An Ugly Side of Wall Street Research
Wall Street prides itself on putting up Chinese walls to separate research, trading, and investment banking. About ten years ago, the SEC and NYSE put in some additional rules as a result of Attorney General Elliot Spitzer’s investigation into the role of Wall Street analysts in promoting investment banking deals. Nonetheless, the walls remain pretty thin and for good reason.
Research is a crummy business for Wall Street. I ought to know. I was Director of Research at a brokerage firm and felt the heat from management, traders, and bankers to help key institutional and investment banking clients. I also appreciated my mentor, Ed Gibson, for protecting me from the worst of these pressures.
|Sorting Out Distribution (1999)|
Research gives Wall Street a thin veneer of respectability and objectivity. However, it is a cost center unless it is instrumental in winning high margin banking business or garnering huge volumes of institutional trades. Until the SEC reforms, most big research firms were joined at the hip with investment bankers. As I discussed in “Financial Regulation Can Never Be Effective (August 13, 2013),” Wall Street has taken steps to undermine the separation between analysts and banking deals.
For most analysts, today’s road to riches is lined with commissions generated by hedge funds and other trading oriented investors, which brings us to the legal settlement between the Massachusetts Securities Division and Citigroup. It turns out that SAC Capital Advisors and other institutional investors put enormous pressure on Kevin Chang, an analyst covering Apple Computer for Citigroup, to reveal his research about a decrease in orders for the iPhone. SAC wanted to be able to trade on Mr. Chang’s findings before other investors received his report. Presumably, SAC wanted to short Apple stock or buy puts in order to profit when the rest of the market got wind of Mr. Chang’s findings.
Massachusetts pursued Citigroup for violating its internal procedures for disseminating research reports rather than pursing an insider trading case. Apparently, any insider trading case would have lacked a necessary element because Mr. Chang did not directly benefit from releasing his report.
While Mr. Chang may not have received the requisite benefits for the purposes of insider trading, the reality is that Mr. Chang probably received benefits for bending to SAC’s pressure. In my three decades of experience on the buy and sell side of the business, analysts’ bonuses were determined by how helpful they were to specific clients. Some broker-dealers even polled their institutional clients to make this assessment.
There is little doubt that Mr. Chang’s value as research analyst for Citi and his remuneration were improved by making important clients like SAC happy. SAC’s trading commissions may have flowed through Citi’s trading desk, but they weren’t paying for execution. Rather, they were paying for information which Mr. Chang and likely others provided. Once the information was widely distributed to investors, it had little value to SAC, and they would have gone elsewhere to execute trades.
The commission system is nicely designed so SAC’s payments and Mr. Chang’s bonus weren’t directly connected. The Chinese wall conveniently filtered the money. Thus, the benefit to Mr. Chang may have been hard to prove, but I’m pretty sure it existed.
In any event, Mr. Chang isn’t where the fault lies. Supervisors at Citi and other investment shops do little to protect analysts when clients badger them for morsels of tradable information. Having put up with an aggressive client, analysts expect to be paid.