Insider Trading and Risk Retention

Also Martin Shkreli, milk tea, Jesus Coin and Bodega.
By Matt Levine

September 14, 2017, 4:20 PM GMT+3
Insider trading.

Here is an incredible insider trading case out of Brazil involving Wesley Batista, the chief executive officer of meatpacker JBS SA, and his brother Joesley:

Police are looking into whether Wesley and his brother Joesley, the former chairman of JBS, profited in financial market dealings during a leniency deal with prosecutors.

Investigators suspect the brothers may have unfairly traded JBS stock and US dollar derivatives in April and May, before shares of JBS and the Brazilian currency tanked following revelations that Joesley secretly recorded a conversation with President Michel Temer in which both men were allegedly discussing bribes.

Earlier this year, the brothers entered a plea bargain deal with Brazilian authorities.

One fun aspect of the case is that the share sales made the Batistas a profit of about 328 million reais, which is "about 46 percent more than the separate fine the brothers and other JBS executives agreed to pay as part of their plea deal." So they allegedly ... insider traded in order to fund their bribery fine? That is an aggressive move, and I like it.

Another fun aspect is this:

Joesley Batista gave authorities an audio recording of a four-hour, often profane conversation in which he and another executive bragged about omitting evidence and getting help from a prosecutor as they negotiated the deal. “We can’t show up and tell them 30 of our shenanigans,” Joesley is heard saying on the recording during the hourslong drinking session. “We’re going to tell, I dunno, 20 of our shenanigans....”

It isn’t clear if the recording, which appeared to have been made by accident, was handed over intentionally.

On the one hand, telling authorities about 20 of your shenanigans, instead of 30: a plausible strategy! On the other hand, recording yourself drunkenly boasting about it, and then giving the recording to the same authorities: what?

But my favorite thing about the case is that police are looking into whether they insider traded in currency derivatives:

Police also allege JBS bought $2 billion of currency before news of the plea deal, putting the company in the unusual spot of being one of the day’s top traders. The revelations about the Batistas’ involvement in the wide-ranging graft scheme saw the real post its biggest drop since 1999, even after the central bank intervened to support the currency.

You don't see a lot of insider trading cases in currencies. This is mainly because not a lot of people are insiders with respect to currencies: I suppose if Janet Yellen day-traded currencies before a Fed announcement, that would count, but most people do not have that level of influence over their countries' currencies. It is also partly because, in another sense, everyone has some inside information about currencies: Every company that operates internationally knows its own demand for dollars or reais or whatever, and a big enough company might move the currency with its own trading. But that is just a fact of economic life and usually not material enough to worry about.

But you could, if you had a very vivid imagination, dream up circumstances in which private citizens could illegally insider trade in a currency. This would have to involve a national crisis that is so huge that it would tank a whole country's currency, bringing its value down by, say, 8 percent in a single day. But it would also have to be a crisis that is so secret that only a few people know about it. A presidential bribery scandal -- one initially known only to the people involved in the alleged bribes, but one that will rock the country's confidence in its government when it becomes public -- is one of the few things that would fit the bill. It is sort of impressive that, when it happened, JBS allegedly took advantage of it. It requires a certain presence of mind to realize that what you are doing is so bad that it could shake your country's currency -- and then go short the currency to profit from it.

Risk retention.

Oh man, I love this stuff:

Not only that, but an entire ecosystem has been created around financing the portion of risk in each deal that needs to be retained. Fund managers have created risk-retention funds that have lured billions of dollars from big institutions around the world. Some of these investors wouldn't have otherwise invested in CLOs, particularly the riskiest slices of them, because those pieces are often sold in small increments and sometimes aren't worth the time of big investors.

Wells Fargo's David Preston estimates that more than $7 billion has been raised for such risk-retention funds since March 2016. It's unlikely that CLO managers will be eager to give up these investors, who seem to like the way this structure works.

That's from my Bloomberg Gadfly colleague Lisa Abramowicz's column yesterday about the collateralized loan obligation market, and of course the obvious question is: Wait, if it's "risk retention," why are they selling it? The answer is very easy and yet very deep! The way a CLO works is, the CLO manager builds the CLO, and then it sells senior slices of the CLO to investors, and it keeps the riskiest bits for itself, as mandated by post-crisis U.S. rules. But "the CLO manager" is a flexible concept. A CLO manager is a company, not a human. You can make however many companies you want. You can just build a new company -- This Particular CLO Manager Number 17 LLC -- and have it be the CLO manager (and retain the risk). But no company can ever really "retain the risk"; a company is just a set of legal instructions for apportioning money. Instead, the company's investors "retain the risk," in the sense that, if the company loses money, it was their money that it lost. So you just find investors who want that risk, and you sell them shares in the CLO-manager company (or a fund that buys shares in multiple CLO-manager companies), and then they have the risk. That you retained. For some value of "you."

So the risk-retention rules, which were meant to cut down on the abuses of structured finance, created more structured finance.

This is not particularly an oversight in the risk-retention rules; it is a central fact of finance. It is hard to legislate risk retention, because finance deeply wants risks to flow from people who don't want them to people who do want them. If you just mandate that the entity building the CLO has to retain risk, then it will, but the people building the CLO will sell that risk -- in the form of shares of the entity -- to people who want to bear the risk. I suppose you could mandate that the people building the CLO have to retain risk, but no one really advocates for that, and it's hard to see how they could. Most people -- even the ones building CLOs -- have limited capital. I guess you could put them in jail if their CLOs fail, but that seems harsh.

Or you could mandate that the entity building the CLO has to retain risk, and also that it be a "real" entity with other businesses, rather than a "clean" entity that is just a box for slicing up that risk. But then what does that get you? If you mandate that, say, banks have to retain the risks of CLOs, then you are explicitly tethering banks' retail deposits to the riskiest tranches of CLOs. In other areas of financial regulation, regulators are trying to reduce the risks that are mixed together with insured deposits; it would be odd to mandate "you can only retain the riskiest portion of a CLO if you also have insured retail deposits."

The point is that this -- the sale of retained risk to "risk-retention funds" -- is exactly what should happen: Risks should be borne by people who want them, and who explicitly agree to bear them. It's just a little embarrassing to call that "risk retention."

How's Martin Shkreli doing?

Martin Shkreli was convicted of securities fraud, but a relatively benign sort of securities fraud. He lied to investors about stuff that was going on at his hedge funds, but all those investors got their money back with big profits. The sentencing guidelines for securities fraud focus primarily on the amount of money that investors lost; here, Shkreli has a good argument that the loss is zero dollars, and that he should get a lenient sentence -- probation, or a year or two in prison.

On the other hand, Martin Shkreli is Martin Shkreli. He is a famous and unrepentant drug-price gouger. He spends his days being weird and threatening on the internet. He makes sexual threats against journalists. He has that smirk. "He disrespected the Wu-Tang Clan." And last week on Facebook he offered to "pay $5,000 per hair obtained from Hillary Clinton" on her book tour. I have no idea why he did that -- presumably there is some online joke or conspiracy theory that I am missing here -- but the Secret Service, and the prosecutors and judge in Shkreli's case, were no more amused than I was. And now he's in jail:

Martin Shkreli, the former pharmaceutical executive who is awaiting sentencing for a fraud conviction, was sent to jail on Wednesday after a federal judge revoked his bail because he had offered $5,000 for a strand of Hillary Clinton’s hair.

He is still scheduled to be sentenced in January, and these sorts of antics don't help him at sentencing either. The statutory maximum sentence for Shkreli's crimes is 20 years in prison. No one expects him to get 20 years: People who do real securities fraud, where vulnerable investors lose their life savings, rarely get 20 years. But the judge in his case is not bound by the sentencing guidelines, either, and she can consider factors beyond the amount of money that investors lost (or didn't). She can also consider the smirkiness, and the drug-price gouging, and the online threats, and the disrespect to the Wu-Tang Clan.

My default expectation was that she mostly wouldn't, that she would separate the (fairly minor) crimes of which Shkreli was convicted from his (fairly horrible) public persona. But that was before Shkreli got sent to jail for sort-of-threatening Hillary Clinton on Facebook. Shkreli really should have just kept quiet for a few months. If he wants to make his horrible online schtick the focus of his life, he runs the risk that it will become the focus of his sentencing.

The hunt for yield.

Here is a story about Yu'e Bao, a money-market fund run by Alibaba Group Holding Ltd. that invests the money that users keep in their Alipay mobile-payments wallets. It is the world's largest money-market fund, with 370 million investors and $211 billion in assets. Its manager has also "boosted Yu’e Bao’s returns in recent years by increasing its allocation of funds to financial instruments with longer maturities." It currently generates a yield of 4.02 percent, as well as this, the single best quote anyone has ever said about a money-market fund:

“I am not too concerned about what Alibaba does with my money since it’s too big to collapse,” said Ms. Xu, “I’m happy that the monthly yield can buy me at least a cup of milk tea.”

Yep that is the money-market industry in a nutshell: modest yield expectations, incuriosity about the underlying assets, and blithe expectations of too-big-to-fail protection.

Blockchain blockchain blockchain.

Yesterday I mentioned Jesus Coin ("Decentralizing Jesus on the Blockchain") as an example of a dumb joke cryptocurrency, but then I went and read their (emailed) press statement and it is actually kind of interesting. Not because it is not a dumb joke cryptocurrency; it absolutely is. But it is a dumb joke that has become self-aware. From the statement:

While the founders had hoped for their joke to gain traction in the community and create a buzz, what they certainly did not expect was hundreds of thousands of dollars of transactions to begin occurring as cryptocurrency investors rushed to actually purchase the coin. Soon after things began to get out of hand as the cryptocurrency began approaching a $1m market cap only days into a 60 day crowdsale.

Exactly why this has happened remains a mystery to Jesus and his colleagues, though there are a number of theories. As Jesus Coin is not a security or share, it's actually on far firmer legal standing than the vast majority of ICO's which may run into issues with regulatory authorities. For similar reasons, Jesus Coin is also going to be more easily tradable on the major cryptocurrency exchanges than comparable projects, meaning investors will be able to trade their Jesus Coins for real currency relatively easily. Quite remarkable, the very useless nature of Jesus Coin, accidentally created a currency that's more useful than almost any other.

"More useful than almost any other" is a stretch, but this is a standard story about fiat currency too. Dollars are a better currency than mackerels in part because nobody eats dollars. A cryptocurrency that can be used as a token in a yet-to-be-built cloud-storage system requires some analysis of that system's proposed architecture, of the team's technical capacity, of its smart-contract implementations, of its competitive position in the cloud-storage market. A cryptocurrency that is just a dumb joke is easy to analyze. There is no market-for-lemons problem, no worry that someone else has more information than you. The currency can trade completely information-free, which can make it more liquid and useful than it would be if it were ... useful.

Of course this argument proves too much: By this logic, any dumb joke of a cryptocurrency would be valuable. Uselessness alone can't make a currency; you also need widespread adoption. You need to get people to believe that the useless thing has value. The thing is, though, in the midst of the Great Cryptocurrency Boom of 2017, that's not that hard. Dogecoin is worth $144 million. Novelty and silliness are not barriers to adoption these days, and usefulness is not a prerequisite. Any dumb joke of a cryptocurrency probably will be valuable.

Bodega.

Here is a story about Bodega, a startup founded by two former Google employees who "Want To Make Bodegas And Mom-And-Pop Corner Stores Obsolete," that got made fun of a lot on Twitter yesterday. It seems mean to make bodegas obsolete! And Bodega's product is basically a big vending machine, albeit one with computer vision and artificial intelligence so it can figure out what you took and what it should restock. And as Helen Rosner argued, the logistics of the business -- restocking a bunch of vending machines with tons of different products -- seem challenging, especially for a little startup.

But the Twitter complaint that I thought was most interesting was this, from Ellen Stark: "Corner bodegas that stay open late can also make city streets feel safer. Machine in my lobby can't do that." I think that that is the essence of what is going on here, and what is often going on in disruptive tech innovation. A bunch of different businesses exist in the world, and they are mostly capitalist and profit-seeking (actual bodegas charge a lot for groceries!), but they are also constantly throwing off positive (and negative) externalities. A real bodega is not a perfectly optimized logistics system for conveying products to people; it's a store, a physical presence, a part of a community, a home for a cat. It does a lot of stuff in addition to its basic business of selling you products, and some of that stuff turns out to be valuable to people in ways that are not perfectly captured by sales figures. Nobody is paying their local bodega for the extra feeling of safety it provides, or to pet its cat. Those are just free bonuses.

And then tech comes in and streamlines out all the externalities. I mean, that's not all that tech does -- Twitter itself, for instance, is basically a business that sells ads, but it also creates huge ancillary benefits for people like me who get to use it for free -- but it is certainly one tech business model. You get rid of all the communal and informal and traditional aspects of a business and replace it with bare economic efficiency. You analyze a bodega as just "a box that sells snacks and toilet paper," and then you ruthlessly optimize that minimalist description. This is more efficient! It is "disruptive," in the high-fiving venture-capitalist sense. But it can be disruptive in the bad way too. Jonathan Shainin quoted Edward Luttwak: "I believe that one ought to have only as much market efficiency as one needs, because everything that we value in human life is within the realm of inefficiency -- love, family, attachment, community, culture, old habits, comfortable old shoes." Maybe bodegas.

Things happen.

"Students at UPenn, Harvard, Villanova, Howard, and 14 other college campuses will be able to snap a picture with a Morgan Stanley themed geofilter." Deutsche Börse to Pay $12.5 Million in Fines in Insider Trading Inquiry. Spotify talks to TPG over future of its investment. Equifax: A Call for Public Utility Regulation of Consumer Reporting Agencies. There’s Never Been a Hotter Time to Freeze Your Credit. U.S. Probing High-Pressure Mortgage Sales That Target Veterans. Union Power Is Putting Pressure on Silicon Valley’s Tech Giants. Rules Reign on Trump’s Fed List as Post-Crisis Economy Breaks Them. Treasury Secretary Mnuchin requested government jet for European honeymoon. Anthony Scaramucci to be a TMZ host for a day. "Essence is fairies in a warehouse somewhere dancing with fruits, and suddenly you have this amazing drink." Arkansas woman admits using county cash to buy dog tuxedo.