Money Stuff: It’s Not Insider Trading If the President Does It

Everything is securities fraud There is a lot going on here, but let's start with the "everything is securities fraud" angle: Presidential contender Elizabeth Warren is demanding a federal investigation into whether President Donald Trump provided advance notice of the deadly strike on Iran's Gen. Qasem Soleimani to stock traders who may have profited illegally from the tip. The Massachusetts Democratic senator made her demand in a letter dated Monday to the chairmen of the Securities and Exchange Commission and the Commodities Futures Trading Commission. It cited a Daily Beast report that Trump had told guests at his Mar-a-Lago resort days before the Jan. 3 strike to expect a "big" response to Iran "soon." "If this report is true, it raises a number of troubling national security questions regarding President Trump's handling of classified and other sensitive national security information," Warren wrote in the letter, which was also signed by Sen. Chris Van Hollen, D-Md., the ranking member of the Senate subcommittee that oversees securities and investments. The senators wrote that the president's Florida resort guests may have obtained "confidential market-moving information and had the opportunity to trade defense industry stocks or commodities or make other trades based on this information." The senators noted that defense stocks rose precipitously between the announcement of the attack and the close of trade on Jan. 3. They cited a 5% rise in Northrop Grumman, a 3.6% rise in Lockheed Martin, and a 1.5% rise in Raytheon. Here's the letter, which, I want to emphasize, (1) "raises a number of troubling national security questions" and (2) was sent to the SEC. If you think that the actions of the president endanger national security, by recklessly risking war or by recklessly disclosing classified information that could be used by the enemy, you ask the SEC to look into it. This is not because the SEC has any special expertise in or authority over national security—the word "securities" in its name is just a coincidence; that means "stocks and bonds"—but because, in our postmodern world, the securities regulator is the meta-regulator of everything. Pollution and global warming and sexual harassment and animal cruelty and air safety and computer security and corporate lobbying and many other issues of public policy are, surprisingly, under the SEC's jurisdiction. If a thing is bad, then it is also securities fraud. If you are unhappy about anything at all, the solution is to write to the SEC about it.  I have suggested before that this is weird. It's weird, right? Imagine the SEC being like "actually the president can't start this war because it is securities fraud." Here I am not talking about the substantive legal analysis, about whether the president's alleged actions actually impact market integrity or fall under insider-trading laws or whatever. I just mean that something is lost, symbolically, when so much of our politics and public policy is contested through securities regulation. I get it! It actually seems to be true that there are no effective checks on the president's national-security actions, and so, if you want to check his behavior, you have to take your shot with the all-purpose meta-regulator. And I get that there is at least a plausible market-integrity argument here, to go along with the obviously much more central concerns about national security and general presidential ineptitude. It's just weird. By the way, there has been a multi-year controversy about how the SEC should regulate war in the Democratic Republic of Congo. That is an actual thing that is under the SEC's statutory jurisdiction. I don't know. Is it insider trading? Oh, I don't know, who cares. There's no actual evidence that any of Trump's Mar-a-Lago buddies traded on his foreshadowing, though of course that's what the SEC is supposed to find out, and it's not especially hard to believe. If they did, I suppose the question comes down to whether Trump had a duty to keep the information secret,[1] and I am not sure how you'd prove that. Trump has made a habit of blurting out classified information, and his defense of that seems to be that when the president blurts it out it's no longer classified, that he is the unchecked arbiter of his own confidentiality obligations. This strikes me as probably correct as a matter of law, and certainly correct as a matter of legal realism. But if that's right then you can't exactly say that the president has any duty of confidentiality with respect to government information, which I suppose means that, as a matter of securities law, he can leak it freely, even in exchange for money. (E.g. to Mar-a-Lago members who pay dues, to his company, in part to get access to him.) That would be bad, sure, and you might want someone to stop him from doing that, but I'm not sure that the SEC could. Ironically it might be the reverse of "everything is securities fraud": a case in which actual stock-market-related malfeasance is not under the SEC's jurisdiction, and you have to settle it through the political system. This is obviously not legal advice; there are not a ton of precedents about presidential insider trading. It didn't come up a lot, until recently. People are worried about bond market liquidity We talk about it less than we used to, but they still are. Here's the New York Fed's Liberty Street Economics blog with "How Does Tick Size Affect Treasury Market Liquidity?" I have to say, this isn't new news or anything, but Treasury tick sizes are absolutely wild: Unlike U.S. equity markets, which switched to decimal pricing in 2001, U.S. Treasury securities still trade in fractions. In particular, prices are quoted in 32nds of a point, where a point equals one percent of par, with the 32nds themselves split into fractions. On the BrokerTec platform, for example, 3- and 5-year notes trade in quarters of 32nds, whereas 7-, 10-, and 30-year securities trade in halves of 32nds. The quoted price for a 5-year note might be 98-15¼, for example, indicating a price in decimal form of 98.4765625 (that is, 98 + 15⁄32 + ¼⁄32). Imagine coming up with that! Imagine being a human, with 10 fingers and 10 toes and centuries of decimal-based culture, and being like "instead of using 100ths of a point, we'll use 128ths of a point, and we won't even call them '128ths,' we'll call them 'quarters of 32nds.'" Of course that's not what happened, no one designed this; what happened is just that prices were quoted in points, and then someone wanted a bit more precision and went to half-points, and then someone wanted a bit more precision and went to quarter-points, and then the binary subdividing continued for a while and stabilized at 32nds, and then when it picked up again everyone was so used to 32nds that you had to say "half of a 32nd" instead of "1/64th." (Actually it's worse than that, you say "+"; a quote of 100 and 63/64ths—100.984375 in human language—is written, insanely, as "100-31+.")  It is an archaeological demonstration of path dependency in finance, a bizarrely branching vestigial tail. I confidently assert that hundreds of computer programmers have shown up on their first day of work at financial services firms to build bond trading platforms, and they were like "we'll let people input prices up to four decimal places, does that sound good," and their bosses were like "hahaha decimals no we don't use decimals here," and they went slowly mad. No one could possibly want this, but it's what we have. Obviously that's not what the Liberty Street note is about. The Liberty Street note is about eighths of 32nds, ahahahaha: Effective November 19, 2018, BrokerTec halved the tick size in the 2-year note from ¼ to 1⁄8 of a 32nd. This was the first tick size change since the platform's inception in 2000. ... The finer price increment resulted in an immediate narrowing of the inside bid-ask spread, defined as the difference between the best bid and offer prices on the BrokerTec platform. In fact, the spread for the smallest trades ($1 million) narrowed about 50 percent, from an average just slightly wider than the old tick size to an average just slightly wider than the new tick size. The spread for larger trades ($50 million or more) showed a similar narrowing. That is, trading costs declined with the tick size change, even for trades that are sometimes larger than the quantity available at the best price. The reduction in trading costs, in turn, spurred a significant increase in trading activity. … We find that the Treasury market tick size change led to improved market liquidity, improved price efficiency, and improved price discovery relative to the futures market. While many of these findings are consistent with evidence from equity markets, two stand out as new: 1) liquidity provision was seemingly not adversely affected, and 2) the informational importance of the cash market improved, albeit only until a similar change took effect in futures. The intuition here is straightforward. There is a natural price of liquidity provision; the bid (the price market makers are willing to pay to buy a security you need to sell) is always going to be a bit below the offer (the price they're willing to accept to sell you a security you need to buy). That natural price is determined by things like the cost of funding and the risk of adverse selection and the salaries of traders and the costs of computers; it changes over time and is somewhat unobservable. But the actual price of liquidity provision—the actual spread between the bid and the offer—is basically always going to be some whole number of ticks, because the word "tick" just means the smallest possible price increment.  You'll pay one or two or three or n ticks more to buy at the offer than you'll get to sell at the bid, and that difference is the market maker's income.  Very frequently that whole number is one; the normal spread, in a lot of markets, is one tick. Sometimes it just works out that the tick size in a market is roughly equal to the natural price of liquidity in that market, and that's lucky. But often the tick size will trail the price of liquidity: The market will get more efficient and it will be cheaper to provide liquidity, but the minimum you can charge for liquidity is still one tick, so you'll overcharge, and the market will be a bit too expensive and illiquid and inefficient. And then if one day the tick size is cut in half, the price of liquidity will also be cut in half, and things will get better. "In fact, the spread for the smallest trades ($1 million) narrowed about 50 percent, from an average just slightly wider than the old tick size to an average just slightly wider than the new tick size." The price pretty much stayed one tick, even as a tick got smaller. By the way, you can't go too far with this. If you are just a logical person, you might think that markets should have very tiny tick sizes, much smaller than any plausible cost of liquidity provision, and let supply and demand sort things out. If the tick size was, like, 0.0001 (or 1/8192 if you insist on binary fractions forever), then tick size wouldn't constrain spreads, the price of liquidity would be the natural price, and bonds would trade at spreads of, like, 30 ticks, or whatever the right number is. But in fact that seems to be bad for liquidity; market makers do not want to offer liquidity for 30 ticks of spread if they know that someone else can cut in front of them for 29 ticks. In U.S. equities, Nasdaq has argued that many stocks have prices that are too high and tick sizes that are too narrow, and that there should be more stock splits to fix it: Other stocks trade at large multiples of the tick increment, leading to wider spreads, increased prevalence of odd-lots, flickering quotations, and non-displayed trading that doesn't support price discovery. When ticks are too narrow, time priority for resting orders diminishes in value: traders patiently awaiting passive executions are outbid by economically insignificant amounts. At the extreme, outbidding is so inexpensive that time priority becomes essentially non-existent, destroying the incentive to post passive liquidity and reducing quote competition. As quote competition declines, price discovery weakens and spreads widen; when spreads widen, quote competition and price discovery weakens further and so on. Investors and issuers suffer. Data show the challenges are growing. A decline in stock splits, and the resulting rise in average stock prices, increases the frequency and inefficiencies of too-narrow ticks. In the decades prior to the credit crisis, stock splits were more common. Today, stock splits are rarer, causing many stocks, including several widely-held blue-chip stocks, to trade at prices significantly higher than historical norms. High stock prices combined with one-penny ticks, 100-share round lots, and sophisticated trading algorithms, makes trading outliers and inefficiencies more prevalent.  Basically it's good if the tick size and the price of liquidity are about the same. If the tick size is bigger, that's bad. If it's much smaller, that's also bad. You want the spread to be about a tick. Elsewhere in bond market liquidity: Almost half of corporate bond traders say they spent less of their workday on the telephone last year, as computers supplant the main way the debt has traded for decades. Traders of investment-grade corporate bonds now use electronic networks for about a third of their transactions, up from one quarter at the start of 2019, according to research by analytics firm Greenwich Associates. Some 34.4% of investment-grade bonds traded electronically in November, up from 24.7% in January 2019 and 19% in the first quarter of 2018, Greenwich reported. And here is a Bank of Canada staff note from last month on "Creations and Redemptions in Fixed-Income Exchange-Traded Funds: A Shift from Bonds to Cash." Fixed-income exchange-traded funds (FI-ETFs) typically create and redeem the bulk of their shares in kind. In-kind transactions consist of exchanging ETF shares for baskets of bonds instead of cash. … In this note, we document a shift in the nature of the creation and redemption activity of FI-ETFs listed in the United States. Using novel data from the US Securities and Exchange Commission (SEC), we find that young FI-ETFs managed by new issuers tend to create their shares almost exclusively in cash. In contrast, older funds of established issuers do most of their creation activity in kind. … Funds that create in cash are more likely to hold less-liquid assets or to be actively managed by new issuers (i.e., they are more likely to seek to outperform an index). …  The shift toward cash transactions implies that new funds are taking on exposure to liquidity risk (Pagano, Sánchez Serrano and Zechner 2019). Like bond mutual funds, FI-ETFs are now responsible for buying and selling bonds in the market and therefore need to manage the liquidity of their holdings. Our findings suggest that the liquidity risk mitigating effects of the in-kind mechanism may be weakened as new FI-ETFs choose to create and redeem shares exclusively in cash. Lockups While the Trump administration may or may not have a policy of giving Trump's golf buddies early access to market-moving official news, it is also considering getting rid of the policy of giving the news media early access to that news: Currently, the Labor Department in Washington hosts "lockups" for major reports lasting 30 to 60 minutes, where journalists receive the data in a secure room, write stories on computers disconnected from the internet, and transmit them when connections are restored at the release time. The department is looking at changes such as removal of computers from that room, and an announcement could come as soon as this week, said the people, who spoke on condition they not be identified. While the rationale was unclear, the government has cited security risks and unfair advantages for news media in prior changes to lockup procedures. … The U.S. move would upend decades of practice, and media organizations including Bloomberg News and Reuters have challenged prior changes to procedures. The shift could also spur an arms race among high-speed traders to get the numbers first and profit off the data, raising questions about fairness in multitrillion-dollar financial markets. One way to read this story is in light of the Mar-a-Lago thing, and the old Texas Gulf Sulphur story for that matter. If you're a Trump administration official and you want to insider trade on government data, it will look suspicious and probably be illegal if you trade an hour before the data is announced. But if you trade a second after the data is announced, who could complain? If you trade in the tiny interval between (1) when the data is officially announced and (2) when it becomes general public knowledge, you have at least a plausible defense to charges of cheating, but you still get to cheat. Putting a delay between the official announcement and the news-media stories might help with that. Another way to read this story is in light of the Mifid II story we discussed yesterday. European regulators cracked down on conflicts of interest in investment bank research, which had the effect of reducing the amount of investment bank research, particularly on small and mid-cap stocks. This meant that the market had less information about a lot of stocks. This meant that hedge funds who were in the business of getting differentiated information had more of an advantage, and could make more money. If data comes out at 10 a.m., and everyone knows it comes out at 10 a.m., and news stories summarizing the data and emphasizing the key points also come out simultaneously at 10 a.m., then everyone has the same chance to react to the data and no one can make that much money. If the data does not come out in easily-human-comprehensible form at 10 a.m.—if the explanations follow the data minutes or hours later—then the people who are better at quickly comprehending it have more of an advantage, and can make more money.  Never mind, Nav Well I was not expecting this: Navinder Singh Sarao, the British trader blamed for helping cause the 2010 Flash Crash from his bedroom, shouldn't get jail time, U.S. authorities said in a recommendation before his Jan. 28 sentencing in Chicago. The government cited Sarao's "extraordinary cooperation," his autism diagnosis and the fact that he hadn't spent most of the 45 million pounds ($58.5 million) that he made trading, according to recommendations filed with the court Tuesday. The Justice Department said a longer prison term for the the U.K. citizen wouldn't be a deterrent to other traders, and would pose serious risk to the 41-year-old's mental health. He spent 4 months in a London prison. When Sarao was arrested, almost five years ago, I was not especially convinced that he caused the Flash Crash, and I certainly didn't think that he should go to prison for ever and ever. But my assumption was that U.S. federal prosecutors tend to want to claim big wins, and "the guy responsible for wiping out a trillion dollars of wealth, for like a minute, got his just desserts" is a bigger win than "some random spoofer got probation." Also typically the way securities-fraud sentencing works is that the sentence is proportionate to the amount of loss that you caused, which means that if you cause a trillion-dollar flash crash you go to prison for a trillion years, even if (1) the trillion dollars mostly came right back, (2) you only made $58.5 million and (3) you didn't even spend most of it. Here, though, reason seems to have prevailed, which is nice. Things happen The Tokyo Job: Inside Carlos Ghosn's Escape to Beirut. Goldman Sachs's $1 Billion Legal Hit Mars Trading Bounceback. BofA Joins Wall Street's Trading Comeback; Consumer Unit Slips. Morgan Stanley Promotes Fewest to Most Elite Rank Since 2002. Restructuring sovereign bonds: holdouts, haircuts and the effectiveness of CACs. "IRRs are being manipulated across the board." Morningstar Nears Settlement With SEC Over Bond Ratings. New York Court Vacates $91 Million Payout to Former Hedge Fund Employees. Ghana Charges CEOs Over Banking Crisis That Cost $2.2 Billion. Bankers Flooding JPMorgan Event Bemoan San Francisco Squalor. "Whenever someone angrily exposes the secrets of a field they've been involved in, the first question to ask is whether they're more motivated by truth-seeking or ressentiment." Yamaha warns musicians not to climb in instrument cases after Ghosn escape. Spotify launches playlists for dogs left home alone.  If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] One could imagine a theory that Trump could disclose the information to the Mar-a-Lago members, but *they* had a duty to keep it secret and not trade on it, because there is some "duty of trust and confidence" among members of a golf club that prohibits them from betraying anything said at the club. This seems pretty dumb, but the law of golf-course-related insider trading is quite complex and well developed, and there is in fact some precedent for the theory of a golf-buddy duty of confidentiality.   Before it's here, it's on the Bloomberg Terminal. Find out more about how the Terminal delivers information and analysis that financial professionals can't find anywhere else. Learn more.   You received this message because you are subscribed to Bloomberg's Money Stuff newsletter. Unsubscribe | Bloomberg.com | Contact Us Bloomberg L.P. 731 Lexington, New York, NY, 10022