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Is the smoke clearing for expert networks?

From a modest hotel room in the Omni Shoreham in Washington DC, the SEC gathered a smattering of reporters, lobbyists, and others for a best practices seminar. But the somber title belied a dramatic observation to be made by an SEC official on expert networks. They’re not the problem.

Carlo di Florio, director of the U.S. SEC Office of Compliance Inspections and Examinations, spent just over six thousand words on reforms made under Chairman Mary Schapiro, the implementation of the Dodd-Frank Act, the focus on examination and training, and various enforcement actions in the advisory community. And then, almost 6000 words in and nearing his final remarks, he decided to “briefly mention the ‘Expert Network’ insider trading cases that the Commission and the Department of Justice have recently brought, and that have received much recent press coverage.”

Contrary to some reports that I have seen, I believe these cases do not represent some inherent hostility by the Commission toward expert networks Read the rest of this entry »

JUSTICE BREYER: So that would mean that every — every businessman — perhaps not every, but every successful businessman typically has something. His firm wouldn’t be successful if he didn’t have anything that others didn’t have. He thinks of a new way to organize. He thinks of a new thing to say on the telephone. He thinks of something. That’s how he made his money.
And your view would be — and it’s new, too, and it’s useful, made him a fortune — anything that helps any businessman succeed is patentable because we reduce it to a number of steps, explain it in general terms, file our application, granted?

MR. JAKES: It is potentially patentable, yes.

JUSTICE BREYER: Okay. Well then, if that were so, we go back to the original purpose of the Constitution. Do you think that the Framers would have wanted to require anyone successful in this great, vast, new continent because he thinks of something new to have had to run to Washington and to force any possible competitor to do a search and then stop the wheels of progress unless they get permission? Is that a plausible view of the patent clause?


JUSTICE SOTOMAYOR (addressing Jakes): No, but a patent limits the free flow of information. It requires licensing fees and other steps, legal steps. So you can’t argue that your definition is improving the free flow of information.

:: via Bilski v. Kappos – oral arguments, Monday, November 9, 2009. Later, Justice Breyer would ask Jakes, counsel to Bilski, whether his novel method of teaching antitrust law is patentable.

I strongly believe that the recent trend to patenting algorithms is of benefit only to a very small number of attorneys and inventors, while it is seriously harmful to the vast majority of people who want to do useful things with computers. When I think of the computer programs I require daily to get my own work done, I cannot help but realize that none of them would exist today if software patents had been prevalent in the 1960s and 1970s. Changing the rules now will have the effect of freezing progress at essentially its current level.

Donald Knuth, letter to the Commissioner of Patents & Trademarks, USPTO, February 1994

Inventions must be tied to a particular machine or transform something. Useful, concrete, and tangible result of State Street is inadequate.

David Kappos, Federal Circuit, in re Bilski, 30 October 2008

Patents aren’t bad. They’re an essential element of our economic system. The patent system and the 1952 shift to the protection of a process is the problem.

The 1952 Patent Act expanded coverage to include industrial processes. With the increasing importance of manufacturing to the economy, Congress had been successfully lobbied to provide a layer of protection around industrial manufacturing processes. With the Act, however, it introduced the framework by which to patent business processes – patents such as one click buy. The patents have muddied the water and introduced an expensive and chilling sense of uncertainty to business and information-oriented innovation.

Patents start with a basic tension. Economies benefit from the dispersion of ideas accompanied by sharing the details of inventions. Inventors, however, have little incentive to share the details if it results in no more than a roadmap for competitors to follow. Patents offer inventors a simple trade-off. Make public the details of your invention, and the government will in exchange grant the exclusive right to exploit it.

The 1952 Patent Act was designed to advance manufacturing quickly. Industrial processes, without the protection of a patent, might remain trade secrets, and these trade secrets were perhaps too valuable to the economy to be kept private. A patent system designed to protect them would open them up and accelerate growth. Or maybe it was more facile than that. Patents would provide legal protection and accrue enterprise to those that developed them. Either way, the patent system shifted from one organized around physical designs to one accommodating of processes. Read the rest of this entry »

Does relying on “industry experts” constitute insider trading?
There is nothing inherently wrong with hiring a company that arranges conversations between analysts or hedge fund managers and those who offer legitimate expertise to assist investors in making investment decisions. The information provided by experts can be part of the “mosaic” of information gathered by analysts or investment managers to assist them in the process of investment decision making. This type of information can include economic or industry forecasts.

Even if a piece of non-public immaterial information takes on significance when combined with primary research or other non-public immaterial information, the information may still be considered immaterial. This concept is known at the mosaic theory.

Michael McMillan, director, ethics and professional standards at CFA Institute, and Jon Stokes head, standards of practice, driving at the difference between expert networks and insider trading: via FT

Integrity Research has done the investment industry and general public the good service of providing more lengthy excerpts from the February 8th news conference in which Preet Bharara and Robert Khuzami outlined the contours of their investigation into insider trading. At the time, most major news coverage centered on a single quote from Bharara that suggested the networks were “verging on a corrupt business model” — without qualification. The expanded excerpts provided by Integrity Research, however, provide a great deal of qualification.

Neither Khuzami or Bharara would say that expert networks are verging on corruption. Bharara, to whom the press has attributed the statement, specifically says, “There is nothing inherently wrong with or bad about hedge funds or expert networking firms.” Khuzami, who heads the SEC’s enforcement division, echoed his statement: “Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions.” Far from suggesting that expert networks are verging on a corrupt business model, Khuzami and Bharara understand and validate the role of expert networks in primary research.

The US Attorney and SEC’s focus is insider trading, not expert networks. Bharara later clarified that the exchange of insider information could transpire in any circumstances, and expert networks may encounter these situations just as any other circumstances might. What matters to the SEC and the US Attorney is that it’s bad people doing bad things: “whether or not it’s done through an expert networking firm or its done as a McDonalds, it really doesn’t matter.”

Why, then, did the press come to characterize expert networks as verging on a corrupt business model?

Now let me begin by making something crystal clear. There is nothing inherently wrong with or bad about hedge funds or expert networking firms or aggressive market research for that matter.  Nothing at all. But if you have galloped over the line, if you have repeatedly made a mockery of market rules, if you have converted a legitimate enterprise into an illegal racket then you have done something wrong and you will not get a pass…If you made criminal activity your business model, then business as usual has to stop or the consequences, as dozens of defendants have now discovered will be severe. There are rules and there are laws and they apply to everyone.  No one is above the law, and those who would excuse or rationalize, brazen criminal conduct of the type of alleged today, are neither friends of Wall Street nor allies of business and they are certainly not supporters of the investing public.

Preet Bharara, US Attorney for the Southern District of New York: via Integrity Research

Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions. We allege that the charges reveal thoroughly corrupt conduct through and through….The only thing I would add to that is if you engage an expert networking firm, you are wise to conduct due diligence, to determine whether or not public company employees are engaged as consultants, and if so, there are a variety of devices and practices, that have arisen, across Wall Street, and in many regulated entities, to ensure that material non-public information is not crossing the transom, and that you are not receiving it.

Robert Khuzami, Director of the Securities and Exchange Commission’s Enforcement Division: via Integrity Research

There was a time when daily prices for US Treasuries were hand-written on two or three sheets of paper from a yellow legal-pad and run by messenger to the Associated Press and Dow Jones. The AP needed the prices early enough to send to their members and Dow Jones was under pressure to make the deadline for the Wall Street Journal and their newswire. The messenger couldn’t wait for the closing prices. They had deadlines. No. A clerk would scribble the list furiously and send it off – smudges and all.

Bloomberg called it the modern day pony express. It wasn’t far off. Some poor runner would bolt into the respective newsrooms, hand over a precious few sheets of paper, and watch the operator enter the prices into their system. But in 1987, Bloomberg would change that.

Bloomberg’s terminals had found a quiet niche in the aggregation and analysis of Treasury pricing data. It had so much data that it had beat the Fed. Bloomberg had better, more up to date data than the Federal Reserve. It’s prices were more reliable than the Federal Reserve. What followed was perhaps one of the finest coups of earned media in history.

Rather than rely on legal pads and couriers, why not wires? Why not a Bloomberg terminal? The AP and Dow Jones each took at terminal. They got better data. They got closing prices. And each day, they ran a full page of Treasury prices, courtesy of the terminal and credited to Bloomberg.

Lesson learned: if you want media, earn it.

From our first day in business, Bloomberg was making news, with numbers
Mike Bloomberg and a modest ambition

While most news organizations today are listing in the high seas of the digital world, Bloomberg News has proven to be an adventurous and successful competitor. They started with a key asset, the Bloomberg terminal, and a gaping niche – business journalism. As it has grown, it’s become an instrument of recognition for the entire Bloomberg enterprise, a sales tool, and a critical hedge against competition.

Bloomberg seems to have demonstrated that it’s possible to make money from reporting the news. It’s a fierce competitor to the Wall Street Journal, Reuters and other business reporting. It runs a thriving business. But Bloomberg isn’t interested in selling news feeds. Indeed, much of it is given away for free on the web portal. Bloomberg gives it away because it wants to eliminate the profit margin in delivering the news, so it can starve competitors and enhance the value of the terminal. It wants to make the news a commodity.

Bloomberg’s entry into journalism would push traditional news sources to improve their coverage and respond to Bloomberg News. The underlying dataset in the Bloomberg platform gave them a distinct informational advantage over the competition. The information and analytics on financial instruments was just not widely available and not something on which traditional news sources had focused. As Bloomberg says, they were already in the news business – just with numbers. The terminal had become, for example, the de facto source of pricing for US Treasuries and replaced the Federal Reserve’s daily pricing sheet with a Bloomberg terminal at the offices of the AP. Each day, when the AP published the closing Treasury prices, sourced and attributed to Bloomberg, they were effectively running a news story, or an advertisement – take your pick. This unique resource separated them from the competition, gave them pricing power and promoted the terminal – all in one stroke.

Business journalism at the time also lacked the luster of reporting on riots, elections, and wars. Journalism schools didn’t teach business and finance reporting. The mainstream, national press would gloss over financial markets on the way toward bigger stories. As Bloomberg remarks, “Even at the Wall Street Journal, it was rare to find top editors who included among their accomplishments daily stints covering stocks and bonds.” Bloomberg News would enter a seemingly uncontested field. In 1988, Bloomberg marshalled Matt Winkler to enter the fray.

Bloomberg News also provided a much-needed hedge against the possibility of losing key news-suppliers, such as Dow Jones. Bloomberg had already eaten into the Dow Jones Telerate business. While Telerate presented static images of Treasury prices, Bloomberg users were presented with live data on which they could run analytics. When Dow Jones did respond, they pulled the plug on their feeds to Bloomberg, expecting that Bloomberg customers would come back to Telerate and abandon the Bloomberg platform. It turned out that clients found Bloomberg News sufficient: at worst, good enough to get the job done and, at best, invaluable in combination with the underlying dataset. Dow Jones eventually relented six months later and resumed delivering their feeds through the Bloomberg platform. Telerate would later be shut down.

The rapidly growing news enterprise advanced and protected the Bloomberg franchise. It spread the reputation and influence of the Bloomberg organization, and this sold more Bloombergs. More Bloombergs funded more news, and Bloomberg news became increasingly visible beyond the terminal. It worked its way into radio and television first. Then it began traditional print syndication, and syndication brought Bloomberg’s business reporting to the New York Times, among others. With these outlets, the Bloomberg brand became more prominent, more potent. It sold more Bloombergs.

The news division at Bloomberg was never designed to sell the news. It was designed to sell Bloombergs. It started with a market niche and a key asset – business reporting and the terminal. But it rapidly evolved into an important hedge against the risk of key suppliers, such as Dow Jones, cutting off Bloomberg as a customer. When Dow Jones dared to do so, Bloomberg had won. Bloomberg news was good enough to be a substitute or an improvement on most serious business and financial reporting from Reuters, the Wall Street Journal, the FT, the New York Times, and anyone else who might have contact with their customers. Business and financial news reporting, at first an area of distinction for Bloomberg, had become a commodity.

Because Bloomberg doesn’t need to sell the news, those that do are at a disadvantage. They rely on profit margins from distribution, sales and subscriptions to the news. Bloomberg doesn’t. Bloomberg makes money through subscriptions, but they’re subscriptions to the terminal. The news is just another commodity, and it suits Bloomberg just fine to see it have commodity-margins. It just makes the terminal more valuable.

BlackRock caused a stir in 2009 when it announced its intention to increase the practice of crossing trades. It signaled to the street that they were sufficiently large to find counterparties within and among their many portfolios and clients. They would no longer rely so greatly on the efforts of outside brokers. Brokerages recoiled in defense and BlackRock was forced to say that it would continue to be a big customer of the street. Nonetheless, their intention hung in the air.

It wasn’t that crossing trades would comprise a new development. Asset managers have crossed trades before and in great number for years. Why should an investment manager go to a brokerage to sell a security when another of the firm’s portfolios or clients would like to buy it? Cross the trade, and you don’t have to pay a brokerage fee. The practice lowers costs and lowers risks by limiting one’s reliance on the street for pricing, market intelligence, and execution. BlackRock’s scale, however, suggested that something might be different this time. But was it?

BlackRock’s proposal represents the slow realization of a long-standing trend in the securities market – the systematic and persistent diffusion of the market center. In practice, it has meant a progressive shift from transactions through a fully regulated cartel at the core to a spontaneous and dynamic arrangement of counterparties. In fact, BlackRock’s proposal today bears the same signature as the odd-lot controversy in 1975, when Merrill Lynch proposed executing odd-lot trades on behalf of their clients. But it differs in one important respect. Rather than a brokerage house, it’s the investment manager that is driving the change: a principal, rather than an agent.

Merrill Lynch approached the New York Stock Exchange in 1975 with a simple proposal. They wanted to execute odd-lot trades off the exchange. Odd-lot trades comprised orders of fewer than 100 shares. Brokers would typically pass these to floor specialists, who would bundle them in round lots and execute them on behalf of a Merrill Lynch client. Merrill proposed to match odd-lot trades with buyers from among their existing clients and execute them at a lower cost than otherwise. The specialists were terrified.

The Floor

Merrill’s proposal would shift transactions away from the specialized floor traders, such as Carlisle DeCoppet, for example, the reigning specialist in odd-lot trades. Odd-lot trading comprised less than 5% of trading on the exchange, but the members feared the change would undermine a carefully constructed cartel that, through policy and procedure, directed the vast majority of trades to the floor of the exchange for execution by member firms. Chris Welles, writing in New York Magazine, 20 October, 1975, laid out the stakes: “Carlisle DeCoppet’s monopoly would be destroyed and its profits all but wiped out if Merrill Lynch goes ahead with its plan, for Merrill’s 1.5 million customers account for 26 percent of Carlisle’s business.” Merrill Lynch would effectively create a mini-stock exchange, separate from the NYSE.

The NYSE had only just been compelled by the SEC to no longer fix brokerage rates in May. The exchange forfeited the 183 year practice on May 1st, 1975, a day that would come to be known as May Day. Members, having lost the organizing influence of the cartel’s discipline, quickly found themselves in a price war, undercutting each other dramatically. With it emerged the first generation of discount brokerages. Many rules, however, remained, but the exchange was losing power.

The debate had moved to Rule 394, which had been designed to limit off-floor execution of trades. Though it did permit them if the off-floor price was better than the floor price, the spirit of the rule was intended to keep as much execution on the floor as possible: “Even if Merrill Lynch isn’t formally breaking 394, they are opening up a wedge. They are violating the spirit of 394,” said Harry Jacobson, a specialist on the floor at the time and then head of the Association for the Preservation of the Auction Market, a 700-member strong association of specialists with an interest in floor trading. Donald Weeden likened it to the Blackout Rule for sports-fans, “league-sponsored rules erected to assure a full-house for club owners.” Welles had just published The Last Days of the Club, in which he outlined the decline of the then stalwart Wall Street firms and subsequent rise of their inheritors. The title alone told the story, but the market for exchange seats made it tangible. The price for an exchange seat dropped in one month from $125k to $65k on the news of Merrill’s plan.

Jacobson, the APAM, and the floor was already under pressure. The increased importance of block-trading and simultaneous emergence of new technology had changed the market. Institutional investors had reached a critical mass. With their increased asset base, they increasingly looked to the floor to handle block trades. These weren’t odd-lots or round lots. They were large lots. Individual investors had rarely required such large capacity, but with their assets pooled in large institutions, it became an expected and regular event for which the specialists on the floor were unprepared. If these trades took them by surprise, new technologies, their adoption by institutional investors, and their impact on the world around the floor would have seemed even more earth-shattering to the convivial contretemps so often associated with the floor – grab-assing, practical jokes, and hijinks. Automation had come and gone for the floor specialists, with one noting, despite the prospect of considerable savings for individual investors, “let’s not engineer ourselves out of business.”

Merrill Lynch would get its way. May Day had weakened the exchange. Merrill’s proposal did not violate 394. It saved their customers money, and it uncovered the swollen and unsympathetic features of the cartel that dominated equity trading through the NYSE. The securities market would begin the systematic and persistent diffusion of the market center in favor of the edge. In 1975, the market moved from the floor specialists at the center to the investor-facing brokers, such as Merrill Lynch, at the edge. The floor lost its monopoly and other firms, such as Merrill Lynch, other exchanges, or agents would emerge as competitors.

Almost thirty-five years later, Larry Fink would voice a similar proposal, but it would come from an asset manager, not a broker or an exchange: a principal, not an agent. In September 2009, Fink announced that BlackRock would organize a system to cross trades within its massive asset-base for the benefit of the firm and its clients. He introduced it in terms of “trading friction cost” and lamented, “we need to make sure we’re not being taken advantage of.” Just like Merrill in the odd-lot controversy, BlackRock would cross-trades to benefit their clients: “our clients are going to make more return.” Fink would go on to say, “There’s no question, you have seen huge profitability in some of these institutions. The widest bid-ask spreads are in fixed income — the more opaque the market, the more money the market makers are making.” BlackRock wasn’t just interested in equities, it was interested in fixed income and perhaps other markets as well.

BlackRock would raise the specter of crossing trades again in late 2010. The FT quoted BlackRock president, Rob Kapito, on 28 December 2010: “We are developing the technology in-house to offer better value by lowering trading costs.” BlackRock’s push was quickly compared to the ill-fated E-Crossnet collaboration between Merrill Lynch Investment Managers and Barclays Global Investors in 2000. The collaboration aimed to provide a buy-side only crossing network to circumvent traditional brokers. E-Crossnet was part of the same shift from the center of the marketplace that began in 1975, but it had more in common with existing ECNs of the time. It failed to gain traction and was sold to ITG who combined it with the POSIT dark pool – effectively as an external agent. BlackRock, however, would operate as a principal, crossing trades across its vast collection of portfolios. BlackRock would effectively create a mini stock-exchange, separate from the NYSE and separate from everyone else, entirely, and entirely different than E-Crossnet.

E-Crossnet relied on a network effect across buy-side clients. The resulting pool of liquidity would provide low-cost transactions among the participants, but someone still needed to run it. It needed an agent, so it went to ITG.  BlackRock’s network relies only on the ability of BlackRock Solutions to design and develop a crossing system that will sit within BlackRock’ trade processing and order management system. BlackRock will run it, and they have sufficient scale to make the returns on those investments economical. Nonetheless, it would not be surprising to see BlackRock license the system to third parties for others to implement in their order flow and trade processing systems, just as they do with the Aladdin system for risk management. It would not be E-Crossnet Revisited. It would be licensed.

The first call for liquidity in BlackRock’s system won’t be to a broker. It will be to BlackRock. And perhaps the first call for Fidelity or Capital Research or AllianceBernstein won’t be to a broker. It will be to themselves, through a clever piece of software written by BlackRock solutions and part of the overarching trend of the market to decompose its center, drive execution toward the edge: from the select membership of the NYSE cartel to a cluster of brokers and other markets, to dark pools and now to the underlying investors and owners of the securities, each linked by pools of liquidity.

Expert networks and traders of inside information are analytically separate categories, not synonyms. This has been the main failure of the press’ coverage of the insider trading scandal. Expert networks match experts with those in need of their expertise. That’s it. Done properly, they bring transparency and compliance to conversations that are otherwise already happening between outside experts and analysts. Expert networks are not clearinghouses for inside information.

Bloomberg News finally brought basic analysis to the discussion around expert networks, rather than the prevailing tone of crude refutation.

Dealbook provides a useful recap of the facts, essentially collecting many of the extant who and what’s that have been involved, along with a fresh set of juicy complaints.

There are users of expert networks, be they hedge funds or mutual funds, that have been known to put a good bit of pressure on the experts to give them more than what they know is permissible information. And anyone who put that kind of pressure on an expert should be very worried right now.

Sean O’Malley, partner with White & Case: via Reuters

The information trafficked by the four ‘consultants’ went way beyond permissible market research. It was insider information.

Janice Fedarcyk, a Federal Bureau of Investigation assistant director in charge of the investigation: via WSJ

Few hedge fund managers have the investment skill to deliver the benefits that they promise. They have to find an edge however they can — in this case through the expert networks.

James Fanto, a professor at Brooklyn Law School in New York, mistaking expert networks for the ethical failings of those alleged to have traded in inside information: via Bloomberg

When I was an analyst, I used build my own network. I’d spot names in magazines where someone was quoted about a company and call them — that’s part of doing fundamental research.

Dan Chung, CEO, Fred Alger, remarking on how, back in his day, they didn’t rely on expert networks or outside consultants. No, they called people quoted in trade magazines themselves, asked all those probing questions, and walked uphill, in the snow, to school, both ways. Chung is the son-in-law of the gentleman behind the eponymous firm: via Marketwatch

Steve Cohen has had among the highest returns in the industry….Insiders in the business for a long time suspected that his special sources amounted to privileged information. The debate amongst insiders was, “Was the special information on the right side of legality or the wrong side?” But I think it was a pretty common view that it was close to the edge….

When you have somebody who doesn’t appear to have that readily identifiable edge, who nonetheless makes much higher returns than other people, you wonder.

Sebastian Mallaby, author of More Money Than God. He went on to share that “in the past, successful investors constructed their own expert networks,” just like Dan Chung, which he attributed to the master networking skills of those such as Julian Robertson, when who you knew was the currency, and those that were known were former executives and outside of the circle of those normally considered insiders. So if what Julian did was ok, why won’t Mallaby afford Steve Cohen the same safe-harbor? Is it any different than a service which will connect anyone else to former executives and others outside of the circle of those normally considered insiders? After all, it’s hard to see a difference in kind between what Julian and Steve are described as having done. The interview merely insinuates. It does not specify: via LA Times update – this was also posted as a comment on the LA Times blog-piece, but they seem to have removed it.

The McClellans might have thought that they could conceal their illegal scheme by having close relatives make illegal trades offshore. They were wrong.

Robert S. Khuzami, enforcement director for the SEC, commenting on a specific insider trading scandal involving the general misbehavior of consultants at Deloitte who misappropriated and tipped material non-public information to trade for their and their relatives benefit: via NYT

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