Tuesday, January 12, 2010

Talking Your Book vs FrontRunning

So today's non-story that's been somehow turned into a story relates to a letter that Goldman Sachs sent to clients of its "Fundamental Strategies Group,"  which was published by Andrew Ross Sorkin on the NY Times' Dealbook.

"Dear client,
We may from time to time discuss with you Trading Ideas generated by our Fundamental Strategies Group. As part of our commitment to managing conflicts of interest appropriately, this message is to explain how the Fundamental Strategies Group interacts with other parts of our organisation and how that impacts on the Trading Ideas.

The Fundamental Strategies Group is a group of cross-capital structure desk analysts employed by our Securities Divisions to assist our traders. They develop Trading Ideas in conjunction with traders. We may trade, and may have existing positions, based on Trading Ideas before we have discussed those Trading Ideas with you. We may continue to act on Trading Ideas, and may trade out of any position, based on Trading Ideas, at any time after we have discussed them with you. We will also discuss Trading Ideas with other clients, both before and after we have discussed them with you.

You should not consider Trading Ideas as objective or independent research or as investment advice. When we discuss Trading Ideas with you, we will not be acting as your advisor (including, without limitation, in relation to investment, accounting, tax or legal matters) and the provision of Trading Ideas to you will not give rise to any fiduciary or equitable duties on our part. We will not be soliciting any action based on Trading Ideas and it is your responsibility to seek appropriate advice.

Any opinions that we express when we discuss Trading Ideas with you will be our present opinions only and we will not have any obligation to update you in the event of a change of circumstances or a change of our opinions. We prepare Trading Ideas based upon information that we believe to be reliable but we make no representation or warranty that such information is accurate, complete or up to date and accept no liability, other than for fraudulent misrepresentation, if it is not.

If you have any concerns about any of these matters, please do not hesitate to contact us.
Kind Regards
Jane Lattin

Clusterstock had it right initially, with a post titled "Goldman Sends A Really Boring Email to Investors,"  but as a commenter on that site points out, they quickly realized that they would get more clicks by changing the title to "Goldman to Clients:  We May Be Frontrunning you."  The URL for the entry shows the initial non-sensationalized title. 

Unfortunately, the folks at the influential ZeroHedge also chose to mis-inform their readers, not only with the headline "Goldman Admits to Frontrunning Clients Through Its Prop Desk," but by suggesting that the letter at hand is a smoking gun for the completely unrelated story they (ZH) published back in July, 2009 about GS's disclaimer for the REDI electronic execution platform.  Believe me - as soon as someone provides evidence that GS is taking client orders that it sees entered in the REDI platform and actually frontrunning them, I'll be up in arms, but today's letter is about an entirely different group at the firm, and has nothing to do with frontrunning. 

This letter is a good thing - it removes any ambiguity and lays it out quite clearly for trading clients that they will not be the only ones getting a given trading call, that they probably wont be the first or the last client to get the call, that they may not get another call if and when the firm's opinions change,  and that, most importantly, the firm may have positions in the relevant securities before the client gets the call.  This is essential for EVERY client to realize, and it applies to every firm - not just Goldman Sachs.

It's also important to realize that this letter refers to the "Fundamental Strategies Group."  This is a group making trading calls - and is distinct from their equity research department. I am fairly certain that GS is not saying that its equity research calls are given to its prop desk before being released to the public, but even if they are - so what - if you don't like the research, don't use it.  If this letter does apply to GS's equity research, all it should do is lessen the validity of the research.  If people still want to ramp stocks on GS's calls even though they know that GS is talking up its own positions ("talking their book," in the lingo), well, shame on the suckers.  If you don't like the trading calls, don't use them.  The point is, these trading calls are calls that GS thinks will make money, and you can be damn certain that they have either acted on them already or at least thought about acting on them, and that they've probably told better clients than you about the trades already.   Rather than rant and rave about it, all one has to do is not do business with this group at Goldman Sachs.  Of course, that's unlikely to happen, because people are greedy, and I'm guessing that these trading calls from GS are still money makers - be it simply because of the "follow GS" phenomenon, or because their insights are actually more insightful.

Put simply, who should be mad about this? No one.   Either you're one of the clients who is getting trading calls, which you KNOW may be biased (biased in the sense that GS wants you to buy stocks that they are already long), and they are working, in which case you're still happy; or you're one of the clients who is getting biased trading calls and they are not working - in which case you stop listening to GS's trading calls.  If the trading calls don't make you money - DON'T LISTEN TO THEM!   Then there is the entire group of people who are NOT getting GS's (biased) trading calls in a timely manner,   yet are still furious at the possibility that the trading calls are biased.  It's patently absurd, like saying "Damn you, GS, I can't believe you're giving out biased trading calls talking your own book, but you're not giving them to me!"

Now, frontrunning is something else entirely.  Frontrunning is when a client gives an order to GS, and GS, instead of executing the client's order, goes and executes the same order in its proprietary account first, usually with the intention of moving the price of the underlying asset and then trading it back to the client at a price advantageous to the firm.  It's outright illegal, and it's a big deal.  However, it's completely unrelated to what the letter released today is talking about.

Goldman Sachs' letter today acknowledges something that should be standard knowledge for anyone talking to any sell-side firm:  a firm may be, and probably is, talking its own book when it gives you a trading call.  These firms are in the business of making money on their trades - they put on a trade, and then try to convince others why it's a good idea.  It's not a smoking gun, and it's not frontrunning.   As a customer, you may actually be suspicious if a firm like GS is hyping a trade to you but they have no prop position - after all - if it's such a good trade, why don't they have it on themselves?  One of the favorite questions my boss used to ask sell side analysts and traders when we were on the buy side was "What do you own in your personal account?"  Those were usually the highest conviction ideas.



Kid Dynamite said...

update: commenter Don Smith on Zerohedge weighs in with this synopsis that makes the point i was trying to make in my middle paragraphs:

"Seriously, though, why do we care? Are you a Goldman client? If so, pull your money. If not, it doesn't affect you. Is it unethical? Well, of course it is. Is it illegal? Eh, I'm sure they have the necessary wiggle room, and Mary Schapiro sure as hell isn't going to knock on their door asking any questions, other than, perhaps, "Um, sirs, do you mind terribly if we issue a press release about not prosecuting anyone ever for anything if they work for a bank or bank-like institution?"

Goldman's clients are not stupid. They obviously make enough ROI to compensate for the siphoned juice. If you had a broker who earned you an extra 2% over market performance by manipulating the market, but skimmed an additional 2% from you, do you care? If you call him out and he has to stop manipulating the market, you lose your 2%.

My guess is GS clients are well aware of what's happening. This revelation is likely to leave them shocked, SHOCKED!, as Mark Macgwire's admission of steroid use.

Don't get me wrong. I'm not saying it's right, or that I even like or approve of it. But it's a) not shocking and b) not going to get so much as a sideways glance from the SEC."

Daniel said...

So is it ok to talk your book if you are a B/D but not if you are an RIA?

Again, and it cannot be better stated, what Wall Street is really, really good at is figuring out which of it's clients are smart, and which of them are stupid, and treating them accordingly.

Lastly, I see lots of posts in defense of GS ala don't hate the playa hate the game, but please, in the interest of fairness, direct me to your post about GS's handling of the hold your nose and bend over float of DOLE?

Kid Dynamite said...

Daniel - what's interesting about this case is that the clients getting the "best" trading calls are almost certainly GS's smartest clients - not its dumbest clients.

i'm not sure what you're referring to in the last part of your comment. one thing is indisputable - this is not frontrunning. And again, what's important is that people KNOW that GS does this - once you know GS does this, there is really nothing else to say. you either pay that vig and trade with them, or you dont, in which case you're not being "victimized" by this behavior.

Kid Dynamite said...

ps - don't get caught up in if it's "ok" to talk your book - the assumption should be that everyone who offers you any sort of investment advice on the sell side, or on TV, or on a blog, is talking his book. ALWAYS. sometimes it may not be true, but you should ALWAYS assume that the advice comes with vested interest.

so what's my vested interest with this blog? i just want people to be educated with the facts, not the hype - so that they can make their own decisions. I really don't care if people like GS or not - i know most don't - but if you hate GS, it definitely shouldn't be because "they admitted frontrunning their clients" - because that's not even close to true.

Daniel said...

My point is it's very difficult to level the playing field from a regulatory standpoint. GS exploits this at every opportunity. And waves their hands at the question of ethics. I continue to short them at every opportunity.

Anonymous said...

> If you had a broker who earned you an
> extra 2% over market performance by
> manipulating the market, but skimmed an
> additional 2% from you, do you care?

Yes, I think you do.

Madoff clients thought exactly what you
describe here -- sure, he's a criminal,
but he's *my* criminal.

Until he's not.

Only a fucking fool would do business
with someone they know to be a sociopath.

Kid Dynamite said...

anon @6:41pm - right - then don't do business with them! problem solved!

Anonymous said...

Kid, can you give ro reference your opinion on the REDI issue? Is GS using that information unfairly? If I put a big VWAP order in, I don't wnat GS using that knowledge to buy the stock ahead of me, and if I try to get clever with my order, I don't want to worry abot whetehr GS is clever enough to fiugure out what I am doing. Is your answer the same (ie. if you don't like it, go trade somewhere else)?

Kid Dynamite said...

I used REDI when i was on the buy side. I think it has the best algos available to the buy side, and offers the best way for traders to compete with better, faster, smarter algorithms that exist elsewhere. If i went back to work on the Street, I would probably look into using REDI again as an execution system.

I think there is approximately a zero percent chance that GS is frontrunning orders in REDI. Look - there is a lot of shady or ethically questionable stuff that happens on Wall Street - but GS frontrunning REDI orders wouldn't be ethically questionable, it would be downright illegal and it's just not something they need to do.

Now, what MAY happen is that orders get internalized before being sent out to other market centers. what this means is that if you submit a buy order in MSFT, REDI will pair it off with any MSFT sell orders that are in REDI at that time. They will NOT, however, call their prop desk and say "hey - this guy is buying MSFT"

REDI is totally separate from GS's prop trading operation too (obviously) - they don't even sit in the same state - the REDI guys are in New Jersey i think.

Look - i know that people read ZH and that people think GS is frontrunning every order on the exchange. I worked on the sell side for many years, on a very high volume program trading desk. We had agency traders separated from principal traders, and if we principal traders found out about an agency order, we had to either get approval from the client to execute the same name alongside them, or stop our principal order, even if we were already establishing or liquidating a position BEFORE the customer order came in. Many times we wouldn't even know about the customer order, but we'd be executing (as principal) with one of our floor brokers who would get the agency order from a different trading desk. Then the floor broker was obligated to call us, and tell us we had to get approval - all to avoid even the illusion of any sort of frontrunning.

Still, a few times every year, we'd get inquiries from the NYSE compliance department, or the SEC - "why were you buying this stock at this time?" when you trade as many stocks as we do (we'd regularly trade full S&P 500 baskets), in a firm as big as ours, it's guaranteed that there will be times that you are executing on the same side of the market as a client at some point. but all orders are tracked, and if you're frontrunning client orders on a regular basis i believe you will be found out.

Kid Dynamite said...

ps, Anon - to your last question - if you don't trust REDI, don't use them. absolutely. that's your prerogative. If you get worse executions via REDI than you do on other platforms - don't use them.

Steve said...

Say you have this Fundamental Strategies Group that is generating good trading ideas and they are generating positive alpha for your proprietary trading.

Then you realize that even after the firm's proprietary trades are put on to the extent of risk/position-size limits that there's still alpha left.

Wouldn't it be a great idea to monetize some of the alpha that's left by sharing the ideas with clients in return for valuable consideration or at least goodwill?

It may or may not add meaningfully to the alpha of your proprietary trades but it definitely won't reduce it.

If there really was alpha it has great benefits for your clients. If there's no alpha there's no incentive for the game to continue because your clients will leave and you will have destroyed goodwill.

I think this arrangement maximizes utility for firm and client alike.

But What do I Know? said...

At first glance, I would tend to agree with you, KD, that "if you think GS is front-running/lying to/cheating you then don't trade with them." Unfortunately, it's not quite that simple.

GS, for better or worse, is widely perceived as the premier IB on Wall Street, and its example sets the tone for the other IB's. Also, there aren't that many IB's around anymore, so the buy side people (running pension funds, endowments, etc.) have limited choices about who they deal with. Since these institutions are running "public" money, one could argue that the IB's are performing a "public" function by participating in the investment "process."

To me, the situation is not equivalent to there being five gas stations in town, and if one gives you bad gas you can go to another; rather, all of the gas stations sell the same kind of gas, so it is important to make sure they are ethical/providing good product--almost like a public utility.

I suppose your response to the issue is predicated by your assessment of the situation; to many people, the IB's have a "quasi-public" function and therefore have a quasi-public obligation not to cheat their clients and customers.

Kid Dynamite said...

BWDIK - i think the group in question here is very much NOT at all quasi-public - it's almost certainly focused on trading calls for hedge funds. in any case, no matter who the recipient of these calls is, they are responsible - i hope i've made that clear from prior posts. Now that GS has made it clear that GS the firm may already be positioned in the names, the recipients are even MORE responsible!

also, the ENTIRE stock market is one big parade of people talking their books - it's how the whole engine churns. It's very much not GS specific

But What do I Know? said...

I hear you, KD, and I would like to believe the best corrective action would be a "Tit-for-Tat" strategy that supposedly works so well in iterative Prisoner's Dilemma-type games. And as a former wirehouse broker, it took precisely one example for me to learn the the firm's recommendations and structured products were not primarily intended to make money for my clients.

I think we agree that one ought to be wary, and to assume that everyone is talking their book. But I still think that the people at Goldman have some kind of ethical standard they should meet, if not for them, for public confidence in the industry--and keeping public confidence in Wall Street is important to our financial system and our way of life.

"No man is an island, entire in himself."

Wez said...


The definition of front running is:

"Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. Front running may involve either buying (where the broker buys for their account, before filling customer buy orders that drive up the price) or selling (where the broker sells for its own account, before filling customer sell orders that drive down the price)."

That definition does not specify specific time periods. Trading ahead of customer orders is the more obvious version, building a position for yourself and then promoting the security is another form of frontrunning.

I work in securities compliance and what you are referring to can be considered either frontrunning or insider trading.

A securities firm who buys a security for itself and then subsequently promotes that security is not acting in it's client's best interest. I work at an RIA firm and we make sure to make client purchases in securities before we buy for our own accounts. I understand their are differences beteen BD vs. RIA activities, but at the end of the day, regulators will find against firms who self deal in such ways.

Now if a regulator ever has the balls to bust the Giants like GS is another matter, but that doesn't mean their activities are not still in violation.