By Ron Robins

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 include HFT.

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 crash.

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.

June 11, 2010

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