Wall Street’s Problem: Conflicts or Competition?

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Readers doubtless know that I am very fond of the Financial Times. I therefore find it distressing when a writer, particularly a capable writer, puts out a story that is enough off base as to be misguided.

Case in point: “Bulge-bracket banking model has spawned monsters” by Tony Jackson. He is unhappy about the way investment banks operate. His argument is that the large investment banks are in so many businesses that their conflicts of interest have become rife. In particular, he thinks their scale and degree of integration gives them an undue and unwarranted information advantage. This paragraph sums up his argument:

The wider question is how far the bulge-bracket model serves the public interest. In providing market liquidity and creating new and useful products, from which big firms earn their crust. It is less clear they are entitled to levy a kind of tax on the saving and investing public through superior market information.

Mind you, I also object to the business practices of investment banks, but these charges, for the most part, either don’t stick or are old news.

Tony, where have you been? Trading firms have always “levied a tax” on their information advantage. In fact, today trading customers have it vastly better than they did 25 years ago. Before the Bloomberg screen, customers were at the complete mercy of bond dealers. All they had to go by were published prices from the end of the day before of a few benchmark bonds. The only way to be certain you were getting a good price was to get simultaneous bids on a bond from several dealers. And since bonds are more fungible than stocks (single A bonds of roughly the same maturity and similar coupons are substitutes for each other, even if they come from different issuers), a buyer might be missing an opportunity if he focused on one bond to the exclusion of others that might be more tradeable.

Now, not only do more customers have access to Bloomberg screens (where dealers post indicative quotes) but actively trading hedge funds can in certain markets can get interdealer screens, which shows the same, more frequently updated quotes that dealers show each other. And for the more actively traded instruments, investors can send orders through services that will anonymously match them up with counterparty offers, without any pesky dealer intervention (the computers don’t know whether you are a podunk bank in Wichita to be treated as a mark, or someone big and tough like Global Alpha, Goldman’s hedge fund).

In fairness, these tools and avenues are available only in the most active areas of the market (but that’s where the majority of trading volume occurs). In newer, more exotic, and more thinly traded instruments, dealers are the source of liquidity and have a considerable information advantage.

But how is this different from any other market? If you go to buy a painting or a piece of estate jewelry, you are uncertain of whether you are getting a good deal unless you do a great deal of homework, and even then, the dealer, because this is what he does every day, all day, will still know more than you do.

What I find curious is the increased touchiness of hedge funds about the behavior of their investment bank counterparties. Hedge funds have not sprung up full grown, like Athena out of Zeus’ forehead. They have been around for a while: Soros, Julian Robertson, Michael Steinhardt, Paul Tudor Jones, along with substantial traders who operated with their own capital, like Tommy Taylor of the Bass Brothers, Odyssey Partners, Cargill. They never complained about investment banks (I’m sure they were careful and divided their trades and knew that their counterparties would happily cut their throats, but you never heard them whining about competition). So why are things different now?

Jackson assumes it’s the investment banks. Yes, they have proprietary trading desks, but many firms have had them since the late 1980s or at worst the mid 1990s. They are not a new development. More annoying is that many firms have established their own hedge funds, but they are housed away from the trading floor and don’t benefit from its market intelligence (remember, the trading floor prop desk competes with the firm’s own hedge fund).

I think the change has as much to do with the huge rise and proliferation of hedge fund strategies. Average returns have fallen and some argue that the keen competition among funds has reduced the attractiveness of certain strategies. So narrowly, the hedge funds are right to be annoyed, but I think it is more because their trading is enriching a direct competitor.

But the traders at the investment banks could take the same point of view. After all, many hedge funds couldn’t prosper without the services provided by their prime broker (a bit of a misnomer, since most firms have several so the PB can’t see the entirety of their business). Most important is leverage, but many provide fund administration as well, and for smaller funds, various reporting activities. So investment banks and hedge funds have a deep, perhaps too deep, symbiotic relationship.

Similarly, Jackson misses the mark on another complaint:

For instance, they advise private equity firms on acquisitions while being rival private equity firms themselves.

Technically true, but no private equity firm worth its salt uses an investment bank for advice about the merits of the business or valuation on the buy side. They make their own determination on those matters. Where an investment bank may be useful is in certain aspects of transaction execution (like buying shares quietly up to the 13-D reporting threshold). And virtually all companies that talk to a PE firm put themselves up for auction, so the process is fairly open. Yet it’s very understandable that a client would be irritated to have paid fees to an institution and have another part of the shop outbid them. But the fees paid to investment banks on failed buy side bids are modest.

No, where clients have cause to be outraged is when they engage an investment bank to sell a business and the same firm’s PE group shows up on the buy side. I have heard stories of investment banks trying to close down auctions to give their PE arm an advantage (Goldman is notorious for this). That’s the kind of conflict that deserves rebuke, because not only is there a conflict, but the units involved are clearly colluding to the disadvantage of the client (in the case above, the client may be harmed, but there is no collusion).

Jackson actually was on the right thread at the start of his story but lost the plot:

A prominent UK hedge fund manager, Chris Hohn of The Children’s Investment Fund, fired a broadside recently at the big investment banks. He was fed up, he said, at the way the banks traded on the back of his deals. “We have definitely experienced cases where information has been leaked,” he said. “We are quite uncomfortable with the situation.”

The conflicts do not exist because the firms span many businesses. The bulge bracket model has been around for over 20 years. The problem is that in the 1980s, firms were more relationship oriented. Yes, they might take their clients now and again, particularly on the trading side, but were very careful to stay within bounds of propriety. But the LBO wave had investment banks funding raiders who attacked corporations, the sort that were clients (first it was just Drexel, an outsider that had never represented blue chip companies, but later even the top investment banks were mounting hostile bids against household names). Companies thus became chary of getting in too deep with any firm and became more transactional in their posture.

The breakdown in loyalty and relationships created an “every man on his own” posture, and has increasingly produced a culture on Wall Street that takes what it can.

That, Mr. Jackson, is the problem. It’s not the structure of investment banking, or the banks’ information advantage. Those conditions have been in place for a generation or more. It’s the erosion of the culture, an extreme version of a widespread decay in values.

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