November 24, 2010

Insider Trading and Rational Investment

Here in Spokane, the landscape is bleak and wintry, the temperature hovering at ten above. Crisp! Before we gather round our well-laid tables (in America at least) Thursday and give thanks, let’s weigh on the scales of investor-relations justice this insider-trading scandal soaking print ink.

The allegation, if you missed the story of the week outside South Korea, Ireland and Cambodia, is that funds are using “channel check” style information to gain an illegal advantage. Federal agents have swept into capital-markets concerns to seize files and persons and stop this pusillanimous peculation.

The last time government contended information misuse, machines took over the trading markets. In 2003, Elliot Spitzer settled with major banks ranging from Bear Stearns and Lehman, to Goldman Sachs and JP Morgan, to Merrill and UBS to strip research from trading. The former was apparently unfair. What exploded after was algorithmic trading, which apparently is not unfair, even though the firms dominating it are a handful while the people using information were everybody else, such as grandma.

Before we call for the heads of the accused, let’s consider what other noggins might land under the guillotine. The heads may be ours. What if investors, petrified to be found, to borrow from Fiona Apple, feelin’ like a criminal, turn fully to machines? The last light will blink out on rational investment, the soul of IR.

We’re not excusing bad behavior, if it exists. But in this contemporary machine market, channel checks are an unethical advantage? Pardon our collective smirk. Issues like Cisco, EMC and Intel price thousands of times per second. Cisco trades 200,000 times a day. Pick a stock. Likely, 90% of volume is maker-taker algorithmic churn for volatility trades or continuously fluctuating “risk-transfer” asset rebalances.

We are a data firm. We’ve spent tens of thousands of hours studying the interaction of executed trades. Rational money changes prices. But any that strays from the math causes reactive ripples. It’s how we know when deal speculation exists, whether good or bad money responds to news or information, and where real price is versus the one manufactured by machines.

Speaking of which, IR folks and execs, if you don’t know your market structure, you’re living dangerously. Not only will it defend your board against recrimination – because it shows whether performance reflects fundamentals or math beyond its control – but it will tell you if something untoward lurks beneath price and volume.

Maybe some tried to capitalize on something somebody else didn’t know. Once, the point on Wall Street was to differentiate your opinion on investments with information that others didn’t have. That’s what made it valuable. What made it competitive is that you could be wrong. Competition teemed, values efficiently reflected all information known or otherwise, and markets produced returns over years rather than seconds.

What I fear is that the IR profession will fall dumbly in line. We’ll praise swift government action. And investors will stop thinking and hand their dollars to computers. Out will go IR as a viable function. People will trade derivatives, too scared to exercise sentient thought about equities for fear black helicopters might swoop down.

We have courts and a Constitution. Like Big Lots, if a company or its holders believes harm has been done, they may petition the court for standing and redress of grievance, just as anyone can. Government lately seems to be petitioner, prosecution, judge and jury in one. If the government is your accuser, how then is the Constitutional right to face your accuser guarded?

So this Thanksgiving, let’s stop looking for somebody to blame and start saying thanks for the right to be counted individually rather than algorithmically. It’s what life and investor-relations are both about.

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