Academics sometimes describe a corporation as a “nexus of contracts”. An investment bank might better be defined as a “nexus of conflicts”. It intermediates between buyers and sellers of loans and securities. A tendency to favour regular counterparties is the industry’s original sin.
US authorities are reportedly investigating banks over practices in block trading. Here, companies or large investors typically employ them to sell large chunks of stock quickly and quietly. The scope for malpractice is obvious.
The Securities and Exchange Commission and Department of Justice are apparently examining whether intermediaries sometimes tip off favoured hedge funds about impending trades. Hedgies could then profit from price pressure when large lines of stock hit the market.
No enforcement action is imminent. Still, do not expect this to be the last time that banks and their employees will be scrutinised about who they might favour.
Banks and brokers get hired partly for knowing everyone on all sides of a potential deal. Being close to a variety of investors is a considerable advantage in block trading. It should mean that an intermediary can get a deal done quickly while minimising the discount to the trading price. In the process, the bank or broker earns a fee and hopes to capture a spread between the prices it bought and sold at.
The task facing the SEC and DoJ is to establish a dividing line. When does legitimate interaction with potential counter parties turn into insider trading? The relationship between investment banks and hedge funds is frequently symbiotic. Many are long-term clients who pay fees in a variety of ways and pursue strategies that banks help dream up. Corporate clients tend to be more intermittent customers.
The investigation is therefore certain to raise a further question it will perforce leave unanswered. To what extent does the financial establishment, intentionally or unwittingly, serve its own interests before those of customers? In trying to balance inherent conflicts, Wall Street can easily trespass across ethical and legal bright lines.
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