Wall Street Thrives on Opacity — Conflicts of Interest and Unequal Access

Friday, 18 Oct 2013 07:55 AM

By Barry Elias

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Wall Street redistributes wealth through opaque transactions based on conflicts of interest and unequal access.

Fortunately, the justice system is beginning to make inroads that can transform this metastatic landscape into one that rewards productive resource allocation and transparent access for all participants.

In 2006, the New York Stock Exchange ceased to exist as a non-profit institution and became a for-profit entity. To raise revenue, it sold access to high-frequency traders through server co-location. Close proximity to the exchange computers permitted these traders to receive the orders in advance and increase trading volume and commissions by moving prices out of equilibrium and back quite rapidly. The flash crash of 2010 was the result of this type of trading in oil.

Recently, high-frequency traders have purchased early release of government data to front run markets, as little as several seconds before others to capitalize on arbitrage opportunities.

New York State Attorney General Eric Schneiderman says this early release of information is "more insidious than traditional insider trading." He is intent on bringing these traders to justice, according to The Wall Street Journal.

The Journal reports that the University of Michigan sold early views of its monthly consumer confidence survey to Thomson Reuters for $1 million, which then sold it to customers five minutes before its official release. High-frequency traders paid even more to receive it as little as two seconds earlier.

High-frequency traders "are moving the starting line halfway to the finish before their competitors even have their feet in the blocks," says Schneiderman, according to The Journal. This opacity provides enormous profits for traders at the expense of investors, which undermines the future credibility of the markets.

Opacity is magnified by conflicts of interest as well.

During congressional testimony in January and April 2010, Goldman Sachs CEO Lloyd Blankfein suggested his firm did not have a moral obligation to inform its clients that it was betting against the products they were buying and that Goldman did not create these products.

However, several months later, Goldman agreed to pay $550 million, the largest-ever Securities and Exchange Commission (SEC) fine paid by a Wall Street firm at that time, admitting what it had previously denied.

According to the SEC, "Goldman acknowledges that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO [collateralized debt obligation] investors. Goldman regrets that the marketing materials did not contain that disclosure."

ABACUS 2007-AC1 was a synthetic CDO that hinged on the performance of subprime residential mortgage-backed securities.

Recently, Carmen Segarra, a former examiner for the New York Federal Reserve, filed a lawsuit contending she was wrongfully terminated by the New York Fed for finding wrongdoing by Goldman during the course of her job as a regulator.

Too often, the relationship between federal regulators and Wall Street is quite opaque.

She identified conflicts of interest by Goldman in several instances. In one case, Goldman advised El Paso in its purchase of Kinder Morgan, a firm with a large stake owned by Goldman. In another, Goldman did not perform anti-money laundering analysis in a deal between Banco Santander, the largest bank in Spain, and Qatar Holding.

However, during her review, she was unable to identify a conflict-of-interest policy within Goldman's departments and firm wide.

According to The New York Times, the New York Fed's legal and compliance team agreed the conflict-of-interest procedures at Goldman warranted a warning, known as an MRA (matter requiring attention). In March 2012, the team approved a downgrade of Goldman's rating from satisfactory to fair.

Two months later, her superiors suggested she excise her negative findings. When she refused, she was terminated and escorted from the building.

Unequal access and conflicts of interest have seriously contaminated the financial waters. Future economic growth is more probable when we reduce the opacity of financial markets.

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