t qualify for being bundled into bonds supported by Fannie Mae or Freddie Mac — government-backed companies that guarantee most US mortgages for investors. The borrowers are usually riskier, and investors owning mortgages directly, rather than slices of mortgage-backed bonds, means firms have to deal with arduous tasks often left to specialists. Not every firm has the size or sophistication to do that, which is why large alternative asset managers like Apollo Global Management Inc. and KKR & Co. are leading the shift. > > So why bother with the hassle of owning these loans directly, rather than in securitized form? Better yields. It’s difficult to quantify exactly, but insurers with the capability to own mortgages directly could save some 35-45 basis points on the cost of securitization itself, and that’s without considering the substantial amount of capital freed up on insurance company balance sheets because of the better risk treatment, according to Ryan Singer, head of global residential investments at Balbec Capital. … > > Helping drive the shift is a combination of favorable industry risk rules and an influx of cash from annuities. Under insurance rules overseen by the National Association of Insurance Commissioners, whole loans get similar treatment as A rated corporate bonds but yield more. What’s more, a pool of mortgages in their whole loan form gets better risk treatment on insurers’ balance sheets than that same pool of mortgages when held in the form of a bond, said Dupont.  > > Insurers have also taken in enormous amounts of cash recently from people buying annuities. Insurers sold $385 billion in annuities last year, a more than 75% increase from 2020, according to data from Limra. Putting that cash to work in whole loans is appealing, said Bayview’s Mueller Handal, as the average life of most annuities sold today generally fits the average life of the residential loans — five or more years, roughly.  So much of the apparatus of modern finance — all this securitization — is weirdly historically contingent. Why shouldn’t giant asset managers with long-term locked-up funding also be in the business of making the loans? [3] That is, 7% annual interest on the $100,000, plus principal payments to amortize the loan over the 30 years. [4] Also both sometimes terminate early, but there are some actuarially predictable prepayment expectations. ## Banks - Matt Levine ### Oh McKinsey The basic analysis of banking is: 1. A bank owns a pile of assets: loans, bonds, etc. Say they are worth $100 today. 2. The bank is funded mostly by senior claims on those assets: bank deposits and other forms of debt that really should get paid back. Say the bank has $90 of debt outstanding against its $100 of assets. 3. The bank also has a little sliver of equity: its shareholders have the residual claim on those assets, after the senior claims paid back. Here the bank has $10 of equity; depositors and other creditors are entitled to the first $90 of the bank's assets, but anything left over — currently $10 — goes to the shareholders. 4. The shareholders, therefore, have a close-to-the-money [_call option_ on the bank's assets](https://link.mail.bloombergbusiness.com/click/34992007.275818/aHR0cHM6Ly9lbi53aWtpcGVkaWEub3JnL3dpa2kvTWVydG9uX21vZGVs/60e87ce39a995a4b1a2deb96B1ce28125): If the assets turn out to be worth more than $90, the shareholders get the excess, but if they turn out to be worth less than $90, the shareholders get nothing. In particular, if the assets turn out to be worth zero — if all $100 of assets turn out to be fake and the bank is worthless — then the shareholders only lose their $10; the other $90 of the losses fall on the depositors. (Or the deposit insurance fund, the taxpayers, etc.) 5. This option is more valuable if volatility is higher. If the bank's assets have a 50/50 chance of ending up worth $98 or $102, then the shareholders will get back either $8 or $12 after paying off the debt, for an expected value of $10. (And the depositors will always get back their $90.) If the bank's assets have a 50/50 chance of ending up worth $70 or $130, then the shareholders will get back either $0 or $40, for an expected value of $20. And the depositors will get back $90 in the good case, but only $70 — a catastrophe, a bank failure — in the bad case. 6. The bank's executives have fiduciary duties to shareholders, and probably own a lot of stock themselves, so they want to make the stock more valuable. 7. Again, the theoretically correct way to make the stock more valuable is to make the assets more volatile, to make the bank riskier, to increase the value of the shareholders' option. 8. Everything _else_ about banks — bank regulation, prudential supervision, capital and liquidity requirements, deposit insurance, rules about bonuses and clawbacks, bank culture and training, speeches by politicians, depictions of banks in popular culture — is about mitigating this essential problem. The essential problem is that, if you look at a bank's capital structure with some financial sophistication but also some naivety, you will say "wait the bank works for the shareholders, the shareholders have an at-the-money option on the assets, and the way to increase shareholder value is to increase the volatility of those assets." Many stories about banks are that story, the story of someone looking at a bank's balance sheet with financial sophistication and also naivety and saying "hey what about some more risk?" Here's a great one [from Bloomberg's Todd Gillespie](https://link.mail.bloombergbusiness.com/click/34992007.275818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMDkvYWZ0ZXItbWNraW5zZXktbXVzaW5ncy10ZXhhcy1iYW5rLWFpbXMtdG8tZXNjYXBlLWZhdGUtb2Ytcml2YWxzP2NtcGlkPUJCRDA0MTAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDQxMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B43cf0e22): > A cadre of McKinsey & Co. consultants strode into a meeting with Houston's most prominent local bank to dwell on the problem bedeviling thousands of regional banks: How to stay relevant. > > "The thing that I laugh at, though, is they had a chart," said Steve Stephens, the CEO of Amegy Bank, recalling the presentation to the board of its parent company in late 2022. McKinsey's message was that banks such as Amegy could find a lucrative business niche, like the so-called specialty regional banks that it spotlighted in slides, he said. > > "Well, that was First Republic, Silicon Valley Bank and Signature," said Stephens, all of which collapsed last year. "It's specialization that got them." This was good advice, that McKinsey gave him! [[4]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E4899#footnote-4)  Find a niche, specialize, make a big bet: Diversification makes you safer but reduces the variance of your returns; specialization increases the variance and thus the likelihood of making a lot of money for shareholders. Also the likelihood of going to zero. [4] To be fair: "A representative for McKinsey declined to comment. That 2022 presentation was meant to provide an overview on the trends shaping the banking industry and the three failed banks were highlighted among about two dozen firms to showcase how investors were valuing them, according to another person who saw the deck and declined to be identified discussing private information." NOTE: THIS IDEA IS A VERY VALUABLE ASPECT OF EXPLAINING WHY FINANCIAL REGULATIONS ARE SO PSYCHOTIC; MAKE SURE TO PARSE AND SUMMARIZE THIS ENTIRE ARTICLE!!! ## Adverse Selection - Matt Levine ### The Harvard of trading I think that, if you had only five minutes with a world-class trader, and you asked her "teach me the essentials of trading," probably she would spend the five minutes on adverse selection. The essential lesson is that, if you are being offered a trade, that probably means it's a bad trade; your job is to understand that thoroughly so you can figure out the exceptions. There are many ways to teach this lesson, but my favorite probably comes from a reader email [I quoted last October](https://link.mail.bloombergbusiness.com/click/35377662.266794/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMTAtMTIvZnR4LWhhZC1tYW55LWJhZC1zcHJlYWRzaGVldHM_Y21waWQ9QkJEMDUxNDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTE0JnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B328a4bcc), when I was writing a lot about Sam Bankman-Fried's coin flipping at Jane Street: > This was a Susquehanna interview question 25 years ago! They made me do the math on 1000 coin flips. EV(heads) (easy), standard deviation (slightly harder), then they offered me a +EV bet on the outcome. I said "let's go." > > They said "Wrong. If we're offering it to you, you shouldn't take it." > > I said "We just did the math." > > They said "We have a guy on the floor of the Amex who can flip 55% heads." The point here is that Susquehanna International Group employed a guy who was really good at flipping coins so they land heads, _so that_ Susquehanna's traders didn't get too cocky about their bets. "I've done the math and this trade has positive expected value," they will say, but then they'll pause and remember the coin-flip guy and think "if this trade really has positive expected value, why is it being offered to me," and they think a bit harder about it and become better traders. This lesson applies beyond individual trades. For instance, there is the structure of the investment management industry. Agustin Lebron, a former Jane Street trader, has a very good book called [_The Laws of Trading_](https://link.mail.bloombergbusiness.com/click/35377662.266794/aHR0cHM6Ly93d3cubGF3c29mdHJhZGluZy5jb20v/60e87ce39a995a4b1a2deb96B9d8d5873), in which he says: > The profitable trades that exist in the world are either (a) the ones you're intimately involved in running, or (b) the ones that are inaccessible to you. There is no (c). And what's funny about the situation in trading is that, if we were talking about just about any other industry, the very notion of a (c) would be laughable. Imagine if someone who's good at manufacturing cars came to you and said: "Hey. I'm a profitable car-maker. If you like, I'll let you take all the profit from my car-making skill in exchange for a small fee for me." You would rightly suspect they're trying to pull one over on you. So why is the situation different in trading? Similarly! At Bloomberg Businessweek, [Alice Kantor profiles IM Academy](https://link.mail.bloombergbusiness.com/click/35377662.266794/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2ZlYXR1cmVzLzIwMjQtMDUtMTQvdGhlLXN0b2NrLW1hcmtldC1tdWx0aWxldmVsLW1hcmtldGluZy1jb21wYW55LWZvci10ZWVucz9jbXBpZD1CQkQwNTE0MjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MTQmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bc83039a9), a multilevel marketing scheme for stock and commodities trading. At the object level, this seems like a bad trading school: > During the pandemic, IM grew from a small New York operation into a global phenomenon by selling the promise that it could teach anyone, particularly teens and twentysomethings, how to become a savvy retail investor. For a one-time $275 fee and $250 a month, members had access to online courses and coaches providing trading strategies—the "Yale of forex, the Harvard of trading," as a salesman described IM in a marketing video. When young people weren't being invited by their friends to become budding stock market mavens, they might encounter Instagram videos showing how others had gotten rich with the IM method or hear about celebrity members, including fashion model Blac Chyna and professional boxer Floyd Mayweather Jr.  But at the meta level, it provides a helpful lesson in adverse selection. [[2]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E5653#footnote-2)  The thing that IM Academy teaches, if you are paying attention, is "if they know so much about how to make money in financial markets, why would they teach me how to do it for just $250 a month?"  NOTE: THE ASPECT OF ADVERSE SELECTION HAS WISDOM TO IT! YOU SHOULD BE HUNTING FOR THE TRADES, NOT THE OTHER WAY AROUND UNLESS THERE'S ANOTHER REASON ## Banks - Narrow Banking - Matt Levine [Narrow banking - Wikipedia](https://en.wikipedia.org/wiki/Narrow_banking) ### SRT-squared Here is a trend in modern finance: 1. Banks have a [fundamentally](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDMtMTAvc3RhcnR1cC1iYW5rLWhhZC1hLXN0YXJ0dXAtYmFuay1ydW4_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bb30ffd62) [risky](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDUtMDQvbm9ib2R5LXRydXN0cy10aGUtYmFua3Mtbm93P2NtcGlkPUJCRDA2MTIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDYxMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Ba03e7e6b) [business](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDUtMDkvaXQtcy1uZXZlci10b28tbGF0ZS1mb3ItYmFua3MtdG8taGVkZ2U_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B89f5e854) model, borrowing short (by taking deposits) and lending long. 2. In some ways it would be nice if, instead of banks with risky short-term deposits, somebody else, somebody with long-term funding, did all the risky lending. Banks could take deposits (a risky funding model), and then invest them very safely; other investors could raise long-term equity funding (a safe funding model), and use it to make risky loans and investments. Loosely speaking, this is called “[narrow banking](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDQtMjAvYmFua2luZy1nZXRzLWEtYml0LW5hcnJvd2VyP2NtcGlkPUJCRDA2MTIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDYxMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B9f124b66).” 3. And in fact, these days, there are regulatory and market pressures on banks to take fewer of the risks they have traditionally taken. There are stricter capital and liquidity requirements (so banks can’t fund their risky loans too much with risky deposits), and prudential pressures on banks to get out of their riskier businesses (proprietary trading, leveraged lending). The banks take less risk. 4. And in fact, these days, people do go out and raise safe long-term funding to take some of the risks that banks have traditionally taken, in part because those regulatory and market pressures have made banks a bit less willing to take them. Hedge funds and proprietary trading firms [now do some of the market-making functions](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDItMDcvaGVkZ2UtZnVuZHMtYXJlLWRlYWxlcnMtbm93P2NtcGlkPUJCRDA2MTIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDYxMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bae8ce124) that banks [used to do](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDUtMTEvYmxhY2tzdG9uZS1jYW4tYmUtdGhlLWJhbms_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bf45e47e9). Private credit firms [now do](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMTEtMDIvdGhlLWJhbmtzLWFyZS13aGVyZS10aGUtbW9uZXktaXNuLXQ_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B84710d0b) a lot of the risky [balance-sheet lending](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDUtMDEvYmFua3MtYXJlLXN0aWxsLXdoZXJlLXRoZS1tb25leS1pc24tdD9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B8393f705) that banks used to do. And banks now [routinely sell](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDMtMTkvYmFua3MtY2FuLWdldC1lbWlzc2lvbnMtb2ZmLXRoZS1ib29rcz9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B5ea4b91b) some of their [credit risk](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDItMjkvYmFyY2xheXMtZGV1dHNjaGUtYmFuay1hcmUtYmFjay1pbnRvLWNyZWRpdC1kZXJpdmF0aXZlcz9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B44a2eb3d) to hedge funds and other investors, essentially buying insurance from those firms against the risk that their loans will default. 5. Great!  6. All these people with their long-term funds have a problem, though. The reason these businesses work, for banks, is _leverage_. If you are a bank doing a trade with $10 of shareholders’ equity and $90 of deposits, and the trade pays $2, that’s great: You pay roughly $0 to depositors, so that $2 is a 20% return on equity. But if you are a hedge fund doing that same trade with $100 of your own investors’ money, it’s not great: That $2 is a 2% return on equity. 7. What you want, if you are an investor with safe stable long-term funding doing these trades that banks used to do, is _leverage_. You want to borrow 90% of the money to do the trade, preferably cheaply, so that you can get a good return on equity for the people giving you that safe stable long-term funding. 8. Where can you borrow all that money? 9. Well, from banks, obviously. They have lots of money! They are in the business of making loans! It just makes sense. 10. This sort of takes us back to Step 1, doesn’t it? The risky business leaves the banking system and goes to people with long-term stable funding, but then it comes back into the banking system because those people lever up their bets with bank loans. So we have [talked about](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDMtMDQvdHJhZGluZy1kZXNrcy10cmFkZS1sZXNzLWxlbmQtbW9yZT9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B2bfe6a51) how banks’ trading divisions are increasingly in the business of _lending money_ to hedge funds and proprietary trading firms, who then do the market-making and trading functions that the banks used to do themselves. And we have [talked](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDYtMDMvZ2FtZXN0b3AtY29tZXMtcm9hcmluZy1iYWNrP2NtcGlkPUJCRDA2MTIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDYxMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bbdb6ccba) a [few](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjcvc2lsaWNvbi12YWxsZXktaXMtb24tZHJ1Z3M_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bb1fb7ade) [times](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDUtMDkvaXQtcy1uZXZlci10b28tbGF0ZS1mb3ItYmFua3MtdG8taGVkZ2U_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96C89f5e854) about how private credit funds sometimes lever up their own investors’ money by getting financing from banks. The risky business itself — proprietary trading, financing leveraged buyouts — is shifted from the banks to other firms, but the other firms turn around and borrow money from the banks to help fund it. Bloomberg’s Esteban Duarte, Donal Griffin and Carmen Arroyo [report on synthetic risk transfers](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDYtMTEvanBtb3JnYW4tcy1iaWctdHJhbnNmZXItb2YtbG9hbi1yaXNrcy1oYXZlbi10LWFsbC1sZWZ0LXRoZS1iYW5raW5nLXN5c3RlbT9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B4fd6251b): > When JPMorgan Chase & Co. arranged a series of trades to shift the risk of losses from $20 billion of its loans, some of those dangers wound up at a familiar place: rival banks. > > The deal, struck late last year, was one of the biggest ever Synthetic Risk Transfer trades, or SRTs, opaque transactions heralded by Wall Street and approved by regulators that are supposed to hand possible loan losses to hedge funds and other nonbank investors. Yet some buyers in the JPMorgan deal — and in multiple other SRT trades — borrowed money from other banks to help finance their stakes and inflate returns, people familiar with the matter say. > > Nomura Holdings Inc., Morgan Stanley and NatWest Group Plc, have emerged as some of the most active lenders to investors in SRTs, along with rivals including Banco Santander SA and Standard Chartered Plc. That leaves them well-placed to profit from an expected surge in the deals — but exposed to potential losses if debts end up going bad and the SRT investor hits trouble. > > The lurking presence of Wall Street loans behind some of these complex trades suggests exposures that were meant to be shifted elsewhere remain tied to the banking system, an outcome that’s starting to spook regulators. > > “If a bank’s lending against the SRT instrument as collateral, you’re clearly not transferring the risk outside the banking system,” says Sheila Bair, who led the Federal Deposit Insurance Corp. during the financial crisis. “Any counterparty investing in SRT using bank-provided leverage should be prohibited, full stop.” The rough idea of an SRT is that a bank buys insurance against the risk of defaults in some portfolio of its loans. Normally the way to do this is by issuing credit-linked notes: The bank sells bonds that reference the underlying portfolio of loans, and if those loans default then it doesn’t have to pay back the bonds. In exchange for this protection, the bank pays a high interest rate on the bonds. This is worth it, to the bank, because it reduces its capital requirements: Paying double-digit interest rates to move risk off its balance sheet is a good deal for the bank, because it would be even more expensive to keep the risk and meet the accompanying capital requirements. The buyers of these bonds — the people taking the credit risk off the bank’s books — are “firms such as Ares Management Corp., Blackstone and Magnetar Capital,” investment firms that raise long-term money from investors and are thus less strictly regulated than banks. And then the buyers go and borrow money from the banks: > To help pay for these trades, some firms will seek outside financing. Hedge funds usually do so through a class of bank lending known as repurchase agreements, or “repos,” in which the lender takes the investing fund’s SRT securities as collateral, according to people with knowledge of the practice. > > Others use different types of bank borrowing such as net asset-value — or NAV — loans, a kind of financing popular with private equity firms that’s secured against a portfolio of their holdings. To back its JPMorgan deal, LuminArx used a non-repo form of borrowing, a person familiar with the matter says. > > While European SRT buyers haven’t used much leverage in the recent past, the trade’s economics are different on the other side of the Atlantic where borrowed money is often needed to deliver stellar returns. “Leverage in various forms has been employed by most investors” on recent US SRT deals, says Alan Shaffran, senior portfolio manager at Magnetar. > > European and Canadian SRTs are commonly made up of only the riskiest portion of a bank’s loans, which offers the best returns. But the US equivalents are broader — or “thicker” — because the buyers have to insure larger portions of the debt, meaning the securities they buy yield less. That creates an incentive to use borrowed money to juice profit. > > If an investment fund just uses its own cash for a US SRT trade, it can make loss-adjusted returns in the high single digits, market participants say. When the booster shot of leverage is added, returns can jump to the mid-teens. Well, right, you need leverage. Schematically, the capital structure is something like [[1]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E6304#footnote-1) : 1. JPMorgan makes $100 of loans and does an SRT. 2. Magnetar — the equity buyer of the SRT — puts up, say, $5 to buy the SRT, and takes the first $5 of losses on those loans: If $1 worth of loans default, Magnetar only gets $4 back from its $5 investment.  3. Nomura — the repo lender on the SRT — puts up, say, $7 of repo leverage to help Magnetar buy the SRT, and takes the next $7 of losses on those loans: If $10 worth of loans default, Magnetar loses its entire $5 equity investment, but it also can’t pay back Nomura’s repo loan, and Nomura loses $5 of its $7. [[2]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E6304#footnote-2) 4. JPMorgan keeps the last $88 of losses: If $20 worth of loans default, Magnetar and Nomura are wiped out and JPMorgan bears $8 of losses. Some risk _has_ been transferred out of the banking system altogether — the equity investor in the SRT really does take the first losses — but some of it has been recycled back into another bit of the banking system. Obviously the next move is for a bank to package up a bunch of its SRT repo loans and issue SRTs against them. An SRT-squared, what could possibly etc. No, I kid, I love it, this is just how the world works. I [wrote about the trading desks](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDMtMDQvdHJhZGluZy1kZXNrcy10cmFkZS1sZXNzLWxlbmQtbW9yZT9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96C2bfe6a51): > It is striking how _normal_ this is. … Broadly speaking, in the economy, there are all sorts of businesses that _do stuff_, and banks are in the meta-business of _lending them money to do the stuff_. That meta-business is supposed to be _safer_ than the underlying businesses: Instead of being in risky businesses themselves, banks have a diversified collection of senior claims on risky businesses; the other businesses run the risks, and the banks get the relatively safe first claim on their revenues.  It turns out that this is true even of the business of taking risks off the books of banks. ## Delta One - Matt Levine ### SocGen Delta One The basic idea of a [delta one desk](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly9lbi53aWtpcGVkaWEub3JnL3dpa2kvRGVsdGFfb25l/60e87ce39a995a4b1a2deb96B64cb360a) is that you are selling Thing X to a customer, and buying Thing Y from the market, and Thing X and Thing Y are exactly equivalent. Thus "delta one": If you sell stock options, you hedge the options by trading stock, and the amount of stock you need to buy or sell — the "delta" of the option — changes over time as the stock price changes. But if you sell index futures contracts, you can hedge them by buying the stocks in the index (or an exchange-traded fund, etc.), and the ratio never changes: It's always one-for-one, always a delta of one. You're buying a thing at a low price and selling an equivalent thing at, ideally, a higher price. At some level this should be a fairly low-risk business: The stuff that you are long and the stuff that you are short exactly offset each other, so you shouldn't make or lose money as the market moves. On the other hand, you are trying to make money, and the only way to make money is to take _some_ risk. If you are not taking market risk — if all your trades are fully hedged — and you're making money, then you're taking some other, slightly more esoteric risk. You're taking funding risk, or interest-rate risk. You're taking the risk of the basis between Thing X and almost-but-not-quite-identical Thing Y. You're writing one-day lookbacks into your swaps trades, and taking the legal and reputational risk that a regulator will [fine you for tricking your customers](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDQtMTEvZ29sZG1hbi1nb3Qtc29tZS1nb29kLXN3YXBzLWRlYWxzP2NtcGlkPUJCRDA0MzAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDQzMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bfcc2b722).  Or bigger risks. One of the great delta-one failures of recent years is when Archegos Capital Management did bazillions of dollars of equity total return swaps with big banks. Those banks fully hedged their stock-price risk — they were long a bazillion dollars of the underlying stock, and short an offsetting bazillion dollars of swaps to Archegos — but they were [taking enormous _credit_ risk to Archegos](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjEtMDctMjkvYXJjaGVnb3Mtd2FzLXRvby1idXN5LWZvci1tYXJnaW4tY2FsbHM_Y21waWQ9QkJEMDQzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bf85b5b52), and when Archegos blew up several of them lost money. But of course _the_ great delta-one failure of recent years was [Jérôme Kerviel's rogue trading](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMDgtMDEtMzAvamVyb21lLWtlcnZpZWwtaW4taGlzLW93bi13b3Jkc2J1c2luZXNzd2Vlay1idXNpbmVzcy1uZXdzLXN0b2NrLW1hcmtldC1hbmQtZmluYW5jaWFsLWFkdmljZT9jbXBpZD1CQkQwNDMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B51c17ebd) at Société Générale in 2007 and 2008. The risk that he took was even simpler: He'd buy Thing X for himself, and _pretend_ to sell Thing Y as a perfect hedge. He was doing [completely unhedged directional trades](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly9lbi53aWtpcGVkaWEub3JnL3dpa2kvSiVDMyVBOXIlQzMlQjRtZV9LZXJ2aWVs/60e87ce39a995a4b1a2deb96B615e3ce7), and tricking the computer systems into thinking he was doing completely hedged trades. When the stuff he bought went up, this was good: It is easier to make money by buying a thing that goes up than it is to make money while being perfectly hedged. And then the stuff he bought went down and he lost $5.2 billon and went to prison. I do not have a fully developed theory of delta one roguishness, but it does seem to have a higher-than-usual incidence of roguishness. There is something about its technicality, about the discipline of making money by buying and selling almost-but-not-quite identical things, that might give people ideas. [Especially at SocGen](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMzAvc29jZ2VuLXRyYWRlcnMtaW4tYXNpYS1leGl0ZWQtYWZ0ZXItb3B0aW9ucy1iZXRzLXdlbnQtdW5kZXRlY3RlZD9jbXBpZD1CQkQwNDMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bc4ef38d0): > A pair of traders in Hong Kong have left Societe Generale SA after the French bank discovered a batch of risky bets that went undetected by the firm's risk-management systems, according to people familiar with the matter. > > Kavish Kataria, a trader on the bank's Delta One desk, departed last year along with team head Ken Ng after an internal review of the transactions, said the people, asking not to be identified as the details are not public. > > While SocGen didn't lose any money from the transactions, the trades could have cost the Paris-based lender hundreds of millions of dollars had an intense market downturn occurred, the people said. The lapse raised questions about risk management at one of Europe's biggest banks. > > "Our strict control framework has allowed us to identify a one-off trading incident in 2023, which didn't generate any impact and led to appropriate mending measures," a SocGen spokesperson in Paris said in an emailed statement. A famous stylized fact about rogue traders is that you only hear about the ones who lose money. From this, you might reasonably conclude that (1) lots of traders take less-than-explicitly-authorized risks with their firms' capital, (2) some of them make money and get promoted, possibly with a "good trade but stop taking unauthorized risks, you lovable scamp" warning, and (3) others lose money and get fired in disgrace. But here we have the rare case of traders getting in trouble for taking less-than-explicitly-authorized risks _without_ losing money. Investment bank risk management is sophisticated enough, and taken seriously enough, that now you can get fired for _theoretical_ losses as well as real ones. (Though if they had _made_ hundreds of millions of dollars, instead of being flattish, I wonder if they'd still be there.) Also it's not clear how delta one [the actual trade was](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMzAvc29jZ2VuLXRyYWRlcnMtaW4tYXNpYS1leGl0ZWQtYWZ0ZXItb3B0aW9ucy1iZXRzLXdlbnQtdW5kZXRlY3RlZD9jbXBpZD1CQkQwNDMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Cc4ef38d0): > Kataria had bet on volatility staying low across Indian stock-market indices, the people said, a strategy that involves dealing in options. SocGen's risk managers failed to pick up on the trades because of a glitch related to their timing, the people said. I suppose if you're an index trader you're also allowed to buy index options. ([Or not](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuZnQuY29tL2NvbnRlbnQvMTcyNTlmYzctNTczNC00NGY4LTkzZjItNWNlYjM3N2U4MjE0/60e87ce39a995a4b1a2deb96B8d031351): "The person who made the trades in Hong Kong had not exceeded authorised trading amounts, but had placed bets on options contracts linked to Indian stock market indices that they had not been authorised to carry out.") Also I must say that Indian stock options are having a moment now: First Jane Street Group was [apparently making buckets of money](https://link.mail.bloombergbusiness.com/click/35212621.276807/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDQtMjIvdGhlLXNlY3JldC10cmFkZS13YXMtb3B0aW9ucy1pbi1pbmRpYT9jbXBpZD1CQkQwNDMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B5f5ead4a) trading Indian options, and now SocGen had a brush with losing hundreds of millions of dollars trading them. ## Financial Instruments - Matt Levine ### Web of debt The Financial Times [has a fun graphic feature](https://link.mail.bloombergbusiness.com/click/36172030.212875/aHR0cHM6Ly9pZy5mdC5jb20vcHJpdmF0ZS1lcXVpdHkv/60e87ce39a995a4b1a2deb96B37dded1c) titled “How private equity tangled banks in a web of debt,” the essential point of which is that everything in finance is more fun with a bit of leverage: 1. If there’s a company, a private equity fund can buy it, putting up some of its own money (the equity) and borrowing the rest, secured by the assets of the company. 2. The private credit fund that made the loan in Step 1 can put up some of its own money and borrow the rest from a bank to fund that loan. 3. The private equity fund buying the company in Step 1 can temporarily borrow the money it uses to write the equity check (a “subscription line”), secured by the commitments of its investors (its limited partners) to eventually put up the money. 4. After buying the company, the private equity fund can take out a margin loan, secured by its equity stake in the company. 5. Or it can take out a net asset value loan, secured by its equity stakes in a whole portfolio of companies it owns. 6. Also the company can borrow more money to pay dividends to the private equity fund. 7. The limited partners can sell their stakes in the private equity fund to a secondaries fund, which can borrow some of the money to buy them. 8. The general partners (sponsors) of the private equity fund can borrow money, “secured by management fees and carried interest income.” 9. Or other funds can borrow money to buy the general partners’ stakes in their firms.  10. I am sure I am missing some? I [once wrote](https://link.mail.bloombergbusiness.com/click/36172030.212875/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjEtMTAtMDcvbWF0dC1sZXZpbmUtcy1tb25leS1zdHVmZi1sb29raW5nLWZvci10ZXRoZXItcy1tb25leT9jbXBpZD1CQkQwNzI0MjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MjQmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B865019d2) that “a (the?) main move in finance” is this: You take a thing with some risk, you divide it into a risky first-loss piece (the equity) and a safer second-loss piece (the debt), you sell the risky piece to people who want high returns and the safe piece to people who want safety. “Also you can compose this move: You can divide a bunch of things into junior and senior claims, bundle a set of junior or senior claims together, and then slice that bundle into new junior and senior claims.” This FT feature is a series of pictures illustrating that point. Take a set of cash flows anywhere in the vicinity of private equity — the earnings of a company, the returns to private equity limited partners, the commitments of those LPs, the fees paid to the general partners, the the payments on a loan — and you can slice it into safer and riskier pieces, fund the safe piece with debt and juice the returns on the riskier piece. It would be weird if it were otherwise? Like, if you buy a house, you will probably take out a mortgage, funding most of your purchase with debt (funded by a bank/[insurer](https://link.mail.bloombergbusiness.com/click/36172030.212875/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDctMTYvYmlsbC1hY2ttYW4tY2FuLXR3ZWV0LWhpcy1uZXctZnVuZD9jbXBpZD1CQkQwNzI0MjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MjQmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B2723cb0e)/whoever who wants a safe return) and some of it with equity (funded by you, who want levered exposure to home-price appreciation). And then you’ll go about your day without thinking “hmm how could I slice this up further,” because you are not fundamentally in the business of slicing up cash flows. But private equity firms are, so every cash flow they come into contact with gets sliced up. The point of all of this is that at the bottom you have some set of businesses with some set of cash flows, and then those cash flows are sliced and recombined in various ways so that lots of different people (private equity GPs, their LPs, the GPs and LPs of secondaries and GP-stake and private-credit funds, bank lenders, etc.) get exactly the package of cash flows they want. And that is the business they are all in. “As higher interest rates put pressure on borrowers,” says the FT, “regulators are asking an important question: could the private equity industry pose a risk to the wider financial system?” Sure? I guess? I am not particularly worried — the _banks’_ claims on all of this stuff seem pretty senior, and the substrate at the bottom of all of this leverage (cash flows from lots of businesses) seems reasonably robust and diversified. But a (the?) main risk to the financial system is when people put money into assets that they think are safe, and those safe assets turn out to be correlated and risky. The more sorts of safe tranches you manufacture out of the basic raw materials of business cash flows, the more ways some of them could go wrong. ## Hard Times - Matt Levine ### Coupons My [favorite](https://link.mail.bloombergbusiness.com/click/35934584.221901/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjAvZGVidC1jb3N0cy1tb3JlLXdoZW4tcmF0ZXMtZ28tdXA_Y21waWQ9QkJEMDcwMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNzAyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Ba31de27b) [theme](https://link.mail.bloombergbusiness.com/click/35934584.221901/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDEtMDMvY29hbC1wbGFudHMtZm9yLWdyZWVuLWludmVzdG9ycz9jbXBpZD1CQkQwNzAyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MDImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bea16931a) in [modern](https://link.mail.bloombergbusiness.com/click/35934584.221901/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMTAtMDUvZnR4LW1pZ2h0LWhhdmUtZm91bmQtc29tZS1tb25leT9jbXBpZD1CQkQwNzAyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MDImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B810743ab) finance is: 1. Interest rates were very low for a very long time. 2. Now they are higher. 3. People just forgot that that was a possibility, and were surprised. There are various important manifestations of this — a frozen US housing market, the 2023 regional banking crisis — but it is pervasive in strange small ways too. For instance, for a long time, the way that debt investing worked was​​​ that you bought some bonds, and their prices went up or down, and you had inflows or outflows, so you had various reasons to sell the bonds you had or buy new bonds. If you asked “what drives demand for bonds,” you’d get answers about client inflows or relative value or whatever. But in 2024 you get [stories like this](https://link.mail.bloombergbusiness.com/click/35934584.221901/aHR0cHM6Ly9uZXdzLmJsb29tYmVyZ2xhdy5jb20vY2FwaXRhbC1tYXJrZXRzL2NvcnBvcmF0ZS1hbWVyaWNhcy1pbnRlcmVzdC1wYXltZW50cy1hcmUtZnVlbGluZy1hLW1hcmtldC1yYWxseQ/60e87ce39a995a4b1a2deb96Bf047f39b): > The Federal Reserve’s rate hike campaign is boosting corporate bonds in an unexpected way, as investors plow coupon payments back into the market. > > Investors’ rising income from their corporate bond holdings is giving them more money to buy corporate bonds now. The total income generated by the high-grade corporate credit market should be around $369 billion this year, or 15% more than last year, according to an analysisby Bank of America Corp. strategists. > > The coupon payments that investors are getting are relatively high compared with the bonds for sale. For the second half of 2024, total corporate coupon payments should equal about $220 billion, while net issuance is likely to be around $89 billion, according to Bank of America.  > > The imbalance between coupon payments to be reinvested and bonds expected to be sold could help keep valuations for corporate bonds relatively strong, said Travis King, head of US investment-grade corporates at Voya Investment Management.  > > “The cash inflow story is one of the most important technical factors in corporate bond demand now,” King said. “The concern is that investors will have more money coming into their pockets with less opportunity to reinvest it.”  Or [this](https://link.mail.bloombergbusiness.com/click/35934584.221901/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDYtMjkvY2xvcy1oYXZlLXRvby1tdWNoLW1vbmV5LWFuZC1hcmUtcnVubmluZy1vdXQtb2YtdGhpbmdzLXRvLWJ1eS1jcmVkaXQtd2Vla2x5P2NtcGlkPUJCRDA3MDIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDcwMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bc5327341): > Demand for the safest [col| | |---| |lateralized loan obligation] tranches soared this year after an influx of money into exchange-traded funds. Banks have also been piling into the AAA bonds, and some Japanese institutions may scoop up more of the debt. On top of that, Bank of America estimates that about $64 billion of the debt has been paid back so far this year, including amortizations and called CLOs, meaning asset owners have more capital to put to work. > > “If you’re an existing investor, you’re getting so much money in the door that’s creating demand in and of itself,” said Amir Vardi, a managing director at UBS Asset Management, at the Global ABS conference in Barcelona earlier this month, referring to amortizations and called CLOs. > > “Forget about increasing the budget to get more,” he said on a panel. “You’re just trying to keep what you have invested.” It turns out that, if you are a bond investor, you buy bonds, and then those bonds _pay you interest_, and then if you want to keep being a bond investor you might use that interest to buy more bonds. Just not a problem people had in 2020! ## Hedge Funds - Matt Levine ### Hedging If you work at a big public technology company, you might get a large chunk of your pay in the form of stock in your company. Over time, you will accumulate a lot of stock; a lot of your net worth might consist of shares in your company. This is good, this is what the company wants, this aligns incentives: If you own a lot of stock, you will work hard so the company does well so your stock will go up. On the other hand, _you_ may not like it. You have a lot of undiversified risk: A lot of your financial net worth is tied up in one company, and a lot of your human capital is tied up in that same company, and if the company goes under you will lose everything. And while it is nice to align incentives, if you are one of thousands of well-paid employees at a large public tech company, there might not be all that much _you personally_ can do to shape the company's destiny. So you might want to diversify. The easy way to do this is to sell your stock and buy an index fund. Your stock probably has vesting periods and restrictions, so you can't sell all it as soon as you get it, but if you've been there a long time you will have lots of unrestricted shares and can sell down. But tech stocks mostly go up, so if you've been there a long time and are selling shares you got years ago, you will have large capital gains. That's nice for you, really, but it does mean you have to pay taxes when you sell your stock and buy index funds.  On the other hand, what you could do is: - Start a _partnership_ with some other people who happen to own stocks in _other_ tech companies. There are lots of those people: If you're a well-paid Meta engineer with a bunch of stock, you can probably find well-paid Amazon and Alphabet engineers who also own a bunch of their companies' stocks. - _Contribute_ your shares to the partnership, in exchange for a stake in the partnership. You put in $1 million of Meta stock for 1/3 of the partnership; your friends put in $1 million of Amazon and Alphabet stock in exchange for 1/3 stakes in the partnership. - Now, instead of owning $1 million of Meta stock, you own a one-third share in a somewhat more diversified $3 million pot of stocks. (And you can expand this to more stocks for more diversification.) The advantage is that, while selling your stock for cash and then reinvesting the cash in an index fund is a taxable transaction, contributing your stock to a partnership in exchange for a share of that partnership is not. And if you do it right, you can make the partnership's holdings look a lot like an index fund. (Not tax advice! It is not in fact quite as simple as this, though this is the right general idea. [[1]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E4915#footnote-1) ) It is not trivial to do this right, _for you:_ You have to get the technical tax structuring right, plus what are the odds that you know a bunch of other engineers at other companies with exactly the right amounts of stock to contribute? But with enough well-paid engineers at big public tech companies, it is sensible for someone else to do this at scale and offer it as a product. Bloomberg's [Eliyahu Kamisher reports](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMTEvdGVjaC1taWxsaW9uYWlyZXMtY2hhc2UtYmlsbGlvbmFpcmUtdGF4LXNoaWVsZHMtd2l0aC1zd2FwLWZ1bmQ_Y21waWQ9QkJEMDQxMTI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDExJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bb9d4e51b): > Known as an exchange fund or a swap fund, the product is familiar to the super rich. Now, share-price rallies at companies such as Meta Platforms Inc. and Nvidia Corp. are creating an opportunity to offer the structure to moderately wealthy techies as well, says Srikanth Narayan, founder of San Francisco-based Cache. > > "The mission is to make these financial products - that have typically been in the upper echelon - available more broadly," said Narayan, a former engineer at Uber Technologies Inc. "All of my friends and colleagues are talking about the same thing, which is that more of their net worth is tied up in a single stock." … > > Cache's swap-fund offering enables participants to pool their stock holdings together, creating a more diversified collection of assets. Investors then get shares of the fund equivalent to their contributions, giving them the benefits of more varied holdings without having to sell their stock. > > There's a limit to how much stock of a particular company Cache can accept because the swap fund is designed to mirror the tech-heavy Nasdaq, Narayan said. Currently, he can bring in more Amazon.com Inc. and Microsoft Corp. shares, and he's seeking stock from non-tech Nasdaq companies such as PepsiCo Inc. and Costco Wholesale Corp. Here are [more details](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly91c2VjYWNoZS5jb20vcHJvZHVjdC9leGNoYW5nZS1mdW5kcw/60e87ce39a995a4b1a2deb96Bbfce0c6b) from Cache. Kamisher notes that, if this really takes off (so far it's pretty small), it could be bad for tax revenue; California gets a lot of money from tech equity compensation. But that effect depends on what this product _replaces_. If it replaces "sell your stock and buy index funds," it will lower tax revenue. If it replaces "just hold onto your stock until you retire," it won't. Me, though, I'm more interested in what it could do for incentives. Presumably the big tech companies pay their employees with lots of stock (in part for accounting reasons sure but also) in order to align incentives and motivate the employees. [[2]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E4915#footnote-2)  You would expect that a lot of Meta employees own a lot of Meta stock, a lot of Alphabet employees own a lot of Alphabet stock, a lot of Amazon employees own a lot of Amazon stock and so forth. Each company has employees with strong financial incentives — not just the desire for raises and bonuses, but also the desire to increase the value of their existing stock — to help their company win in the general competition among tech giants. But what if all of the midlevel employees of all of these companies ended up owning diversified portfolios of all of them? What if workers in Big Tech were compensated with, effectively, a portfolio of Big Tech Index shares? (Plus Costco, if Cache can find any. [[3]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E4915#footnote-3) ) What does that do for competition? "Should index funds be illegal," I [sometimes](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDQtMDIvYS1oZWRnZS1mdW5kLXRoYXQtcy1hbHNvLWEtbmV3c3BhcGVyP2NtcGlkPUJCRDA0MTEyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDQxMSZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B04329024) [ask](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTUtMDQtMTYvc2hvdWxkLW11dHVhbC1mdW5kcy1iZS1pbGxlZ2FsLT9jbXBpZD1CQkQwNDExMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MTEmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B2396d19d) [around](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL25ld3NsZXR0ZXJzLzIwMTgtMTItMDcvbW9uZXktc3R1ZmYtcmVndWxhdG9ycy1hc2staWYtaW5kZXgtZnVuZHMtYXJlLWJhZD9jbXBpZD1CQkQwNDExMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MTEmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B83e29b6c) [here](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL25ld3NsZXR0ZXJzLzIwMTgtMTItMDcvbW9uZXktc3R1ZmYtcmVndWxhdG9ycy1hc2staWYtaW5kZXgtZnVuZHMtYXJlLWJhZD9jbXBpZD1CQkQwNDExMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MTEmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96C83e29b6c): If every public company is owned by diversified investors who also own all of its competitors, will those companies have less incentive to compete? One of the [main responses](https://link.mail.bloombergbusiness.com/click/35003841.260818/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjIvZG9lcy1tYXJrLXp1Y2tlcmJlcmctb3duLXRvby1tdWNoLW1ldGE_Y21waWQ9QkJEMDQxMTI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDExJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B858b2171) to this concern is that, while the _institutional shareholders_ are mostly diversified, the _executives and employees_ tend to own concentrated positions in their employers' stocks, so _they_ are motivated to compete. And they run the company from day to day. But what if the employees were all diversified too? NOTE: AN IMPORTANT IDEA: INDEX FUNDS ARE THE ENDGAME OF DIVERSIFICATION, AND EVERYONE OWNS NEARLY EVERYTHING WHEN THAT HAPPENS --- A few months ago, [I mentioned](https://link.mail.bloombergbusiness.com/click/36159276.205878/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDItMjAvYmlsbC1hY2ttYW4tcy1zdG9ja3Mtd2VudC11cD9jbXBpZD1CQkQwNzIzMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA3MjMmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B59dc17e6) “Bill Ackman’s old-school approach to managing a hedge fund — he’s a famous guy, he makes concentrated high-conviction bets on stocks, he doesn’t hedge much,” and a reader wrote in to chastise me. The _old-school_ approach to managing a hedge fund is [Alfred Winslow Jones’s](https://link.mail.bloombergbusiness.com/click/36159276.205878/aHR0cHM6Ly9lbi53aWtpcGVkaWEub3JnL3dpa2kvQWxmcmVkX1dpbnNsb3dfSm9uZXM/60e87ce39a995a4b1a2deb96B8e1aeb38): Jones invented the hedge fund, and his early approach was arguably more like that of modern multistrategy funds that hire lots of smart investors to pick stocks and hedge out market exposure. (Thus the name.) Jones also invented the hedge fund compensation scheme, though (particularly the 20% performance fee), and _that_ proliferated among funds that didn’t do as much hedging. But a famous guy making big stock bets and charging 20% of returns was, in the long history of hedge funds, something of a novelty. Still, I stand by what I wrote: There _was_ a fairly long vogue for high-profile individual hedge fund managers who made big bets, and that era is passing, and now hedge funds are big institutions stocked with well-paid but somewhat anonymous portfolio managers grinding out alpha with low volatility. At Business Insider, Linette Lopez [meditates on the transition](https://link.mail.bloombergbusiness.com/click/36159276.205878/aHR0cHM6Ly93d3cuYnVzaW5lc3NpbnNpZGVyLmNvbS9kZWF0aC1oZWRnZS1mdW5kLXN1cGVyc3RhcnMtd2FsbC1zdHJlZXQtc3RvY2stbWFya2V0LXRpdGFucy1nb25lLTIwMjQtNw/60e87ce39a995a4b1a2deb96B2f1708af): > What is clear is that hedge funds run by an individual star, by one prodigious mind, are not raising the massive money they used to. Clients who once were proud to hand their money to a specific person are pushing back; they want to pay lower fees and see less-volatile returns. The funds that have survived rely on a stable of faceless traders testing out different ideas, brokering transactions, and harvesting the returns for the collective. Quant strategies — which are built on algorithmic trading — have also become more popular with the ultrawealthy. More robots, fewer people, lower overhead. … > > In decades past, clients were mostly HNWIs: high-net-worth individuals. Nowadays the biggest money runners are institutions, and institutions are more exacting. One legendary but shy fund manager told me that these institutions are more interested in steady returns, and the wild swings in performance that hedge funds offer simply give them heartburn. "They can sleep better at night," the person said. "The economy can turn bad, the stock market can crash, and they're not going to share losses." > > Sebastian Mallaby, the author of "More Money Than God: Hedge Funds and the Making of the New Elite," told me that institutions are also less willing to be enchanted by the personal magnetism of a founder like Julian Robertson, the founder of the legendary fund Tiger Management. > > "In the old days, Julian Robertson would hold a party for HNWIs and have some kind of wacky show for them at the Met, and they'd say 'Julian, what a guy' and leave him alone for a year," Mallaby said. "That's gone away because individual investors aren't as important as institutional investors, who have to show they've been careful where they put the money.” The story here is something like “institutions demand that they actually get identifiable alpha and uncorrelated, high and stable returns in exchange for all the fees they are paying hedge funds, and the hedge fund industry is responding by building stable professional institutions that actually provide that service.” That’s a good story! But the parties might be less fun. ## Hedging Against Risk - Matt Levine ### Rates went up In some sense [the main story of finance](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjAvZGVidC1jb3N0cy1tb3JlLXdoZW4tcmF0ZXMtZ28tdXA_Y21waWQ9QkJEMDQyMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDIyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bb8f2b007) in the 2020s is "interest rates were very low for a very long time, everyone got used to them, and then they went up rapidly and everyone's intuitions were messed up." This is of course the main story of the [2023 US regional banking crisis](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDUtMDQvbm9ib2R5LXRydXN0cy10aGUtYmFua3Mtbm93P2NtcGlkPUJCRDA0MjIyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDQyMiZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bcebc208d), and it is arguably a crucial part of the story of [tech startups](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDMtMTAvc3RhcnR1cC1iYW5rLWhhZC1hLXN0YXJ0dXAtYmFuay1ydW4_Y21waWQ9QkJEMDQyMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDIyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B758358c8), or crypto, or [environmental, social and governance investing](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDEtMTgvY29pbmJhc2UtdHJhZGVzLWJlYW5pZS1iYWJpZXM_Y21waWQ9QkJEMDQyMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDIyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Beba58a75), or [private equity](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjAvZGVidC1jb3N0cy1tb3JlLXdoZW4tcmF0ZXMtZ28tdXA_Y21waWQ9QkJEMDQyMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNDIyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Cb8f2b007), or [private credit hurdle rates](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMTAtMDUvZnR4LW1pZ2h0LWhhdmUtZm91bmQtc29tZS1tb25leT9jbXBpZD1CQkQwNDIyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MjImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B71cbb9b0), or any number of other things. Or here's Bloomberg's [Justina Lee on risk parity](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMjIvcmF5LWRhbGlvLXMtZmFtb3VzLXRyYWRlLWlzLXNwdXR0ZXJpbmctYW5kLWludmVzdG9ycy1hcmUtYmFpbGluZz9jbXBpZD1CQkQwNDIyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MjImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bac108044): > "It's been disappointing for a long time," said Eileen Neill, managing director at Verus Investments, an adviser to New Mexico's roughly $17 billion public employee pension, which axed its risk-parity allocation in December. "The only time risk parity was really successful was at the time of the Great Financial Crisis and that was really its heyday." > > The lackluster run through the post-pandemic booms and busts has rattled faith in an allocation method pioneered by [Ray] Dalio, who built Bridgewater into the world's largest hedge fund. The strategy focuses on diversification across assets based on how volatile each is, and often uses leverage to optimize returns relative to the risks taken. > > It flourished after the 2008 financial crisis as investors sought a way to protect themselves from the next big cataclysm. But as investors went on to plow back into stocks, they lagged in the up years. Then when markets cracked in 2022 — pummeling safe assets like US Treasuries — they were hit even harder. Intuitively [the way risk parity works](https://link.mail.bloombergbusiness.com/click/35121691.264812/aHR0cHM6Ly9lbi53aWtpcGVkaWEub3JnL3dpa2kvUmlza19wYXJpdHk/60e87ce39a995a4b1a2deb96B5168851c) is that you invest some of your portfolio in stocks and some of it in bonds, with the goal that each part contributes the same amount of volatility to the portfolio. So if stocks have 30% volatility and bonds have 10% volatility, you put three-quarters of your money in bonds and one quarter in stocks, crudely speaking. The more volatile an asset has been, the less money you allocate to it. When bonds have been very stable for a long period, you put a lot of your money in bonds. When stocks then go up a lot for years, you underperform a more-stock-weighted portfolio. When interest rates suddenly go up a lot — and bonds crash before you update your historical volatility measures — you lose money.  ## Index Funds - Matt Levine ### Should index funds be illegal? We [talked last month](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDUtMDIvaG93LWNvdWxkLXRoZS1kZWF0aC1iZXRzLW1ha2UtbW9uZXk_Y21waWQ9QkJEMDYxMjI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNjEyJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Be67a2d10) about a Federal Trade Commission ruling involving Scott Sheffield, the former chief executive officer of Pioneer Natural Resources. Exxon Mobil Corp. had a deal to buy Pioneer, and the FTC demanded, as a condition of approving the deal, that Sheffield not be allowed to serve on Exxon’s board. The FTC claimed that Sheffield conspired with the Organization of Petroleum Exporting Countries to keep oil prices high: Sheffield had some meetings and communications with OPEC officials, and he also went around making public statements that US oil companies like Pioneer should be more disciplined about capital expenditures and drilling. Instead of rushing to drill more wells every time oil prices went up, they should moderate production so they could actually profit from those high prices. This view, I should say, was (and is) not at all uncommon, and you do not need a conspiracy to explain it. The US oil industry had quite well-known cycles of overspending during booms and then collapsing in busts; investing in oil drillers was a good way to lose money. The companies knew this, the shareholders knew this, and it just made sense for them all to rethink things. Instead of losing money on oil drilling, wouldn’t it be nicer to _make_ money? The way you do this is by not investing too much in new capacity all the time. Everyone could have come to that conclusion on their own, without conspiring with OPEC, or with each other. Last month Sheffield [filed a comment with the FTC](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly9maWxlcy5sYnIuY2xvdWQvcHVibGljLzIwMjQtMDUvc2hlZmZpZWxkJTIwMS5wZGY_VmVyc2lvbklkPUVSa1VyNHNxQmluUzFLblFmd1V1MnZOSUJzQjZhcUFEJnV0bV9zb3VyY2U9c3Vic3RhY2smdXRtX21lZGl1bT1lbWFpbA/60e87ce39a995a4b1a2deb96B3d487de9), objecting to how he was treated in the Exxon settlement. His basic complaints, which strike me as pretty fair, are (1) the FTC’s claims about his ties to OPEC are false or exaggerated and (2) he didn’t have any opportunity to respond to them, because the FTC’s criticism of him came in a settlement with Exxon without his involvement. But he also defends his decisions to moderate production by saying they were informed, not by conversations with OPEC, but by conversations with BlackRock: > Pioneer’s new capital framework was informed by discussions with shareholders and Pioneer’s Investor Relations Department, which tracked shareholder and analyst feedback and other public reports. Within the first month of returning as CEO, Mr. Sheffield traveled the country speaking with nearly three dozen of Pioneer’s largest shareholders (comprising more than one-third of the outstanding shares at the time), including major investment managers like Fidelity, TIAA/Nuveen, Capital World Investors, and Blackrock. These firms were managing trillions of dollars for pension and retirement funds and others. > > Nearly all of the shareholders with whom Mr. Sheffield spoke expressed support for moderating growth to improve Pioneer’s free cash flow, strengthen its balance sheet, and lower costs and execution risk. Pioneer and Mr. Sheffield frequently received questions from shareholders on these topics during road shows and conferences. The decision to return more free cash flow to shareholders was undertaken to provide shareholders the level of returns that they expected regardless of oil prices, not to impact oil prices or output. These issues became even more critical when COVID hit. > > There are numerous industry reports documenting the shift in how analysts and shareholders were thinking about the oil industry around the time of Mr. Sheffield’s return as CEO. One report published by Wolfe Research in 2017 explains that “[s]hareholders are demanding cash return.” The analyst firm says, “We implore companies to exert capital discipline and temper growth targets in the pursuit of cash returns. We will resolutely oppose aggressive growth targets and strategies, in general.” The report explains that “oil stocks dramatically underperformed the market” because of concerns about the “End of the Oil Age.” These demands were not hidden from the public or government authorities. Major news organizations covered them. Mr. Sheffield regularly discussed his views on Pioneer’s capital framework given shareholder interest in it. Again! If you had asked Fidelity, TIAA, Capital and BlackRock “thinking only from your perspective as shareholders _of Pioneer_, ignoring everything else, should Pioneer drill more oil or return cash,” I bet they would all have said “return cash.” The boom-and-bust cycle was well understood at that point, and bad for shareholders; returning cash was the rational thing to do. And yet those shareholders were _not_ shareholders only of Pioneer: They are giant institutions who own shares in many oil companies. It’s _possible_ that a Pioneer-only shareholder would have said “no, let all the other companies cut production; Pioneer should invest more in drilling to grab market share while everyone else is cutting back.” That is a possibly rational thing to think if you are a shareholder of _one_ oil company, but an insane thing to think if you are a shareholder of _every_ oil company: If everyone increases production, no one gains market share and the price of oil goes down. If all of these shareholders were meeting with Sheffield on the same day they were meeting with other oil CEOs, of course they expressed support for moderating growth. You [know](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL25ld3NsZXR0ZXJzLzIwMTgtMTItMDcvbW9uZXktc3R1ZmYtcmVndWxhdG9ycy1hc2staWYtaW5kZXgtZnVuZHMtYXJlLWJhZD9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Becc1df72) the [theory](https://link.mail.bloombergbusiness.com/click/35693829.260780/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTUtMDQtMTYvc2hvdWxkLW11dHVhbC1mdW5kcy1iZS1pbGxlZ2FsLT9jbXBpZD1CQkQwNjEyMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTImdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bb89eab82): Common ownership of all the companies in an industry, by a handful of big diversified institutional investors, leads to reduced competition over price. This theory is hotly controversial, in part because no one believes that diversified investors go to meetings with CEOs and say “you should cut production to keep prices high.” But here is a CEO almost saying that, as a _defense_ to charges that OPEC told him “you should cut production to keep prices high.” It wasn’t OPEC, it was the mutual funds. ## Private Equity - Matt Levine A story that I would have told about private equity is that, in the olden days, a private equity fund was a couple of youngish ex-bankers who put up their own money and raised some money from outside investors to do leveraged buyouts of companies with very small equity checks, a novel and risky model in which all the participants — the fund's founders, their outside investors, the lenders — were consciously taking big risks in the swashbucklier corners of the financial markets. And now, decades later, those private equity firms have become gigantic alternative asset managers that run hundreds of billions of dollars for insurance companies, with thousands of employees and much steadier and more diversified returns. Everything has become domesticated and institutionalized. You don't invest with a private equity firm, these days, because you like the fire in the eyes of its 30-year-old founder; you invest because of its giant platform and suite of products and long track record. Still you want a little fire in the eyes. Bloomberg's [Laura Benitez and Swetha Gopinath report](https://link.mail.bloombergbusiness.com/click/35081496.281811/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDQtMTgvcHJpdmF0ZS1lcXVpdHktaW52ZXN0b3JzLWRyaXZpbmctdG91Z2hlci1kZWFscy1hcy1wb3dlci1iYWxhbmNlLXNoaWZ0cz9jbXBpZD1CQkQwNDE4MjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA0MTgmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B9d8cf01b): > The biggest backers of buyout firms are wielding their ever-growing bargaining power to drive increasingly tough deals. The latest in a string of investor demands is this: If you want our money, put more of yours in first. As a result, some private equity executives — at both big and small firms — are loading up on more debt and pledging personal assets to appease them. This includes their homes and other valuables as well as traditional collateral such as fees and stakes in other funds. > > The equity contributions from buyout firms into new funds has jumped to an average of 5% from 2% last year, and in some cases as much as 20%, according to people familiar with the matter. It's leaving some managers scrambling to find significant amounts of capital in often short time frames, the people said, asking not to be identified discussing private agreements. > > To raise cash, some are taking out high-interest loans that can charge rates into the mid-to-high teens, and are often backed by holiday homes, cars, second businesses and art collections, the people said. Some banks are demanding that executives pledge the bulk, if not all of their personal assets, some of the people said. "We are not going to invest in your private equity fund unless you'd lose your house if you mess up" just seems like more of a 1970s ask than a 2020s one, but I like it. Meanwhile of course the giant alternative asset managers are also in the business of lending each other money to invest in their funds: > Investec Plc and JPMorgan Chase & Co. are among banks providing such loans, according to people familiar with the matter. The industry's need for more capital has also given rise to several private credit lenders such as Ares Management, Oaktree Capital Management's 17Capital and Pemberton Asset Management, who have raised, or are raising funds to lend out. So: 1. Do you think that the Ares and Oaktree professionals need to put a lot of their personal assets into those lending-money-to-private-equity-people funds? Do they have to borrow to do so? From each other? Or what? 2. There's going to be an absolutely amazing Money Stuff when Oaktree tries to seize an Apollo managing director's house after a fund does poorly. NOTE: THIS AXIOM IS TRUE: MAKE SURE THEY HAVE SOMETHING TO LOSE AS WELL! ## Shadow Trading - Matt Levine ### Nvidia [Meanwhile](https://links.message.bloomberg.com/u/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl1XNhuq11IZCFYAyAH9rdyNhwpvDfj6U5tQaO-3bGQ5l5upTug7jVenIPky1niJYdZyfq1M3ipz8m3c6f2xN8gNQE26ySlrkh1jVr996qEEQ_POKDO6E3FkuIe-fckTZGOjTTZjla-N9XeHKSxoRePxvSun3Guksv13hGsO1Qm_RfnrskoMjC5G4GFzAyQjZVMvpcvY0JN2CSxcYI4WkIlfaGyq7ih8zVepxCWamDyGJQT08M4Z6V3VjTpnDUOgnNw%3D%3D): > Nvidia’s earnings have become as important for US markets as key economic data, according to analysts, as the chipmaker prepares to announce quarterly results that will allow investors to gauge the health of the artificial intelligence boom. ... > > Nvidia’s share price has surged 160 per cent this year, propelled by a boom in spending on AI, which its chips power, and now has a $3.1tn market value, surpassed only by Apple. It accounts for about 6 per cent of the S&P 500 and more than a quarter of the benchmark’s 18 per cent gains this year. > > Nvidia has become “one of the most important events on the macro calendar”, with recent results leading to market reactions “that rival the sort of moves taking place after a surprise US jobs report or consumer prices index release”, said analysts at Deutsche Bank. > > The bank noted that the S&P rose 2.1 per cent the day after Nvidia’s results in February, its second-best daily performance of the year. Well! Obviously you know the question we ask around here: If you worked in Nvidia Corp. investor relations, and you have the earnings a day early, and they are a surprise to the upside, what should you do with that information? Nothing, the answer is nothing, but here are some other hypothetical answers, none of which are legal advice: 1. Buy Nvidia stock and short-dated out-of-the-money call options, which will go up when the earnings are announced. I trust I do not have to explain to you why this is a bad idea. (It is illegal insider trading.) 2. Buy shares of other, correlated companies that also participate in the artificial intelligence boom, which will probably also go up when Nvidia announces good earnings. This is called “[shadow trading](https://links.message.bloomberg.com/a/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl1bcicJV0f_E2aUtt3kF9L77dxNcF7KcJAlwJY888KsZZk_ZRXnscPioxHW0IVq_GH352NMb6y25JFO-wkCa2MaGSdlywAYzSzJFYXPNcOkM7nFHDsv2M2psPLN-M7k_RLXbJSDbggYi_jEZ5bdOH_SFKw5OQ-vZSqdJ9tNqzlyEUud-Iea5gUOWVaHM_QA2m3zteYiRfxBiga50r-IcA3ycbnomy3Tq_Roc6PQjmkPsMCO4U0LmCkQjb9vYHiCoSEp1XtXrro7N4uiFRXrrjr9ICHbXzXHQXW1KV-wvj9SulhaUBZBJQhnEI0F9p8b21aDDhKyWkK0uh0jKMSUXGIVl_pSbYLKP_rPLrma1izBvcxCWmRnFfo_Nnq7cY5G2wQik_XGLHL0_fmVorItVyhorZGoS3kALbR04dINOlIzlleJtNtqTeP8sQEsdNngFcA%3D%3D),” and is also probably a bad idea, though less of a bad idea than Option 1. 3. Buy _index funds_ based on the S&P 500 index of large US stocks, or perhaps the more tech-focused Nasdaq 100 index, which will also probably go up when Nvidia announces good earnings. In part because Nvidia is a big component of both indexes, so if its stock goes up a lot that will mechanically move the index up, but also in part because you expect other stocks in those indexes to react positively to Nvidia’s news. If Nvidia earnings are “one of the most important events on the macro calendar,” and you know the earnings ahead of time, presumably you could make some macro bets. This strikes me as about as bad an idea as Option 2, basically [another form of shadow trading](https://links.message.bloomberg.com/a/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl1bcicJV0f_E2aUtt3kF9L77dxNcF7KcJAlwJY888KsZgEvkFxbC4eizvmioE2jgu8xdgACKq0tJ1g5XnSZLcdAUtbbQcJoW59CTxJE3avvZjNELIXKGtZJlEl-tWBh8Bn3A0b7Yu7OOW0hBCEsinaWFpHo7nvm6t1ARvsKdaaV82UMCHYvhefpeIvFsBaBgihSEis33JV_hRdwphob9HUT9_KEFDvGFt0TG5mrRifacsOk7bf2YkjmiAENnTXLg7Fg5N4F5u0oVa-uXpsg_IQ8-0k48Xh5Vl-3sJwf4l06g-g1E9yc_gpjDnOh8QIQ-uaXsZTLc4jn203bwtwK08rcbEL231VDbM2QYKmxoBMk8C2hII7N3Fy9nsQq0Vn8xW8kIqTOd74Ukuqoug-Zzj2ZNLgqH7v0SDe701-TdYaQg). 4. Short Treasury bonds? Long the dollar? Long oil? In fact there does not seem to be much correlation between Nvidia and those sorts of macroeconomic variables but, if it did work, this would be a fun novelty in shadow trading. Again I do not think that doing any of these things, as an Nvidia employee with early access to earnings, would be all that great of an idea, but this is not legal advice, the rules seem a bit ambiguous, and if you are doing any of this stuff please do email me about it. [[3]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E8518#footnote-3)  But [the basic rule](https://links.message.bloomberg.com/a/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl1bcicJV0f_E2aUtt3kF9L77dxNcF7KcJAlwJY888KsZsM2IcFtPsG-SCieGbfrpu-honap3j9ypTS7MusCIWhU8WAYXiSiFJJwRRGhVz6aQ9JiMTX5jLO-a7t3PJQBX7tmTRvtRnhfJV4bGLvH8dwxrtYnyIok5ZdcD4rTJn411MkO-FtWD-vZdUk9OYdv5aRoJJDA-qm9yXwZlCEo67ilvc8RlEw_ceCj1E2JfO-jxpUytJQ87PDz5AQnIf04REZiWeAW7oxCmMRZLDzZu1MObEEhu3e62kRHysWhKnci-5vetcrGqNicls3oVueR8HZ9BfpqRomHbUwQK8xEwMzezsLk-r2WOMErKQnyk4WSpo000727s4NZbJBVhpj9CGfgvZhkmDB1WbGK6qBCIT7kvLCGvDANzmMD0V3paqsew) seems to be that if you get material nonpublic information about Nvidia in the course of your work at Nvidia, you have a _duty to Nvidia_ not to trade on it for your own profit, whether “trade on it” means “trade Nvidia stock” or “trade index funds.” But here’s the other question: What about _Nvidia_? If you are Nvidia’s chief financial officer, and you have the earnings a day early, and they are a surprise to the upside, and you manage more than $30 billion of cash and marketable securities on Nvidia’s [balance sheet](https://links.message.bloomberg.com/u/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl25my5nwWnCRrVx0L1mPXDyf-pexvZ39_TYfrHzz0NcvOO0trdr5uq08Hvf6VhakxjMFzghZ6OvDLx_7b4ceej5vGC8iJjGVw_RpTFmj0lf6jCG3l4_C1Q-yqqRPOHvbBou6ecDB_RBqREFSZSBAkEmiKA1uaML4vkCGicAKZPaRUL_4dy7ViIEv5NhAm7pUcWhISduoPM5NjSLM-h7O04FHBZlstV5AYiOkTNxSxLDaTGkmHuUf5IEhkwjNprvJJcKbC4IIyMJhw7rABiM9Qm0EPwNcH0Ju0x4LDuHfD-nQ), would you be just the littlest bit tempted to make some trades? Not in Nvidia stock, of course — that’s insider trading — but in S&P 500 funds? Put the $30 billion into the S&P for a day, make 2% ($600 million), it’s not _that_ much — Nvidia’s net income was almost $15 billion last quarter — but still that’s like a 4% boost to your quarterly earnings. And surely Nvidia has no duty _to itself_ not to use its own information to make macro bets? [[4]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E8518#footnote-4)   I mean, it’s probably not worth it: The market rewards Nvidia for earning money by selling chips, not by doing sketchy stock trades, and it’s possible that the multiple the market would put on these earnings would be negative. (“They’re distracted from their core mission and are just making stock market bets now, sell!”) If you’re Nvidia’s CFO, you’re probably busy managing its gusher of earnings and/or [being rich yourself](https://links.message.bloomberg.com/a/click?_t=f574328d4d0c4c359b90d8e49b10e21d&_m=bcacf955749f4ea49b00d9df2256859c&_e=2xa8JtLHUmefwbDePM2vl1bcicJV0f_E2aUtt3kF9L4zZ64WMBmfVW8_NMbHJcYGaJpKRgzwYesBXgmC_ooeDbbXKq4TeEVjDNirLz2YatqY2lTjuW7yJxDNRaFNoe2B5_9qO5LtHhKkLkZ3GfpZG20qo7Xh2UC5CXgAEFQ_YJ1Zc8OiJ-DD_VI9NGrKhp2K0ReqHblZSLPikt-OdQwBPD9IbSADa6Gyn10xc66cmdFtMSWdrBMvo5KOXyOS-tNPU2A8iBtVKk01XGdU4Bpq-drggnSga5E6wOg-UfNMgUh7LmoRLI8Qc3XJDh8jud2oyvfHIyO0V4sokkBQzQTDZrydU-8v6mtHhxDw73_vHSHNMO4s9TWBW42HJ-w0wmGFWanLIW4Fd5x0Sx4rCTTg86j1te1_f7NyVnfbEu9_HSrSC3TV_vIE2Gl0dVfiawX6DmJg8oNMU6GG58ro_791C09v0732W9cazoA2nuGCk2RY8Lgc3Za1mKNyF5Sl15IP); why spend your time on a little light shadow trading? Still it is weird for a company to generate its own important macro news, and if _I_ were able to generate my own macro news, I’d probably use it to make macro bets. [3] Don’t, actually; I’ll probably get subpoenaed. [4] Not legal advice. I suppose buying the S&P index — where Nvidia itself is a component — is arguably a form of insider trading, since it mechanically results in buying of Nvidia’s own stock. (Companies are not supposed to trade their own stock while in possession of material nonpublic information like earnings.) Buying a dozen correlated companies is maybe cleaner, though if they are customers you’d worry a little about whether you have any material nonpublic information *about them* (and a duty not to trade on it). Making interest-rate bets is cleaner still, but I’m not sure there’s enough correlation for it to work. ## Unsecured Notes - Matt Levine ### QIS I have occasionally, as a writer about finance and a former equity derivatives banker, made fun of structured notes. A structured note is essentially a package sold by a bank to private wealth customers consisting of: 1. Some option or set of options on one or more stocks, indexes, commodities or what have you; 2. An unsecured bond of the bank; and 3. A big fee for the bank. “If you want those options,” I used to think, “you should just buy the options directly; you don’t want the bank’s unsecured credit risk and you certainly don’t want to pay the fee.” But over time I have been talked out of that purist position. In fact, it is not always easy to buy the particular options in the quantity that you want, and your trading costs might be higher than the bank’s. But also, what the bank is doing in building the structured note is finding an _appealing_ collection of options, one with a good clear story, so that instead of going out and piecing together a complicated portfolio of options you just get a thing that is like “the return on the S&P 500 Index over the next year, [but it can’t go down](https://link.mail.bloombergbusiness.com/click/35707099.284777/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDctMTkvYS1zdG9jay1mdW5kLXRoYXQtY2FuLXQtZ28tZG93bj9jbXBpZD1CQkQwNjEzMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA2MTMmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Be42ba9e5).” You are paying the fee for simplicity, for a way to very directly implement some intuitive thesis rather than mucking about in the guts of derivatives markets. This is true more broadly: Banks market all sorts of expensive, crude, one-size-fits-all versions of complex bespoke trades that you could do yourself. If you are an expert in the business of doing them yourself, you should. But if you are even slightly a tourist in the area — even if you are an expert in doing _other_ complex bespoke trades yourself, but you want to do a quick trade in a new asset class — you might reasonably shrug and buy the crude thing that the bank is selling. The thing that the bank is _really_ selling is convenience. Bloomberg’s [Justina Lee reports](https://link.mail.bloombergbusiness.com/click/35707099.284777/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9uZXdzL2FydGljbGVzLzIwMjQtMDYtMTEvaGVkZ2UtZnVuZHMtcGlsZS1pbnRvLWNvcHljYXQtcXVhbnQtdHJhZGVzLXRoZXktb25jZS1kZXJpZGVkP2NtcGlkPUJCRDA2MTMyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDYxMyZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B449aceb6): > Once hostile to the copycat products being churned out by big banks, hedge funds are becoming a major driver of the boom in what are known as quantitative investment strategies, or QIS. > > These tools take popular systematic trades and typically turn them into swaps or structured notes, creating a quick and cheap way to gain exposure. They’ve long drawn fire from asset managers for being pale imitations of the sophisticated strategies they replicate, which were often developed in academia and pioneered over decades by the likes of AQR Capital Management and Dimensional Fund Advisors. > > Yet money managers are increasingly giving in to the sheer convenience of QIS. ... > > Uses vary, but in a typical case a fixed-income team at a multi-strategy hedge fund might trade stock options with QIS. Or a firm that’s never done commodities might utilize them to quickly add some exposure to raw materials. > > “To multi-pod type of hedge funds, QIS is a cheap way for them to get access to an asset class” where a team doesn’t have trading capabilities, said Arnaud Jobert, the co-head of global strategic indices at JPMorgan Chase & Co., which runs a notional $85 billion in the business.  You’re paying some fees to the bank, but those fees might be lower than the cost of hiring a trader to do it yourself. ## When is it Securities Fraud? - Matt Levine ### Shadow trading Insider trading, [I like to say](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTktMDMtMTMveW91LWhhdmUtdG8tcGF5LXRoZS1yaWdodC1wZXJzb24_Y21waWQ9QkJEMDUzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B9e799341), is not about fairness: It’s about theft. In the US, most of the time, it is illegal to trade on inside information about a company not because that’s unfair to everyone else who doesn’t have the information, but because you have some _duty_ to somebody else not to misuse their information. So if you work for a public company, you have a duty to the shareholders not to trade on inside information before disclosing it to them. Or if you are the [spouse](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDItMjYvaG9uZXktaS1pbnNpZGVyLXRyYWRlZC15b3VyLW1lcmdlcj9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B94c8c332) or [golf buddy](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS92aWV3L2FydGljbGVzLzIwMTQtMDctMTEvc2VjLXByb3RlY3RzLWludGVncml0eS1vZi1tYXJrZXRzLWFsc28tZ29sZj9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B40eec714) or therapist of an executive at a public company, and she tells you about an upcoming deal, you have a “[duty of trust or confidence](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cubGF3LmNvcm5lbGwuZWR1L2Nmci90ZXh0LzE3LzI0MC4xMGI1LTI/60e87ce39a995a4b1a2deb96Bc337ce3a)” to her not to go trade on it, and if you do that’s a crime. But if you don’t have a duty to keep the information confidential, probably you can go ahead and trade on it. (Nothing here is legal advice!) Some important, though somewhat hazy and controversial, examples: 1. If you are an old friend of an executive at a public company, and you go out to drinks with her and she tells you “ugh I’ve been working so hard, we’re getting acquired,” probably you have a duty to keep that information confidential, and if you trade on it that’s a crime. But if you are just some random person sitting at the next table and you _overhear_ her saying that, you have no duty of trust and confidence to her, and you [can probably trade](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTgtMTItMDMvaW5zaWRlci10cmFkaW5nLWluLXRoZS1wb3RhdG8tdHJhZGU_Y21waWQ9QkJEMDUzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bc6ab8353). 2. If a corporate raider or strategic acquirer or Warren Buffett is planning to propose a takeover of a public company, and you are working on the deal, you have a duty to the acquirer to keep the deal confidential, and if you go out and buy some call options that’s a crime. But if the acquirer _itself_ quietly buys some stock — a “toehold” — before making the proposal public, that’s probably fine: The acquirer has no inside information _about the company_; it only has inside information _about its own plans_, and can do what it wants with those. Warren Buffett’s Berkshire Hathaway Inc. is allowed to buy a stake in a company and then announce that stake, rather than the reverse; it is allowed to trade knowing its own intentions.  3. In fact, if the acquirer _wants_ to share that information with somebody else, so that _they_ will buy shares to support its bid, it [can probably do that](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTQtMDQtMjIvYmlsbC1hY2ttYW4tZ2V0cy1pbnRvLXRoZS1ob3N0aWxlLXRha2VvdmVyLWJ1c2luZXNzP2NtcGlkPUJCRDA1MzAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDUzMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96Bd63523ca), though this one is [more controversial](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMTQtMDMtMjgvc2hvdWxkLWFjdGl2aXN0LXNoYXJlaG9sZGVycy1iZS1hbGxvd2VkLXRvLXRhbGstdG8tdGhlaXItYnVkZGllcz9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96Bdf5c076a). (In particular it does not work with [tender offers](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS92aWV3L2FydGljbGVzLzIwMTQtMDgtMDEvYWxsZXJnYW4tZG9lc24tdC13YW50LXRvLXNlbGwtdG8tYS1idW5jaC1vZi1pbnNpZGVyLXRyYWRlcnM_Y21waWQ9QkJEMDUzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96B2526156d).) But the acquirer’s information belongs to it, and if it wants to _give it away_, insider trading law can’t stop it. Again, not legal advice. Last month, the US Securities and Exchange Commission [won an insider trading](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDQtMDgvcHVibGljLW1hcmtldHMtYXJlLXRoZS1uZXctcHJpdmF0ZS1tYXJrZXRzP2NtcGlkPUJCRDA1MzAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDUzMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96B22830f96) case against Matthew Panuwat, who worked at a public company called Medivation Inc., which was acquired by Pfizer Inc. in 2016. Panuwat [found out about the deal](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjEtMDgtMjMvc3BhYy1zdWl0LWxlYWRzLXRvLXNwYXJjcz9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B6f63a5ce) ahead of time, and did _not_ trade Medivation stock. (That would be illegal!) Instead, he bought call options on Incyte Corp., a competitor to Medivation, apparently on the theory that when the Medivation deal was announced Incyte’s stock would also go up. It did, and he made money. The SEC argued that (1) he had material nonpublic information _about Incyte_ (something like “its competitor would be acquired and its stock would go up”), (2) he got that information _from Medivation_ and (3) he had a duty _to Medivation_ to keep it confidential and not trade on it. Therefore, the SEC said, it was illegal insider trading — theft of Medivation’s information — for him to trade Incyte options. And a jury agreed. This — trading one stock using inside information about another stock — is [often called](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjEtMDgtMjUvaW5zaWRlcnMtdHJhZGUtaW4tb3V0c2lkZS1jb21wYW5pZXM_Y21waWQ9QkJEMDUzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bf35fed46) “[shadow trading](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjItMDEtMjYvd2F0Y2gtb3V0LWZvci1zaGFkb3ctdHJhZGluZz9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B06b2fa28).” Where did the SEC get the idea that Panuwat had a duty to Medivation to keep this information about Incyte confidential? Well, because that was his explicit agreement with Medivation. It was in Medivation’s insider trading policy, [which said](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9hc3NldHMuYndieC5pby9kb2N1bWVudHMvdXNlcnMvaXFqV0hCRmRmeElVL3JOeDczMXlwUzc0OC92MA/60e87ce39a995a4b1a2deb96B1095a01e): > During the course of your employment ... you may receive important information that is not yet publicly disseminated ... about the Company. … Because of your access to this information, you may be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities ... or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company. ... For anyone to use such information to gain personal benefit ... is illegal. Medivation’s policies said that he was not allowed to use information he got about Medivationto trade other stocks. Therefore, the SEC argued — and a judge and jury agreed — when Panuwat did that, he was violating the policy; he was stealing information from Medivation. Therefore he was guilty of insider trading under federal law. Fine. But that was just Medivation’s choice. If Medivation’s policy hadn’t had the “or the securities of another publicly traded company” bit, then I _think_ the SEC would not have had a case. (Still not legal advice! And I think the SEC disagrees. [[1]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E6017#footnote-1) ) I [wrote last month](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjQtMDQtMDgvcHVibGljLW1hcmtldHMtYXJlLXRoZS1uZXctcHJpdmF0ZS1tYXJrZXRzP2NtcGlkPUJCRDA1MzAyNF9NT05FWVNUVUZGJnV0bV9tZWRpdW09ZW1haWwmdXRtX3NvdXJjZT1uZXdzbGV0dGVyJnV0bV90ZXJtPTI0MDUzMCZ1dG1fY2FtcGFpZ249bW9uZXlzdHVmZg/60e87ce39a995a4b1a2deb96C22830f96): > Not every company has a policy like that; some have policies saying, for instance, “don’t use inside information to trade our stock,” without mentioning competitors. For [all](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDYtMjIvZG9lcy1tYXJrLXp1Y2tlcmJlcmctb3duLXRvby1tdWNoLW1ldGE_Y21waWQ9QkJEMDUzMDI0X01PTkVZU1RVRkYmdXRtX21lZGl1bT1lbWFpbCZ1dG1fc291cmNlPW5ld3NsZXR0ZXImdXRtX3Rlcm09MjQwNTMwJnV0bV9jYW1wYWlnbj1tb25leXN0dWZm/60e87ce39a995a4b1a2deb96Bea1dd678) I [know](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly93d3cuYmxvb21iZXJnLmNvbS9vcGluaW9uL2FydGljbGVzLzIwMjMtMDMtMTYvY3JlZGl0LXN1aXNzZS1wdXRzLW9uLWEtYnJhdmUtZmFjZT9jbXBpZD1CQkQwNTMwMjRfTU9ORVlTVFVGRiZ1dG1fbWVkaXVtPWVtYWlsJnV0bV9zb3VyY2U9bmV3c2xldHRlciZ1dG1fdGVybT0yNDA1MzAmdXRtX2NhbXBhaWduPW1vbmV5c3R1ZmY/60e87ce39a995a4b1a2deb96B9cd8370f) some companies might _encourage_ their executives to trade competitors’ stocks. The meaning of Panuwat might be something like “shadow trading is illegal if your company tells you it is.” I will say, when I wrote that, I heard from a number of readers to the effect of “actually most companies have a policy like that.” For instance, here are a [paper](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9wYXBlcnMuc3Nybi5jb20vc29sMy9wYXBlcnMuY2ZtP2Fic3RyYWN0X2lkPTQ2MzQ0ODA/60e87ce39a995a4b1a2deb96B114e0b9b) and related [blog post](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9jb3JwZ292Lmxhdy5oYXJ2YXJkLmVkdS8yMDI0LzAxLzE2L3N0cmF0ZWdpYy1jb21wbGlhbmNlLw/60e87ce39a995a4b1a2deb96B134937d0) by Geeyoung Min of Michigan State University finding that “approximately seventy-six percent of the disclosed, stand-alone insider trading policies from S&P 500 companies prohibit the trading of any other publicly traded companies’ stock based on MNPI [material nonpublic information].” And here is a [client memo from Cleary Gottlieb](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9jbGllbnQuY2xlYXJ5Z290dGxpZWIuY29tLzUxLzMyMzYvdXBsb2Fkcy8yMDI0LTA0LTEwLWp1cnktZGVjaXNpb24tbGVuZHMtc3VwcG9ydC1mb3Itc2hhZG93LWluc2lkZXItdHJhZGluZy10aGVvcnkucGRm/60e87ce39a995a4b1a2deb96B12139e9e), written shortly after the Panuwat verdict, saying that “companies should consider expanding their insider trading policies to expressly prohibit trading in their own securities and securities of others that could be impacted by MNPI acquired in the course of their employment.” But … why? Medivation was not _actually harmed_ by Panuwat’s trading in Incyte’s stock. [[2]](imap://dave%40stucky%2Etech@mail.stucky.tech:993/fetch%3EUID%3E.INBOX%3E6017#footnote-2)  Perhaps, as a matter of, like, fairness, or being friendly with the SEC, companies really should have policies saying “you can’t shadow trade in our competitors’ stocks.” But perhaps as a matter of employee relations (and keeping the employees out of trouble), companies should instead have policies saying “go ahead and shadow trade in our competitors’ stocks, that is explicitly allowed by our policies, have fun.” Why would a company want to have a policy that could send its employees to jail for doing something that doesn’t hurt the company? At Bloomberg Law today, [Matthew Bultman reports](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9uZXdzLmJsb29tYmVyZ2xhdy5jb20vdXMtbGF3LXdlZWsvY29tcGFuaWVzLXJldGhpbmstaW5zaWRlci10cmFkaW5nLXBvbGljaWVzLWFmdGVyLW5vdmVsLXNlYy13aW4/60e87ce39a995a4b1a2deb96B6051495e): > The Wall Street regulator’s victory, likely to eventually reach a federal appeals court, is forcing companies to take a second look at their own insider trading policies. Some have expanded those policies to explicitly address shadow trading, according to a Bloomberg Law search. Others are considering narrowing their prohibitions, hoping to limit employees’ exposure. … > > Now, some companies are considering narrowing their policies, wary of exposing their employees to similar liability. > > “From the SEC’s perspective, that is perhaps an unintended consequence of the Panuwat case,” [Morrison & Foerster LLP lawyer Edward] Imperatore said. > > But other companies have already moved in the opposite direction, underscoring the difficult decisions firms face. > > At least some insider trading policies now include the term “shadow trading” and reference the _Panuwat_ case, a Bloomberg Law review of company disclosures found. The theory of narrowing the policy seems fairly straightforward: Why get your employees in trouble unnecessarily? The theory of broadening the policy is something like “well, if the employees shadow trade, the SEC is going to go after them anyway, and you want to look like you have  effective policies against insider trading so the SEC doesn’t get mad at you too”: > Companies can be liable for insider trading by their employees, and may have viewed the broad language as a way to minimize potential liability, [Geeyoung] Min said. If regulators or prosecutors came knocking, companies could argue their policies went beyond what was required. ... > > Lawyers who urge companies to explicitly restrict shadow trading in their policies note there may have been other reasons Panuwat found himself in hot water: the SEC also argued he had a duty to avoid trading on the merger news, even absent Medivation’s policy, because the company entrusted him with confidential information. But I am not so sure; I do kind of think that the right reading of Panuwat is that it’s illegal if the policy says it is and not if it doesn’t. Which, sure, is weird: > Under that logic, whether a person’s trade is illegal may depend on what’s in their employer’s insider trading policy, legal scholars said. > > “That does seem to give companies too much discretion to make a special law for themselves and themselves only,” said Columbia law professor John Coffee, whose specialties include securities regulation and white collar crime. “The criminal law doesn’t like the idea of different scopes depending upon the decision of the corporate issuer.” Yes, in general, it is odd to have criminal law that companies get to make for themselves. But that’s how insider trading law works! [1] This April [Cleary Gottlieb memo](https://link.mail.bloombergbusiness.com/click/35548615.276783/aHR0cHM6Ly9jbGllbnQuY2xlYXJ5Z290dGxpZWIuY29tLzUxLzMyMzYvdXBsb2Fkcy8yMDI0LTA0LTEwLWp1cnktZGVjaXNpb24tbGVuZHMtc3VwcG9ydC1mb3Itc2hhZG93LWluc2lkZXItdHJhZGluZy10aGVvcnkucGRm/60e87ce39a995a4b1a2deb96C12139e9e) says that “the SEC’s theory also relied on common law principles of agency that would not require breach of an insider trading policy or employment agreement.” But I suppose the company could *expressly waive* those principles, saying “we’d love for you to trade competitors’ stocks, have fun.” [2] Could you tell a story? Something like “Panuwat’s buying of Incyte options, if it was big enough, could have pushed up the price of Incyte, which would have alerted the market to possible deal activity in the sector, which could have pushed up the price of Medivation stock, which could have made Pfizer get nervous and walk away from the deal”? This strikes me as not crazy, in the general case, though clearly not true in Panuwat's specific case. But the point is that the company gets to decide how worried it is about stuff like this.