Black Edge
One way to think about finance is that it is an incredibly complicated system of incentives that ultimately is meant to allocate capital effectively across the economy. Nobody understands how everything works, and everybody within the system is more or less maximising their own utility. And to maximise their utility, they employ some secret plans and clever tricks (to quote The Enormous Crocodile), and sometimes their secret plans and clever tricks work. And some of the secret plans and clever tricks are illegal.
How should we think about financial crime? Two ways: you can either treat it like murder - something to be stamped out at all costs - or accept some level of crime. The question of how you should accept that crime, and how much of it, is pretty crucial, and it underlies a lot of the discourse around finance as an industry.
You can think about social conflict in a similar way; Machiavelli, one of my favourite philosophers, devoted most of his Discourses on Livy to the topic. The nineteenth-century German historian William Dilthey wrote that “what Machiavelli wants to express everywhere is that man, if not checked, has an irresistible inclination to slide from passion to evil: animality, drives, passions are the kernels of human nature - above all love and fear” - I think that’s a good summary. This inclination creates conflict: in particular, what Machiavelli calls setté, or conflict between the nobles and the people.
Most classical thinkers thought that conflict was something to be eliminated: Sallust’s aphorism “concordia res parvae crescunt, discordia maxime dilabuntur” (small things grow from harmony, and are greatly harmed by discord) was a commonplace. But Machiavelli argued in contrast that social conflict, the dialectic between the nobles and the people, was a productive, creative force, for which we have much to be thankful:
“Those who condemn the tumults between the nobles and the plebs, appear to me to blame those things that were the chief causes for keeping Rome free, and that they paid more attention to the noises and shouts that arose in those tumults than to the good effects they brought forth, and that they did not consider that in every Republic there are two different viewpoints, that of the People and that of the Nobles; and that all the laws that are made in favour of liberty result from their disunion.” - Machiavelli, Discourses on Livy, I.iv
Transplanted to finance, Machiavelli’s idea suggests that the conflict between the SEC and Wall Street is not just unavoidable; it’s actually productive. The effort that goes into finding ways to exploit the financial system actually makes it more efficient.
Anyway, the rest of this essay is about comparing two books that talk about hedge funds from opposite perspectives. My focus is Sheelath Kolhatkar’s 2017 Black Edge; but I think it’s worth reading it alongside Sebastian Mallaby’s 2011 history of the industry, More Money Than God. Black Edge narrates the rise and fall of SAC Capital Advisors, the hedge fund founded by Steve A. Cohen in 1992, and it culminates in the insider-trading scandal that destroyed the firm in 2014.
Kolhatkar acknowledges that Cohen had an extraordinary feel for the market; an “almost inhuman ability to stay calm and make rational trading decisions when the financial stakes were high… practically a genetic anomaly, this ability to behave like a reptile when he was trading, as opposed to a human being prone to fear and self-doubt.” Nonetheless, Kolhatkar argues that the key to Cohen’s success was “black edge” - unfairly-obtained non-public information - and she generalises from this particular case to the entire rotten industry. In contrast, Mallaby’s book tells the story of hedge funds from the 1960s thorough to the 2007-08 financial crisis, and throughout the book he mounts a sturdy defence of the industry:
“In sum, hedge funds do not appear to be especially prone to insider trading or fraud. They offer a partial answer to the too-big-to-fail problem. They deliver value to investors. And they are more likely to blunt trends than other types of investment vehicle.”
The fall of SAC happened after Mallaby published his book; but I don’t think it invalidates the argument. Cohen is analogous to Catiline and Clodius; a regrettable but inevitable part of an immensely valuable system.
Kolhatkar identifies three distinct periods in the history of SAC. In the first period, when Cohen managed much of the trading himself, he made money through his intuition for the market; but by the late 1990s, his fund had grown too big for these trades to work. In the second period, SAC gained an edge from their relationship with equity research analysts; in the third, from about 2000, the firm moved to making directional bets on material non-public information; especially by obtaining financial and scientific results from insiders at public companies.
The ‘black edge’ in the late 90s, according to Kolhatkar, came from SAC’s relationship with equity research departments.
“One Monday morning in 1998, a group of Goldman Sachs employees gathered for their division's weekly meeting an hour before the market opened... 'SAC Capital', [a Goldman securities salesman] announced, 'is now the single largest generator of commissions to the equity division.' The equity division was responsible for all of the stock trading on behalf of Goldman's clients, and during the technology boom of the late 1990s, this trading generated a significant amount of profit for Goldman…
Up until that point, the hierarchy on Wall Street that determined who took whose phone calls and who got paid what had been clear. Huge mutual funds such as Wellington, Fidelity and State Street, which managed trillions of dollars in retirement accounts, were the industry's most important customers. They were not in the business of lightning-quick trading... The Goldman securities salesman who was handling the SAC account was about to turn all of that upside down. SAC was a hedge fund, he explained to the confused Goldman employees, some of whom had never heard of the company. They don't just buy blocks of IBM to hold for months at a time while playing gold and collecting dividends... SAC was interested in one thing: short-term movement in the stock price that it could exploit for profit…
In exchange for giving Goldman Sachs millions of dollars of its business, SAC wanted something in return... 'If you change a penny or two on your estimates, you call SAC first.'…
The Goldman salesman's directive reflected an important shift on Wall Street, although its most entrenched players took a long time to recognize it. The new way to command power in the financial industry was to start a hedge fund. Doing so at the right time could turn someone who might have accumulated a millions over the course of a twenty-year career at Goldman Sachs or Morgan Stanley into a billionaire almost overnight. In a matter of a few years, hedge funds went from a peculiar subculture on Wall Street to the center of the industry.” - Black Edge, p.39-41
I want to make two points about this quote: one about equity research, and the other about a possible turning point.
The edge SAC gained from their relationship with Goldman was second-order. Stock prices are affected by fundamental changes, like quarterly results and natural disaster; but if that’s a first-order effect, then the rating influential analysts put on the stock is a second-order effect. If an analyst moves their recommendation from ‘hold’ to ‘buy’, then that may also cause a price move. It seems that in the 1990s, you could generate returns by having a good relationship with equity research analysts, who worked in tandem with the equity sales teams. This is interesting to me for a few reasons.
First, it fits what seems like a broader pattern of equity research departments being used as a tool by the rest of the bank to do vaguely fraudulent things. Kolhatkar talks about a different case from around the same time on page 78. In the aftermath of the dotcom bubble, NY Attorney General Eliot Spitzer went on a crusade to tighten rules about the relationship between equity research and the investment banking division. Essentially, banks who wanted to do advisory work with large clients felt that their ER divisions had to say nice things about those clients if they wanted to win business. If the IBD division were to do the IPO, or the LevFin division were to help issue some debt, the equity research analysts would jolly well have to write nice things about the client. This was bad, and so in April 2003 the Securities and Exchange Commission came out with the Global Analyst Research Settlement, that banned this sort of communication. In Kolhatkar’s words, “analysts could no longer be paid in relation to how much business they generated for their firms. Almost overnight, the job of being a Morgan Stanley or Goldman Sachs technology analyst went from being one of the most desirable positions in the financial industry to that of a glorified librarian.”
More recently, and more subtly, MIFID II rules in the EU banned equity sales teams from bundling research reports with their execution services. Asset managers need to work with brokers to execute their trades; they have a fiduciary duty to get ‘best execution’ for their clients. But some brokers bundled together research reports with their execution services. If you’re an asset manager, and broker A says that they can buy you a security for $100.0001, and broker B says that they can buy it for $100.002 but they will throw in a lot of juicy research reports too, you’re meant to go to broker A as a matter of fiduciary duty; MIFID II enforced this in practice. This has slightly more in common with what Kolhatkar says was happening between Goldman and SAC, in that it’s sales and equity research working together; but it still seems less egregious than what was going on in the 1990s.
More importantly, though, Kolhatkar’s framing of “one Monday morning in 1998” implies a structural shift in the way Wall Street worked. This actually follows really nicely from another essay of mine, on Ron Chernow’s 1997 book The Death of the Banker. The book sketches the growth of the “huge mutual funds” Kolhatkar mentions, and Chernow goes on to say:
“If I can play the soothsayer for the moment, I would wager that, during the next generation, the world of finance will be completely reorganized around these leviathans and the large retail brokerage chains—the two major conduits for the retirement money pourinig into the stock market. As gigantic suppliers of capital, mutual funds are already taking over the capital-allocation functions once exercised by bankers in an age of scarce capital. Consider the riches of Fidelity Investments, the parent of the flagship Magellan Fund, with more than 10 million customers. In a preview of things to come. Fidelity has relentlessly expanded into underwriting, brokerage, insurance, and credit cards and has even struck a strategic alliance to distribute stocks underwritten by Salomon Brothers.”
So was this actually a turning point in financial history? Were the large but slow mutual funds beaten out by hedge funds, starting that Monday morning in 1998? The timeline fits neatly, but Mallaby’s book sees the 1990s as a time of continuity rather than change in the world of hedge funds. Instead of an abrupt rise to power, Mallaby narrates a cycle of rising and falling funds, a cycle which started in the 1960s and would continue through the 2007-08 financial crisis: George Soros and Stanley Druckenmiller’s successes in the Asian financial crisis of 1997 and the Russian default of 1998, LTCM’s collapse in that same year, and then Julian Robertson and Druckenmiller’s losses betting against the dot-com bubble in March and April 2000. There’s no sense that this period saw the giant-killing that you’d suspect from reading Chernow and Kolhatkar side by side.
In 1999, Cohen decided to change the way his firm operated: henceforth, their edge would come from deep industry knowledge and fundamentals. In short, SAC were going to become equity research analysts. But according to Kolhatkar, “one of the things SAC looked for in new traders was personal connections the trader had with people working at public companies that might yield valuable intelligence.” Fundamental edge turned into black edge.
One story that illustrates this change began in late August 2007, when Michael Steinberg, an SAC trader focused on tech stocks like Intel, Apple, and IBM, spoke to his thirty-seven-year-old analyst Jon Horvath:
“I can day-trade these stocks and make money myself, I don’t need your help to do that. What I need you to do is go out and get me edgy, proprietary information that we can use to make money in these stocks. You need to talk to your contacts and the companies, bankers, consultants, and leverage your peer network to get that information.”
Horvath became part of an email list run by another hedge fund analyst - and former Intel employee. In August 2008, this networking would pay off. One of the informants being paid by the group reported that Dell was going to miss its target gross margins; as such, Steinberg’s group went short about $10M worth of Dell stock. But Horvath realised realised that Cohen’s personal account, which was monitored by all the analysts in the firm, was long Dell - and according to Horvath himself, “Steve didn’t like losing money. You were kind of in the bad books if you lost him money.”
Horvath began discussing the stock with Gabe Plotkin, another SAC analyst; and finally, Horvath revealed his source in an email to Plotkin: “I have a 2nd hand read from someone at the company - this is 3rd quarter I have gotten this read from them and it has been very good last two quarters.”
This email was written evidence (which would end up being used in court) that SAC traders were trading on inside information. Plotkin forwarded the email to Anthony Vaccarino, who acted as Cohen’s ‘conduit’ to the traders; Vaccarino forwarded the email to Cohen, and called Cohen’s cell. Shortly after the call, Cohen sold 500,000 shares of Dell.
The network that Horvath used to get his “2nd hand read” included traders from across the hedge fund industry, but was informal. In contrast, expert network firms provided the same service professionally. Expert networks at the time could work a bit like an escort service; you pay for one thing, and the expert/escort can provide something else at their discretion. On November 19 2010, the WSJ published an article titled “US in Vast Insider Trading Probe”:
“Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders, and analysts across the nation, according to people familiar with the matter. The investigations, if they bear fruit, have the potential to expose a culture of pervasive insider trading in US financial markets, including new ways non-public information is passed to traders through experts tied to specific industries or companies, federal authorities say.”
One of the firms named by the article was PGR, which paid $10,000 a month for the services of a Stanford grad called Winifred Jiau. She had worked at TSMC, and could provide accurate revenue, gross margin and earnings numbers for Marvell and Nvidia; when Samir Barai, the founder of a small hedge fund and close associate of a former SAC portfolio manager asked her where her sources came from, she replied “You should not ask me who my sources are.” Shortly after the article was released, Barai shredded all his files relating to PGR; and both he and his friend at SAC would end up pleading guilty to securities fraud.
Expert networks had become ubiquitous because of an arms race dynamic between funds; and according to Kolhatkar, “it had become obvious to investigators that many of the expert networks provided a cover for the exchange of inside information, and that traders were making money using this information at the expense of other investors.”
In 2001 GLG, one of the largest expert network firms, recruited a Michigan neuroscience professor called Sid Gilman; he started taking calls from hedge funds, and in 2004 he was recruited to serve as the chair of the safety monitoring committee for a candidate Alzheimer’s drug called ‘bapi’. Despite taking this position, Gilman continued to work with traders through GLG, and he struck up a relationship with an SAC trader called Mathew Martoma - a relationship which lies at the heart of Kolhatkar’s book, and is also detailed in this New Yorker piece.
Throughout their relationship, Gilman provided Martoma with details of the bapi trial. Most crucially of all, Gilman shared the slides with bapi’s Phase II results - over a week before the results were to be made public on July 28, 2008. The bapi results were a huge shock - rather the expected success, the data showed the drug to be ineffective, and possibly harmful. SAC had had a significant long position in Wyeth and Elan, the two public companies developing bapi; but in the week between Martoma gaining access to Gilman’s presentation and the announcement, SAC turned the position into a $960 million short. For these two trades - Wyeth/Elan in July 2008, and Dell in August - SAC would be fined more than $600 million; the 2013 settlement was the largest insider trading case in history.
These cases are well-documented; the evidence seems clear. Even though Steve A. Cohen himself was never charged as an individual, he oversaw funds which had a culture of insider trading. But does this example of wrongdoing indict the entire industry? If SAC was doing crimes, can one reasonably draw the same conclusions about other firms?
I guess there are two trivial answers to that question.
no: SAC’s wrongdoing was proved in court; but everyone else should be presumed innocent until proven guilty.
yes: one bad apple ruins the whole barrel, and more relevantly, the arms race dynamic that led to widespread adoption of expert networks would have applied just as persuasively to the insider trading they facilitated. Steinberg’s demand for “edgy, proprietary information” must have been echoed all over the Street.
Kolhatkar leans towards the latter view; her book is an attempt to tell the story of SAC in such a way as to indict the entire hedge fund industry. But is that fair?
Mallaby deals with the accusation by zooming out; sure, hedge funds sometimes do crimes, but they’re no worse than the rest of the financial industry. And if we’re talking about the industry as a whole, I think this perspective from Matt Levine is insightful:
“I did have this sense in 2011… that writing about finance was very much about, like, talking about evil the banksters were? And I was working at Goldman and I was like, we’re not that evil? We’re fine. Let me explain this stuff, it’s not as evil as it sounds… The world is less interested in being mad about banks now, but there’s still this sense that Wall Street is this big evil cabal and people are doing things out of gleeful evil, and it is still useful for me to be like, this is what’s going on here. You don’t have to love it, but these people aren’t motivated by ‘HAHAHA we’re evil’, there’s some goal that they’re trying to achieve”.
To me, Kolhatkar’s book tells the story of American setté; the conflict between Wall Street and the SEC. Fraud is inescapable, but the enforcement agencies get there in the end. There will be more Catilines - and more Steve Cohens.
“Anyone wishing to see what is to be must consider what has been: all the things of this world in every era have their counterparts in ancient times. This occurs since these actions are carried out by men who have and have always had the same passions, which, of necessity, must give rise to the same results.” - Machiavelli, Discourses on Livy, III.xliii