Tuesday, July 28, 2009

Perfection vs. Robustness

I'm affiliated with a company whereby I have to provide all my brokerage statement per SEC rules. This is designed so that those with inside information do not 'front run' orders in other accounts. Say I work for Fidelity (buy side), or Goldman (sell side). I have access to information that can be very profitable. This is not so much knowing the Fidelity thinks IBM is a good buy, but rather transacting a few moments prior to the much larger institutional order, or corporate action like an analyst upgrade or stock repurchase plan announcement.

My friends told me that in the 1990's, many people who worked at brokerages would routinely get in front of recommendations ('strong buy'), and this made them as much as they made from their 'day job'. Clearly, there is a strong conflict of interest, this basically robs their customers, who merely end up paying more. So, this appears a good regulation.

But consider how this is being enforced. You have regulators who get stacks of hard copy reports from various brokerage accounts for many employees. As these reports are in all different formats, there's no way to do this but to 'eyeball' thousands of pages of documents, and compare this to electronic trading records which include hundreds of thousands, if not millions, of transactions. It's like looking for a needle in a haystack. As regulators have finite resources, this prevents them for looking at other transgressions.

Now consider I wished to front run, knowingly break this law. My first obvious thing to do would be to set up an account and not tell anyone. I have several accounts. There's no national account registry to make sure I gave all of them to the SEC. How would they catch that? I don't know, but I imagine any such fraud occurs not by hoping the SEC won't match up my trades with actual orders, but rather they won't know I had another account I did not mention.

I think a better regulatory mechanism would merely be to get everyone's 1099 form that lists dividends, interest, and capital gains from each of their brokerage accounts. As the brokerages all supply them to the IRS, I can't unilaterally withhold such information without getting caught there. Only in cases where profits are large, say capital gains greater than 10% of my salary and I traded more than 10 times, should this then flag that regulators receive my transaction report from which to check against company trade records. After all, if I don't trade much, or don't make sufficient money trading, I probably was not cheating (or if I was, not enough to matter).

But think outside the box. If this is the system, one could easily outfox it: bring in a father-in-law, or a friend. The bottom line is that any system put into stone can be easily gamed if one tries hard enough. The easy fraud should be checked and made illegal. A system should be set up recognizing that resources are finite, and should not assume that a system will catch everything. The current approach relies on rule-breakers telling the truth, and that their regulators have the attention span of a an autistic looking at design specs. It is useful to check brokers personal brokerage accounts, but a simple system that can be automated would allow humans to do what they are best at, looking at funds like Madoff's with suspicious returns, and have discrete authority to audit their financials.

If you just set up rules, and then hire bureaucrats to implement mind-numbingly boring rules, that is pretty lame. But that's all we can expect out of Washington, which is why the best regulator is competition.


Thomas Themel said...

So, a web form where you can rat on the guy in the next cubicle and collect 10% of what they fine him?

Anonymous said...

A 1099 doesn't show capital gains. It only lists the gross proceeds. Whether its a gain or loss is between you and your tax return. Alas, this huge tax dodge ends in 2011 when the Brokerage 1099s will indeed report gains and losses.

All that's besides the point. Are you suggesting that bureaucracies will become more concerned with providing the appearance of a good job than the effective conduct of good job?

ephpostfacto said...

The compliance office of a firm should be the one keeping track of employees account information to make sure that an employee does not trade on material non-public information. Depending on the type of firm, this may be a regulatory requirement.

Many firms require that employees preclear all equity trades with the compliance department. The department should also maintain a restricted list of securities that cannot be traded by individuals due to conflicts of interest.