OTC Derivatives Fraud – FT Piece

Fraud in the privately traded markets? Aline van Duyn of the FT wrote a fascinating piece over the weekend about the lessons of the Galleon case going much wider than stocks. We agree. Next wave of large and complex fraud will be in non-exchange traded products. Here is the piece.

Lessons of Galleon case go wider than stocks
By Aline van Duyn in New York
Published: May 13 2011 20:10 | Last updated: May 13 2011 20:10
The seizure of 105 tonnes of marijuana in a Mexican warehouse last year made for dramatic pictures. The 10,000 packages, colour-coded and labelled with symbols, covered a huge car park. The images brought home the sheer scale of the drug industry, not least because, as every cop knows, the amount found is only ever a fraction of the total trafficked.

Wall Street is this week dealing with its equivalent of a drug bust: the conviction of Raj Rajaratnam on insider trading charges. And the drama of his trial raises a similar question as the Mexican haul did. How much of the profit made by hedge funds from equity trading comes from insider trading rings such as the one operated by Mr Rajaratnam at Galleon?

It is, of course, impossible to know. Already, as my colleague Kara Scannell has reported, business practices across corporate America and Wall Street could change following the breakdowns in compliance revealed in the trial.

Questions about whether some investors are breaking the rules or unfairly manipulating prices should not just be asked about stocks.

Share trading was once the bread, butter, meat and potatoes of the financial industry. It has long stopped being the biggest game in town, as the sale of hundreds of billions of dollars of debt and derivatives linked to US housing markets around the globe in the run-up to the financial crisis illustrated.

Just to give a rough sense of scale, a McKinsey report in 2009 estimated that global equity securities were worth $34,000bn. The value of private debt was estimated at $51,000bn and government debt was believed to be worth $32,000bn. Bank deposits were worth $61,000bn. These figures do not include derivatives or real estate.

Many of the non-equity markets are unregulated, or at least not subject to the same strict rules as stock markets are.

“The presence of millions of small investors had politicised the stock market,” writes Michael Lewis in The Big Short, his account of the build-up of the housing and credit bubble that burst in 2007. “It had been legislated and regulated to at least seem fair. The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they would be reported to some authority.”

Plenty of bond experts would disagree with this characterisation. However, as the top legal official at one large hedge fund explained to me, it is much harder to pick up warning signs of potential market abuse in privately traded markets such as bonds or derivatives. In many cases, for example, trades do not have reliable time stamps. Without a time stamp, it is almost impossible to build an insider trading case.

The senior hedge fund executive also admitted that the fact that few outsiders can understand what is happening in a private market can affect the way traders behave. “I may think insider trading is as wrong in credit derivatives as it is in stocks, but the attitude of the traders may be different.”

The Dodd-Frank financial reforms are trying to tackle this and swaps will be subject to specific market abuse regulations. As more swaps move on to exchange-like trading venues, prices will be reported, and time stamped. It will be possible for someone – whether it is internal compliance departments or external regulators – to at least look out for odd behaviour.

Narcotics cops would never expect to stamp out all illegal trading, not least because drug traffickers have far more resources at their fingertips. Regulators face similar challenges. But until there is more information about who trades, and when, it is hard to even build a case to tackle problems in markets that now dominate finance. More information about trading is also needed for Wall Street to shake off the persistent allegations from Main Street that the markets are stacked in favour of the professionals, and against the “little guy”.