Goldman Sachs and the Moral Hazard of the Broker Dealer Model

Tell the client he is filled!

Once upon a time a commodities floor broker was overheard talking to his clerk after crossing a client order with his own position and writing up those trades on his cards. “Take these trading cards, rip them up, and throw them out. I don’t ever want to see copies of these trades lying around after today.” Basically what the floor broker did was: buy from his own client at a price below where the market was trading. He did this legally, as it was permitted back in the day. But nevertheless, he knew the client got hosed and did not want evidence lying around.

The question is: Why does this practice, so many years ago recognized as a conflict and prohibited at the individual member level, continue to exist at the broker-dealer level? Traders on the floor have not been able to take the other side of their own client orders for years. How is it that banks and other entities can, and do this on a systemic scale?

GS Complaint Recap

The accusation leveraged by the SEC against Goldman Sachs is by now well known to most FMX Connect readers. We first read about it at Zero Hedge. Fresh news that the UK and Germany are looking into their own cases against GS, and that other firms are sure to be accused of copycatting GS methods do not help matters. Many are already beginning to generalize that this is a wider indictment of the Investment Banking industry. We think scapegoating that industry is incorrect, and would rather people begin to examine the moral hazards of the Broker-Dealer model in general and perhaps take a lesson from the CFTC prohibiting floor brokers from taking the other sides of their clients’ orders.

Conflicts of Interest

The heart of the SEC issue with GS is whether conflicts of interest went undisclosed or not. Regulating potential conflicts of interest assumes people are objective. At the risk of sounding a little like Hobbes; people are selfish, and will act in what they feel is their best interest. Sometimes that behavior will not be in the best interest of others. Containment is not the best approach when the culture has degraded as much as it has in recent years.

Permitting a firm to handle orders for a client while it trades for its own account, or a firm that operates an entity in which it has a beneficial interest and trades for its own account, makes for a moral hazard. Trade for yourself, or trade for your clients; But not both at the same time.

At the heart of the conflict is the Broker-Dealer model. Over the years, both commercial banks (where they were allowed to) and Investment Banks (where they could afford to) morphed into Broker Dealers.

The Broker Dealer Model

Broker Dealers offer two distinct services from which they generate revenues:

·         Brokerage or Execution Services- filling client orders. Acting as agency for a client

·         Dealing or Market-Making Services- trading for their own accounts (Prop, Principal etc) often times with clients as counterparties.

Brokers

A broker handles the placement and execution of customer orders in capital markets. Within that model there are marketers who are paid to come up with proactive ideas for their customers to execute trades thru them. Brokers act as agents for their customers in the markets they execute orders, they do not trade as counterparties to their clients and are not in the business of transacting trades for their own accounts prior to the execution of their clients’ trades. They capture revenues with explicit service fees.

Dealers

Dealers take the other side of market trades. They are the liquidity providers that a broker must often interact with to get his customer filled. They take market risk and hope to be paid for it thru implicit fees in the bid-ask spreads they broadcast in their markets. In cases of illiquid markets the same applies, but they are more likely to balance their own lack of exit liquidity with wider bid-ask spreads and/or smaller volumes traded.

Broker-Dealers

A Broker-Dealer as you can imagine does both. What is difficult even with regulation in the model is putting immediate client interest before immediate firm interest. The less regulated and opaque a market is, the more difficult it is to satisfy both directives: Thus the inherent conflict for which Investment Banks are being demonized. It might be helpful to walk thru the difference between an investment bank and a commercial bank to see where the differences actually lie.

The Death of the Bank as Ward for their Client

Commercial Banks

Although they utilize the Broker-dealer model, they initially acted as Brokers mostly. This was especially true in Equities and other markets where the combination of secular liquidity, lots of competition, symmetric information and regulation made for poor Dealing reward potential.  They used Dealing services to make sure execution fees are kept in house. Their earnings model had smaller margins but was much more scalable than their IB cousins. Commercials are highly dependent on the network effect and marketing to stay competitive. They use research and technology as marketing tools to add value and attract/retain clients because their basic service is commoditized.

The more continuously liquid, transparent, and regulated an asset class is, the more likely a participant is making money as a broker and therefore is a commercial bank.  Market-making is not very profitable if everyone sees the flow of a liquid, regulated product.

Investment Banks

Initially, Investment Banks were facilitators of investments in newer industries. They made bridge financing and investments. To be sure they were involved in asymmetric information flow. But this flow was in balance with the true market risk they took. They protected their clients for a price. Execution and market-making were mostly added-value services to help facilitate the continuous flow of capital to the firms and to their clients.

Now, for better or worse, IBs offer execution services as a means to get dealing business. Traditional investment banking business is secondary to capital market transactions. They execute trades for clients in order to take the other side and make implicit fees on the Bid/Ask spread of their markets. It is dependent on distribution networks as well, but usually external ones like exchanges.  It thrives on asymmetric information, opacity, and lack of regulation restrictions. Its margins are higher and its market risk is perceived to be higher while its business is not as easily scalable.

Glass- Steagall Repeal

As IBs morphed into dealing intermediaries, Commercial banks looked on enviously. Some decided to move more aggressively into that arena.  Many of them either grew IB divisions or acquired them. This started even before the formal repeal of Glass-Steagall.  They sought to participate in increasingly fertile areas of “under” or non-regulated markets. It also let them better utilize their in-house networks as distribution points. Most importantly it grew their earnings. Many already had principal desks in areas where the OTC markets were still dominant, like in Commodities, so the model was not new to them by any means.

Banking De-Evolution

As Banks evolved into the trading culture we have today the Broker-Dealer model increasingly became their weapon of choice. These firms also realized they needed marketing and sales to feed their growing prop desks. They needed to create counterparties to their proactive ideas. And so the model slowly flipped. They went from providing finance to other people’s ideas, to generating their own ideas for clients (usually clients that did their financing with them and were captive). Then, from giving those clients first bite at an IB idea, the IBs actually started buying first and giving clients a chance to buy from them. Finally, the model inverted completely and IBs started to sell some clients on the idea of taking the other side of their (or in the Abacus case, client generated) ideas.  At the granular level, clients have always been used as stop-outs for Broker-Dealer prop books. Now they were using the old “lean on the client interest” tactic to stop out whole deals. The Banker (actually Trader in a 3 piece suit) now viewed the client as counterparty and thus potential sap at the table.

Other Exit Strategies

As the recommendations became more complex, it became harder for the IB to divest of them effectively while preserving “convenience premiums” and back-to-back gains. It is at this point an IB learns how to sell, brand, or otherwise package its ideas in a way that further legitimizes it and broadens its reach to the secular market. They begin to sell downstream to Private Clients.

A distribution network is needed. And if you don’t have the sales force, then outsource it. Sell to other entities that may have better salesmen and can sell downstream effectively or better yet, put their clients into it in the form of pensions. IBs do not have a habit of informing their adversary (counterparty) of risks if they don’t have to. And while people in control of huge sums of money were given “access” to the brilliant ideas that the IB was showing them, they had no clue what or who they were dealing with

Often times the IB still does believe in its own recommendation at first, but at some point it recognizes a reversal is imminent, and it gets out, reverses position. It may still recommend the trade to its clients, but mostly because the client IS the exit strategy for them. At this point, only the most important clients are in the loop and they are along for the ride getting out and possibly reversing along with the IB as the ones that are last to know are poorer for it.

Editor’s note: I saw all of this starting at Lehman when I was cold-calling in the 1980’s, although it was beyond my comprehension.  Then it was stocks that Lehman was making money in. But this was post the Banker-Trader civil war at Lehman, and their retail broker and dealing network was raping clients and cashing in on its image as a reputable firm, before their rep as a bank was totally underwater. Back then, with the SEC involved, the problem was contained and lines were not crossed for fear of reprimand, but the culture was there, and looking for ways to apply the Broker-Dealer model in other areas. I remember brokers telling prospective clients that XYZ stock made up 20% of their own portfolio. This was true, the broker held 5 shares of stock, and one of those shares was in XYZ.  The modern Bank is the logical end of this evolution.

Dear Saps, AKA Bank Clients

An IB’s clients should know with whom they are dealing and accept their own risks that the trading needs of the IB are sometimes at odds with the execution needs of the client in the form of front-running and non-competitive pricing. Or don’t do business with them.  This is NORMAL in OTC trading with IBs as counterparties. But sadly, either they did not know or did not care about their banker’s revenue model.

Imagine the gray haired middle management at pensions, commercial banks, and other “sophisticated” entities tripping over themselves trying to get pieces of transactions that Goldman was doing to make money. They sought to buy whatever GS was dealing in for their own client networks.

Greed, job security, peer pressure and a need for status were all factors for doing business with GS and other IBs. But the brain power was just not there. They lacked the knowledge that their investment was not a protected business like buying into a mutual fund. There were no accepted common empirical measurement standards like PE and EBITDA for these things they bought. They didn’t have counterparty knowledge or market structure knowledge of exactly how Goldman makes money. And finally, they did not know what they did not know.

At every level Goldman was either hedging what they sold these morons, puking to them what GS did not want on their own books, or making convenience fees on the client’s inability to do their own homework. If GS is guilty of not disclosing the potential conflict then so be it. But know that they were doing what they always did, and were enabled by a lax or improper regulatory environment. Their clients however, were the wards of less sophisticated people’s money. They had a responsibility to their own clients and shareholders and dropped the ball.

As it stands now

Investment banks eat their clients now; they make money in the zero sum game of trading. Creating a larger pie of value is a long gone concept. That role has been replaced by VC and Private Equity firms. Banks took the intermediary culture to the next level, where they would knowingly prey on institutions with main-street as its client base. And given time, the IBs would have created a nice retail network and leveraged their brand further downstream, like a Cadillac Cimarron for retail investors.

There is no personal responsibility when it comes to a corporation, just maximizing shareholder value. The sheep has been sheared one too many times though, and changes may be coming. Maybe Banks will begin to see customers like clients again.

·         Customer- someone with whom you do business

·         Client- a repeat customer who comes back to you to do business again because of trust.

If you want to remove conflicts of interest, consider altering the rules for Broker-Dealers or how entities interact with them.

FMX Connect

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