|June 11, 2010
Investment Industry Ethics Should Bother You
By Ron Robins, Founder & Analyst -
Investing for the Soul
Two recent stories concerning the U.S. investment
industry are the ‘tip of the iceberg’ when looking at
the industry’s ethics.
The first story concerns the May 6 flash crash where the
Dow Jones Industrial index in minutes lost 9% of its
value—though it quickly recouped most of the loss. Some
knowledgeable observers cite high frequency trading (HFT)
as responsible for the crash by pulling liquidity (cash)
from the market. The SEC looked into the crash and in a
preliminary report released on May 18 said it could not
find a specific cause for it. However, they did mention
the need for further investigation—which is expected to
Market experts familiar with HFT say it can be a source
of liquidity and illiquidity to financial markets. Since
HFT now accounts for more than 70 per cent of all trades
on the NYSE, sudden withdrawal of liquidity from the
market i.e. not buying shares, could cause a market
There are two key principles for making HFT work and
both are ethically problematic. Firstly, they tap into
the raw exchange data feeds versus the slower data/quote
feeds that regular market participants would get from
Bloomberg, etc. Secondly, HFTs locate their servers at
the exchange’s computer centres. This minimizes
potential latency in sending orders.
Thus HFTs have the advantage of market information and
prices before other clients get theirs. They can place
orders, buying and selling in milliseconds, ahead of
orders placed by other market participants. Such
‘front-running’ of orders has long been considered
unethical behaviour in markets as it creates the
opportunity for market manipulation and illicit gains.
Therefore, allowing HFTs to operate this way is unfair
and abhorrent to most market watchers.
To me, the stock exchanges also exhibit possibly
unethical behaviour by giving HFTs priority of trade
information. As the exchanges receive fees from the
HFTs, they believe it is just another source of revenue
for them so giving them priority of trading information
is therefore justified. However, some of the information
that the HFTs are getting might be private trade
information which, if known, may also give an unfair and
unmerited trading advantage.
A principle rule in the industry has always been the
separation of private and public information. If allowed
to be public, the information has to be available to all
market participants simultaneously. The exchanges appear
to be violating this cardinal rule.
The second major and continuing story is where the U.S.
Securities Exchange Commission (SEC) accuses Goldman
Sachs of double-dealing. That is, the company created
and sold a mortgage collateralized debt obligation (CDO)
that it allegedly believed would fail. Not disclosed to
the CDO buyers was that Goldman knew that Paulson & Co.,
a hedge fund, had taken out credit default swaps betting
that the CDO would fail. In addition Paulson & Co. had
been engaged in designing the CDO, a fact also allegedly
never revealed to the CDO buyers. Losses to investors
buying the CDO are well over $1 billion. Clearly either
lack of transparency or purposeful misrepresentation
could be at play here.
It is reported that Goldman is seeking to pay a fine to
end the case. However, if the parties come to such an
agreement, be sure to look at the settlement details.
They will probably include ‘no admission of guilt.’ By
not admitting guilt Goldman will be less liable to be
sued and thus avoid possible further huge civil suits
and loss of reputation and revenues. This is the case in
many settlements with the SEC. It is my opinion that by
including no admission of guilt in these settlements,
and letting firms off the hook for additional suits and
damage awards, only encourages even more misconduct and
moral hazard in the years following the settlement.
In hindsight, we see the use of the no admission of
guilt axiom in the $1.4 trillion 2003 settlement between
the SEC and 10 major U.S. brokerages may well have
contributed to the moral hazard that fed the market
frenzy between 2003 and 2007 and the subsequent meltdown
and economic collapse in 2008/9. In 2003 these firms
were fined for getting their clients to buy highly risky
securities while their analysts and brokers were
remarking how bad these securities were—and actually
unloading them in the market to their clients.
Lastly, among the litany of ethical concerns I have
regarding the investment industry is the combining in
one person the activities of investment advice and
financial planning. Since this individual is receiving
fees and commission for the products he/she sells to
clients and yet is also advising them on their
investments, there is a clear conflict of interest. In
addition, different products offer varying commissions
therefore the advisor/planner may want to have clients
purchase the higher commission products even though they
might not be in the clients’ best interests.
This is such an important issue that the UK Financial
Services Authority (FSA) is preparing to ban financial
planners from receiving commissions by 2012. I believe
it will not be too long before relevant regulatory
authorities in most countries take this approach.
All these issues, as well as numerous others, cast an
ethical pall over the entire investment industry. These
concerns are not the prerogative of just the U.S. or
Europe, but are prevalent in countries globally.
Investment firm ethics should bother you a whole lot.