New York, NY – In April 2003, the SEC, NYSE, and then New York Attorney General Eliot Spitzer reached a settlement with ten major US investment banks, including Merrill Lynch, Goldman Sachs, Morgan Stanley, Citigroup, Credit Suisse First Boston, Lehman Brothers Holdings, J.P. Morgan Chase, UBS Warburg, and U.S. Bancorp Piper Jaffray, finding that these firms produced and distributed biased equity research to investors. A landmark $1.4 billion fine and a series of rules were implemented in an effort to eliminate the conflicts of interest that existed between these firms’ investment banking units and their research divisions.
And while the investment banking / research conflict seems to have been addressed, other conflicts of interest remain at sell-side firms – including investment bank’s reliance on proprietary trading as the primary growth engines of their businesses.
Growing Popularity of Proprietary Trading
In recent years, Wall Street investment banks have suffered a significant squeeze on margins as full service equity commissions continue to plunge and the use of Direct Market Access, and other low cost electronic trading venues pressure equity commission revenue lower.
In response to these trends, investment banks have been diligently searching for a workable business model. A number of well known analysts, including Brad Hintz of Sanford Bernstein, have pointed out that the strategies used by many investment banks to battle this squeeze on margins include:
* Expand Proprietary Trading
* Downsize Traditional Sales
* Increase Investment on Algo Trading & Execution Technology
* Internalize Trade Flow
* Tier Equity Clients
* Restructure Equity Research
* Pursue Equity Capital Markets Volume
* Expand Prime Brokerage
One of the most obvious examples of the focus on proprietary trading has been Goldman Sachs. Recently, Goldman Sachs recorded $25 billion in Trading Revenues for Fiscal Year 2006 – a gain of 50% year-over-year. Last year, trading provided 68% of the firm’s revenue (and a like portion of profits), up from 43% in 1999. Asset management provided 17% of the firm’s revenue and 15% came from investment banking.
Proprietary Trading Defined
If an investment bank or brokerage firm acts as an agency broker, they buy or sell a specific stock at the request of a client. The investment bank finds the stock in the market and purchases that stock on behalf of the client, acting as a broker, receiving a trading commission.
Many investment banks don’t conduct a great deal of agency trading. A more common scenario might be where a client wants to sell a large amount of stock, which if sold through a traditional broker could potentially trigger a decline in the value of the stock due to flooding the market. The investment bank might agree to buy the entire amount of stock at a discount if it believes it can sell the inventory over time. The profit comes from selling the stock at present value but buying it at a discount (also called Block Trading).
However, if an investment bank chooses instead to buy or sell stocks on its own behalf (for its own account), it is trading on a proprietary basis. The investment bank has decided to profit from a market move rather than from generating commissions by putting buyers and sellers together. Firms that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns.
Conflicts of Interest in Proprietary Trading
However, there are numerous conflicts of interest that arise as a result of proprietary trading. One common complaint is that the sell-side traders will buy a stock they discern their buy-side customers are purchasing in order to profit from the price appreciation that will result from their customer’ purchases. Of course, this negatively impacts their clients.
Another conflict that might occur is that when the proprietary traders buy securities that have been performing badly. In this instance, the investment bank might instruct their institutional sales staff to call clients to try and convince them to purchase these securities.
Lastly, because investment banks are key players in mergers and acquisitions, a possibility exists that the traders could use prohibited inside information to engage in merger arbitrage. This was exactly the reason that Australia’s Securities and Investments Commission (ASIC) recently leveled a complaint against Citigroup.
The regulator asserts that Citigroup was acting as both an advisor to Toll Holdings in its bid to acquire Patrick Corporation, as well as actively trading in Patrick Corporation’s shares. And while ASIC has since amended its claim against Citi, suggesting that is no longer concerned about insider trading issues, it continues to argue that Citigroup had a fiduciary duty to disclose to its client, Toll Holdings, that it was actively engaged in proprietary trading in its target, Patrick Corporation. In fact, Citi was the fifth largest accumulator of Patrick’s shares on the Friday before the Toll Holdings bid was launched.
Little Concern Over These Conflicts
Despite the real and potential conflicts of interest associated with proprietary trading by many sell-side firms, most buy-side clients remain unperturbed about the rather “cozy relationship” that their major execution partners experience. Of course, much like what occurred in the Spitzer settlement, we suspect this lack of concern could change over night if a major insider trading scandal were to hit the news where a bulge bracket firm allegedly misused its inside information or privileged position to generate excess prop trading profits.
Comment by Rob Tholemeier:
There are many other conflicts. Most obvious is the close relationship between research and institutional sales. All too often individuals in institutional sales “learn” about pending upgrades and downgrades from their research analysts days before they are made public and consequently “sales” feed this info to their preferred clients. Look at charts and notice how often a big move in a stock precedes downgrades or upgrades from major brokers.
A second conflict is that many of these firms have “professional services” relationships whereby the brokers manage the investments of the covered companies’ executives and the companies’ own investments. Analysts are under pressure to preserve these relationships.
As long as analysts have close relationships with institutional sales and these relationships are not monitored research conflicts will persist.
But by far the biggest skew to the “level” playing field are buyside-company one-on-ones. The funniest one is when companies webcast the formal presentation at “investor conferences” then go into one-on-one meetings to give major investors the real skinny. Reg FD enforcement is a joke.
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