Rethinking The Wall Street Business Model (Part 1)

"Too Big To Fail." "Shrink Wall Street."" Ban credit default swaps." These are just a few of the themes dominating the discussion around the Wall Street business model. They all, unfortunately, miss the point. Size, scale, and instruments that properly used help manage risk have their benefits. Lost in the fallout of the financial crisis is the reason why Wall Street exists: to facilitate capital formation and to provide tools for efficient capital allocation. These are customer-focused activities. This cuts across the Wall Street firm, touching underwriting, credit, M&A, security sales and trading, derivatives, foreign exchange and asset management. I'd argue that these business lines are appropriate for the Wall Street firm and really do help customers, be they corporations, municipalities, sovereigns or institutional investors, achieve their objectives. The problem is that both regulators and risk managers have not kept pace with the increasing scale and complexity of the 21st century Wall Street firm, leading to the dramatic (over) reaction to the financial crisis by the US Government and the populist backlash from ripped-off US taxpayers. Further, the role that ratings agencies have come to play in the capital formation and asset allocation process must also be considered, because without them the recent crisis could not have happened. And this chaos has opened the door for opportunistic, PR-centric intellectual lightweights and politicos to foment movements around new regulations that will hurt - not help - capital formation and market efficiency. In short, it is a mess. But some reason needs to be brought into the discussion - and fast.

First, which elements of today's model don't fit and should be shut down or hived off? Then, what needs to be done to ensure that the model functions as intended? My over-riding goal is to provide customers with the products and services they want without promoting the privatization of profits and socialization of costs. Somewhere along the line we got off the rails, and it is easy to point fingers, e.g., ill-informed and simple-minded regulators, greedy and opportunistic Wall Streeters, incompetent and money-grubbing rating agencies, etc. Bottom line, we need to move beyond the finger pointing and towards real solutions. Here are my initial thoughts of what needs to be done, with an eye towards practicality and reason:

Idea #1: Separate proprietary trading operations from Wall Street firms

When thinking about Wall Street, it is important to remember its core mission: to facilitate capital formation and provide tools for capital allocation. Internal proprietary trading operations do not fall under either category. They are, in essence, subsidized hedge funds with an implicit Government guarantee. Artificially cheap financing costs. Less transparency than their independent hedge fund counterparts of like scale. These operations are readily separable from the customer-driven business. There is simply no rational reason why they should exist as an appendage of a Wall Street firm. Move them out and make them compete in the free market with their independent peers. Note, however, that this does not mean that all proprietary trading risk is wiped away on Wall Street. Desk traders as part of the main sales and trading operation will always take proprietary positions, making markets and taking views. This is a far cry from the separate, off-trading floor synthetic hedge funds run across Wall Street (like Andrew Hall's Phibro, which was recently split off from Citigroup, or my former employer, DB Advisors), and are part of the customer-facilitation business.

Idea #2: Push over-the-counter assets onto exchanges

This is not just limited to credit default swaps. Most derivative contracts. Most cash bonds. Even many larger syndicated corporate loans. There is no good reason why such assets shouldn't be listed and traded in a public forum. This would help with liquidity, transparency and risk capital weighting. This would also assist with the overall risk management of the firm. Many assets have been slow to migrate to exchanges because - surprise - transparency and liquidity tends to drive down bid/offer spreads, making them a less interesting proposition for those standing in the middle of these deals, e.g., the Wall Street broker/dealer. Trading volumes should somewhat mitigate spread compression, but the benefits to society of moving previously opaque assets onto exchanges shouldn't be minimized. This is a no-brainer. 

Idea #3: Eliminate sell-side payments to rating agencies (and perhaps the agencies themselves)

I'm including rating agencies in the Wall Street discussion because they are inextricably linked. Paying for favorable research is a non-starter in the equity business. Why should it be any different in the fixed-income world? The way the rating agency industry has grown up is fraught with conflict and must be changed. Is rating agency research valuable? Let the market decide. Insist that the buy-side pay for it. If the very concept of quasi-sanctioned ratings falls by the wayside, and it becomes more akin to the buy/sell/hold of high-quality equity research, then two things will happen: (1) value-added research providers will emerge to compete with the rating agencies, as firms will fill the information vacuum once headline ratings are eliminated; and (2) the buy-side will have to get back to basics and do real research, without offloading their fiduciary duty to the rating agencies. Only good stuff comes out of this change. Sure, pension funds and endowments across the globe will have to rewrite their investment policies to eliminate allocations tied to ratings, but then the brainless exercise of filling these allocations will stop and be replaced by bona fide research. Unlike Wall Street, the rating agency business is one that really need not exist. Stop the gravy train and make the buy side pay for value.

Idea #4: Revisit risk-weighted capital methodologies and move towards a mark-to-market framework

In a world where Wall Street assets are far more liquid and transparent, but where assets are far more correlated than previously imagined, a new view of risk management and capital provision needs to emerge. Wall Street firms will principally have two types of assets: exchange-traded and non-exchange traded. Exchange-traded assets will each attract their own risk capital provisions based upon liquidity, volatility and float, with a portfolio-wide benefit given for some measure of imperfect correlation among the asset classes (though with correlation matrices that are informed by fat tails and black swans, which we know are extremely fat and not so rare). These assets will always and at any time be marked-to-market. The non-exchange traded assets are more complicated. As I've written previously, I believe these assets should be marked-to-market unless they are (a) intended to be held to maturity AND (b) the firm has term financing in place to be able to carry the asset until maturity. There can be no 30:1 levered balance sheets aren't almost entirely marked-to-market; this problem became immediately apparent in the wake of the market meltdown. "You mean [name your favorite Wall Street firm] can't finance itself overnight??" This should never happen, yet it did. It shouldn't happen again.

Idea #5: Give traders an equity interest in their strategies

The compensation culture on Wall Street is severely messed up. Trader payouts look like a long call option: lose your salary on the downside but get a percentage of profits fueled by a massive balance sheet and cheap capital on the upside. And with a calendar-year orientation driven by the annual bonus cycle, there is motivation to swing for the fences to lock down that "career year," or to swing for the fences when you are down since, hey, what do you have to lose beside a few hundred grand of base salary? I know it sounds crass, but this is reality. Sure, clawbacks can help address some of this asymmetry, but overly complex and punitive pay structures will cause the great traders to all move to hedge funds, leaving Wall Street the victim of adverse selection (some would argue this already happens today). But what about literally creating a trading account for each trader than can rise and fall, where only a portion of the year's gains can be withdrawn with the balance remaining invested in the trader's strategy? One of the big downsides of trading on Wall Street and not at a hedge fund is that you start at -0- at the beginning of each year, while at a hedge fund you get the benefit of compounding capital, e.g., I get to keep my capital account and compound off that higher base each year. Over time, the power of compounding drives many traders to hedge funds, but there is no reason why such an alignment of motives shouldn't exist on Wall Street. Wall Street's shareholders should want this, too, because traders will begin thinking long-term, like their better hedge fund brothers and sisters. Shifting from an asymmetric payout culture to an entrepreneurial hedge fund culture would help with risk management as well, smoothing returns and generating more rational decision-making over time. Revolutionary, yes. Impossible, no.

This is simply the beginning of my thoughts on this theme. I'd love to hear your ideas, too. I'll be sure to incorporate your thinking into my next installment.

Deal With It, Mr. Einhorn

David Einhorn is without question an exceptionally bright man and a very astute investor. However, the latest message being delivered from his bully pulpit, proposing a ban on credit default swaps (CDS), is misguided at best and dangerous at worst. Are his motives for putting forth this radical view pure, or perhaps informed by the complexity of being an equity investor in a world where the entire capital structure can be sliced, diced and priced? I have no idea. But banning CDSs is akin to banning Twitter. Are there some negative outcomes associated with using each of these tools? Sure. But do their overall benefits outweigh their costs? I believe so.

Here are a few extracts from Henny Sender's Financial Times' story on Mr. Einhorn's Letter to Investors:

“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.

CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”, Mr Einhorn says.

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“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.

That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”

The crux of Mr. Einhorn's argument is that CDSs, by their nature, are negative tools, e.g., the holder wants the company to do poorly, and will do things to hasten this fact, and that merely putting CDSs on exchanges won't solve the larger problem of taxpayer support for "too large to fail" institutions. 

Are CDS negative tools? Sure. Is shorting stock a negative tool? Certainly. The ability to go long and short creates what I call "positive stress," e.g., it's stressful, but it keeps managements' focused and penalizes poor corporate decision-making. They both provide essential checks-and-balances in the financial system, provided they are not used fraudulently. The mere fact that an instrument is "anti-social" is no reason to ban its use: Mr. Einhorn knows this. And while he might argue that shorting a stock doesn't have as direct an impact on a company's need to enter bankruptcy, it might be that a poorly run company should be in bankruptcy with its assets better deployed by others. Also, the CDS market has been a kind of early detection system for the equity markets, providing a leading indicator of corporate woes before this information has been fully priced into stock prices. Taking away this kind of information hurts everyone, including Mr. Einhorn. And if bankruptcy laws need to be brought up-to-date to reflect the fact that a multi-trillion CDS market has emerged, then so be it. But to merely toss out the information value associated with the CDS market is ludicrous. In fact, I'd argue that the market should be bigger, more transparent and more liquid, which gets to Mr. Einhorn's second point.

Clearinghouses are not a panacea, according to Mr. Einhorn, because the CDS market is too big, their price movements too discontinuous and collateral requirements too difficult to quantify, invariably leading to private profits and socialized costs. One word: Garbage. Think about it this way. As one moves down the capital structure, from senior debt to junior debt to equity, price volatility and discontinuity goes up. Why? Leverage and the hierarchy of claims. A company's equity price can move all over the place while its senior debt trades in a narrow range. It stands to reason, therefore, that CDS should have price movements more stable, e.g., less discontinuous, than equity prices. Do stock prices gap? Yes. Can CDS prices gap? Yes. But because of the seniority of their underlying in the capital structure they should gap less frequently and less violently than stock prices. Yet Mr. Einhorn doesn't want to ban equity trading. What would become of his hedge fund?? The issue is one of liquidity and transparency. Discontinuity comes from opaqueness and thin trading volumes, both of which can be addressed through an exchange mechanism. And this is directly related to the collateral question. As the market becomes more liquid and more continuous, collateral requirements will be increasingly easy to set, far easier than they are today through the daisy-chain of over-the-counter margining arrangements. So at the end of the day, I find Mr. Einhorn's arguments specious and likely self-serving.

As a rule, turning back the clock of innovation is almost never a good thing, and it isn't here, either. Better to harness it and use it prudently than to pretend it simply doesn't exist. Mr. Einhorn knows better, which is why this whole meme makes me very curious...

Barking Up the Wrong Tree

After reading the news, participating in key industry conferences and doing some thinking, I've come to the following conclusion: the regulators - and Congress - are barking up the wrong tree. They would have you believe that the equity markets are rigged, retail investors are screwed and that the market structure is flawed. They would further argue that the equity markets are in need of dramatic new regulation, flash orders and high frequency trading are the root of all evil and that "dark pools" are something promulgated by Darth Vader. I have only two words to say to Congress, the SEC and the White House: Bull. Shit.

There are some problems to be sure, but they are not what the spin-meisters in Washington would have you believe...

Which markets stayed open for business every day in the teeth of the crisis? The EQUITY MARKETS. You know, the ones that are now in the cross-hairs of every member of Congress with a populist agenda in dire need of scoring points with their electorate. The markets that were virtually closed for weeks? The DEBT MARKETS, including the OTC DERIVATIVES MARKETS. Why was this the case? Uh, maybe because the equity markets are EXCHANGE-BASED and didn't have BS entities called RATING AGENCIES that lobotomized decision-making and facilitated hundreds of billions to be deployed in assets investors didn't really understand.

And which entities are receiving the most heat? The exchanges. The least? The OTC derivatives markets and the rating agencies. Why is this?

The exchange players have awful public relations. The come across as ultra-complex, technologically incomprehensible and in league with the reviled financial institutions and hedge funds. And clearly dark pools and high frequency traders fall into this category. Markets go up and markets go down. The main thing that matters is that they stay open, provide access to investors big and small and promote competition. The exchanges have done a masterful job of delivering on this for both institutional and retail investors. But Congress and the White House appear destined to focus on policies that ostensibly focus on the retail investor (though it is arguable as to whether the prescriptives will actually help; they most likely will hurt), though the retail investor has become increasingly less important in the overall scheme of the equity markets. Most retail money is handled through pension funds and mutual funds, effectively institutionalizing much of the potential retail flow. Further, the retail investor has never had better access or cheaper execution than they have today, yet the picture is painted that they are getting screwed at every turn. It just makes no sense.

In every era certain subsets of market participants made investments to gain an edge. Whether it was the stagecoach, the telegraph, cheap silicon, abundant fiber or co-location, innovators with capital have always sought to be one step ahead. It is this inexorable move towards better, cheaper, faster that delivers benefits to all, even if more benefits go to those who made the investments. Should the retail investor get the exact same execution as a smart algo that is the result of millions of dollars of development, leverages (and pays for) co-location and puts enormous amounts of capital at risk? Not in my opinion. If the ultimate goal is that every market participant, regardless of size, amount of investment or capital at risk is in the EXACT same boat, then we'll see what happens to innovation: It will plummet to zero. The populist denizens in Congress and in the White House are pushing towards the lowest common denominator: mediocrity for all.

Why, oh why, haven't the broken OTC derivatives markets and rating agency crimes been aggressively pursued by lawmakers and regulators? One reason: because they are far less sexy than the exchanges and don't DIRECTLY impact the retail investor. Not too many mom-and-pops have purchased a 5 year GM CDS or stop by Moody's for a report on the SocGen CMBS Non-Conforming Pool XII. They are far more likely to have a brokerage account, an IRA or a self-directed 401k. What's more systemically important, banning "flash orders" or mitigating the counterparty risk associated with tens of trillions of over-the-counter derivatives contracts? We already know the answer, since Mr. Geithner and his friends did a back-door bail-out of Wall Street with taxpayer money via the AIG gift. This was due to credit derivative counterparty performance risk, friends, not because they had a lousy stock portfolio that they couldn't liquidate. And why do rating agencies even exist? They have simply resulted in an abrogation of responsibility on the part of investors: THEY are the true WMDs, which is ironic considering Mr. Buffet's long-standing position in Moody's. Yet we seldom hear about this.

Sadly, we live in a world of sound bites, and Congress and the White House have found far better sound bites to attack the denizens of the equity markets rather than the derivatives and debt markets. And as usual, it will be this stupidity that will cost us all, except the Congresspeople who will have pandered to their constituents in order to get re-elected. Someday, perhaps, we'll have a vehicle for measuring the efficacy of elected officials, not on the basis of success in getting their measures through but in the worth of the measures themselves. There will be many perceived winners when Congress and the SEC enact short-term popular and long-term stupid regulation that increases costs (including to retail) and stifles investment. Quite simply, they are barking up the wrong tree.

This is why I seldom blog anymore. Because just thinking about the irrationality and long-term consequences of this stuff makes me sick...

   

Fixing Wall Street? The Feds Blew It.

Today's press is constantly filled with bluster about "new" regulatory regimes, Executive Pay Czars and other gripping topics stemming from 20/20 hindsight and populist zeal. Sadly, they all miss the point. Wall Street's weakest link, it's super-leveraged capital structure and reliance on overnight funding, was laid bare in the depths of the financial crisis last fall. If not for the wide-open purse strings of the US Government, institutions ranging from Citigroup to Goldman Sachs would have gone down. No doubt. This was the moment in history when smart minds could have gotten together and projected - really projected - what a better, safer, smarter Wall Street might look like, a Wall Street that wouldn't have collapsed like a house of cards so completely in the face of the mortgage crisis and credit derivatives melt-down. Rather than mindlessly shoveling liquidity in the system to prop up a broken model and failed institutions, a concerted effort could have been made to call time-out, not with respect to the markets but with respect to the institutions whose functioning had just been shown to be dangerously fragile. Needless to say, this is not how it was handled and we are suffering the aftermath today.

What we have is a return to business-as-usual. Except it's worse than that. The US taxpayer has been systematically looted out of hundreds of billions of dollars, yet the press is focused on Andy Hall and his $100 million payday. Whether this is too much pay for Mr. Hall misses the big picture. Yes, the Wall Street pay model is messed up, and I recently provided an alternative approach. But how about the fact that Goldman Sachs is posting record earnings and will invariably be preparing to pay record bonuses, not nine months after the firm was in mortal danger? Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today.

Goldman is a great firm with a stellar culture, and in most circumstances it's risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities. And while it had a massive cushion of collateral, it would likely have been inadequate if the Treasury and the Fed hadn't come to its rescue. In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm. While JP Morgan Chase CEO Jamie Dimon prefers to poke a stick in the eye of the Treasury, seeking to negotiate down the payment to buy back the TARP warrants, Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion... $1.1 billion...Hmm...something doesn't seem right. You know why it doesn't seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman's equity could have done a digital, dis-continuous move towards zero if it couldn't finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren't discriminating back in November 2008. If you didn't have term credit, you certainly weren't getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let's just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It's a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won't let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down. I thought the best way was to impose Good Bank/Bad Bank restructurings on troubled institutions, making plain the value of the assets, hiving off the most troubled and letting the healthy institutions live on and thrive with a healthier capital structure and significant US taxpayer ownership that would eventually be re-offered to the marketplace. An alternative would have been a more accurate and representative pricing of the option inherent in the bail-out given to Wall Street firms. But the US Government elected to pursue neither approach.

Where we are left today, dear taxpayer, is a lot poorer. Unless you are a major shareholder and/or bonusable employee of Goldman Sachs. Brains, ingenuity and value creation should be rewarded in all fields, Wall Street included. But when value created is the direct result of the risks borne by others for your benefit, the sharing of benefits needs to be re-allocated. This has not and apparently will not be done, and we, dear taxpayer, are the worse for it. Further, such a crisis could have provided the opportunity and the impetus for a re-look at capital markets risks, getting CDS users to support a central credit derivatives exchange and revised capital rules to incentivize better gap management. The banks lobby like hell against these changes, because it cuts into their fees, notwithstanding the systemic benefits such changes could have on the global financial markets. Banks now lobbying with US taxpayer dollars against changes that could protect the US taxpayer from more harm in the future. Something is terribly wrong with this picture, yet all anyone wants to talk about are executives getting paid too much. It's called missing the forest for the trees, and it is a fixture of both those trying to sell newspapers (get clicks) and run our Government, and it pisses me off.

Re-designing the Wall Street Trader Compensation Model

The recent flap over Phibro's Andrew Hall and his $100 million+ compensation package makes for good headlines, but fails to get at the essence of the real problem: the manner in which Wall Street trader compensation is calculated and disbursed.

But even more importantly, the talk of nullifying or modifying his contract simply because neither Citigroup nor the US Government like it brings with it dark and threatening implications. If contracts entered into legally and without prejudice are all of a sudden cast into doubt, the entire foundation of free and fair commerce is in jeopardy. Say what you may about a trader getting paid $100 million per year, but if you are a Citigroup shareholder: (a) you've known about this; (b) you've benefited handsomely from it; and (c) there are lots of contracts where Citigroup is paid a lot of money, and if they were nullified would bring grave harm to the firm. I wish muckrakers and whiners would use their brains and hold their tongues when talking about stiffing people pursuant to legally valid contracts. The issue should be "Are these contracts appropriate and do they create value for the firm?" and not "These pigs are getting paid too much money. We should tell them to go to hell." Because once you can simply say "I don't like this deal" and walk away, lawlessness and economic chaos is sure to follow. The Obama Administration should run as far away from this talk as possible, and even publicly stand behind the rule of law as an essential component of a free and fair society. As I tell my children: Think before you speak.

Back to Wall Street trader compensation. The issue is inextricably tied to risk-taking, where the Wall Street "heads I win; tails you lose" payout paradigm rewards excessive risks and places little to no premium on risk management. Further, given that current year cash payouts are a significant part of the trader compensation package, subsequent year losses have little impact on monies actually collected by the losing trader. It's also important to note that Wall Street traders effectively start at zero P&L each and every year, institutionalizing a short-term mind-set that doesn't create sustainable equity value for the firm. In short, the Wall Street trader compensation model is badly broken, in large part because of the agency effects of risking hundreds of millions to billions of dollars of "other people's money" (OPM) with a grossly asymmetric payout function (e.g., shaped like a call option where the trader's max loss is their base salary, while their max gain is effectively infinite and is a function of gross profits).

Like them or hate them, the hedge fund compensation structure has many positive attributes that can be instructive for Wall Street (especially when the lion's share of the trader's net worth is tied up in the fund):

• Diluted agency impacts. While hedge funds generally involve running large amounts of OPM, when much of a trader's net worth is invested in the fund their risk-taking directly impacts their financial wellness. This is not the case on Wall Street, where traders don't get to actively participate in their strategy on an ongoing basis.

• Compounding capital. As Wall Street traders get paid out on current year results, there is no concept of compounding gains from current year returns applied to prior years' capital balances. This is a huge disincentive for prudent risk taking and an emphasis on making profits in all market environments. It encourages a "swing for the fences" mind-set on Wall Street since each year stands on its own. Hedge funds, conversely, permit capital balances to accrete upward and benefit from lower levels of volatility in their IRRs.

• Long-term perspective. Since hedge fund traders are generally only able to withdraw a small amount of their capital each year, they have strong alignment of motives with their investors. Sure, while it can be argued that a hedge fund trader can take on huge risk, try and kill it and simply close down and start again if it fails, the fact that significant partner capital is wiped out with poor peformance makes this a less-than-likely outcome.

Personal investment in one's strategy. Compounding capital. Long-term perspective. This sounds like a much better model for Wall Street, and can also serve as a vehicle for substantially increasing transparency and more accurately measuring performance. The way most proprietary trading on Wall Street is done is not with committed, funded capital, but with "notional" capital. The concept is that internal traders get to trade using the bank's balance sheet and margin lines as collateral, but without a fixed amount of capital assigned to a particular book. How much leverage is a particular book using? No idea. What is the strategy's true risk profile? Hard to ascertain. What is a portfolio's actual risk-adjusted return? Since capital is unknown and risk is hard to calculate and attribute, computing returns is virtually impossible. Therefore, it is also hard to fully grasp a traders track record, not in terms of gross dollars but in terms of risk-adjust returns on capital. This is why proprietary trading returns are not able to be presented to institutional investors should a trader or team wish to raise third-party capital. The assumptions that must be made to compute performance are simply too many and subject to manipulation, making investment management attorneys very uncomfortable allowing such figures to be used in marketing materials.

But what if Wall Street moved to a model where books were actually funded (but would still benefit from risk offsets with other books across the firm), returns to capital tracked and auditable track records created? And what if traders were compelled to leave, say, 80% of the increase in their capital account in the fund, ensuring that their wealth is tethered to their performance over many years, not just a single year? This would more firmly align traders with shareholders, much more than owning stock would. Today most proprietary traders get a chunk of their annual compensation in company stock. Honestly, these traders don't care about company stock, and having lots of it does not make them feel more aligned to shareholders.They apply a huge haircut to this form of compensation. But if their compensation was in cash and reflected as an increase in the accreted value of their capital account, they would be much more likely to protect this than company stock. Traders would also get to benefit from the compounding of their capital balances, providing a huge carrot relative to the current economic model on Wall Street. Finally, since the performance is happening in a transparent fund structure with true capital, the track record can be used should the trader and the bank wish to spin them out as a separate hedge fund.

Structurally, trading businesses on Wall Street are designed as they are for capital and regulatory reasons. Banks get favorable capital treatment for trading books by running them as transparent (and able to be converted to cash in short order), value-at-risk based businesses. Fund structures - when applied to external funds - generally attract less favorable capital treatment because of the inability to compel a manager to reduce risk and because of less-than-perfect transparency. This wouldn't be the case here, since the fund structures would merely be a structural vehicle for delivering the benefits noted above but with the bank retaining the control necessary to secure favorable capital treatment.

Bottom line, the current Wall Street trader compensation system stinks. It is terrible for shareholders. It is bad for long-term equity building. And it isn't that great for traders. Moving to a funded-book structure with long-term trader investment scheme would eliminate most of the bad aspects of the current model while bringing in some new, positive impacts. A radical change? Yes. A rational change? Absolutely.

The Quants Must be Crazy

As a number of historically top-ranked long/short managers have decided get out of the LP game, there is another pocket - a quieter, more stealthy pocket - of the hedge fund universe that is heating up to bubble-like proportions: high frequency statistical arbitrage trading. Where long/short managers were once the kings of the hill, the AUM titans that could move markets with the mere awareness of their interest in a particular security, the secretive, underground, geeky uber-quant crowd is now being feted by top shops looking for talent. Hedge fund strategies rise and fall in favor in a cyclical manner, as "hot" strategies become over-crowded and returns get compressed, while those out-of-favor are fertile ground for some truly differentiated alpha generation. Then those shunned strategies attract new assets while the previously desirable lose assets. And so it goes...

Generally, such strategy shifts are a function of alpha opportunity: investors will generally tilt towards strategies that can generate the most alpha in the current environment, and since investment conditions oscillate strategy allocations oscillate as well. But there is a new factor weighing on investors' minds (and pocketbooks) that is having a pronounced effect on strategy allocation: liquidity. Among the universe of hedge fund strategies, which is the one that has the best liquidity profile? High frequency stat arb.

With signal horizons measured in sub-seconds, minutes or sometimes hours, these strategies trade highly liquid instruments long and short and generally will end the trading day at or near flat. Money is made through rebate capture strategies, rapid-fire pairs trading and the like. They good high frequency books tend to have Sharpe Ratios that are multiples of those of long/short and relative value strategies, specifically because the volatility of these strategies is muted due to the microscopic holding period. But this gives rise to the big drawback of high frequency stat arb - massive capacity constraints. In general, these strategies don't scale well, and as the frequency goes up (with "ultra high frequency" being the moniker for the most silicon-intensive, millisecond holding period strategies) the capacity tends to go down. Books of $10-$20 million are not uncommon, and it is hard to build an ultra high frequency book north of $100 million. This compares to the multiple billions that can be profitably run via a value-oriented long/short strategy, where much more concentrated positions and much longer holding periods rule the day. But in today's environment, this is not what investors want. Long lockups and high volatility? Out. Short redemption periods and low volatility? In.

And investors are willing to grant much higher payout to such strategies, and for good reason. Gains are losses are realized daily, not weekly, monthly or yearly. The mismatch between strategy holding period and the payout of incentive compensation is the driver of the backlash by LPs towards many of the premier long/short funds, and it makes sense. If your strategy has a holding period that is 18-24 months, should incentive comp really be paid quarterly? There is no rational argument for why the industry has grown up this way, and my guess is that this feature will, over time, come to an end. Both the timing and level of incentive comp needs to be calibrated to holding period - when these finally come into line, there will be a true alignment of motives between GPs and LPs.

But back to the high frequency frenzy. Of course, there is no free lunch. The influx of capital into what is a fundamentally capacity constrained strategy will compress returns and strip the alpha out in short order. And unless these funds amp up leverage as they did in 2007/08 to try and keep returns constant while spreads were compressing (which is what contributed to the quant fund blow-up), capital will necessarily flow out and into strategies previously tossed to the side where alpha once again exists, e.g., long/short. This is simply the nature of things. But for the hedge fund industry to rebuild its asset base and develop a healthy relationship between managers and investors, the timing and level of fees has to match the strategy. A "one size fits all" approach is neither appropriate nor desirable. It's high time the LPs asserted their power and the GPs grew a conscience to do the right thing for the industry.

Private Equity Markets: Not Today, Perhaps Tomorrow

Claire Cain Miller penned a story in last Wednesday's New York Times concerning the development of private markets for venture-backed equity investments. The article raised several important issues, but I'd like to provide further color beyond my quotes in the story. Private markets, their opportunities and risks are very complex: my belief is that while it would be great for a "third exit" to emerge, its realization remains far, far away, except for the most popular, "branded" private companies. Think Facebook, Twitter and the like. Legal and regulatory issues are a problem. Scaling is a problem. And the demand side is a problem. For these and other reasons, I believe it will take years for a true alternative means of liquidity to emerge.

Not a Technology Problem

First off, let's be clear: this is not a problem that subjects itself well to a technology solution, at least not now. The hardest issues with these types of transactions are operational: compliance with transaction documents, e.g., Right of First Refusal provisions, etc.; transfer and custody of physical stock certificates; receipt of stock powers; alterations to books and records; collection of sufficient information about the company to make an educated investment decision, etc. Due to investor demand and regulatory limitations, technology as a vehicle for price discovery hasn't really been necessary. So those that consider this a technology problem to be solved are far off the mark. Think of one of the single most successful financial start-up of the past decade: Gerson Lehrman Group. The company is worth over a billion dollars. The vast majority of this market value is not attributable to technology, but to making a match between information seeker and information provider. The technology that has been built in recent years is nice but certainly not a key driver of firm value. The largest and arguably most successful company in the private/illiquid asset space, SecondMarket, has painstakingly built an back-office environment to rival that of a small broker/dealer. Companies that are at all successful in this space will have significant infrastructures to handle the operational requirements of trade execution and settlement. Everyone else is simply pretending.

Not a New Idea

Making a match between a large seller of restricted/private stock and a buyer. Hmm, that sounds familiar. Who else does this? Right, Mergers & Acquisition bankers and block desks. Depending upon whether the sale is to a strategic buyer or a financial buyer, Wall Street has long dealt with exactly the problems these private exchanges are purporting to solve. If it's employees with small holdings ok, not the same, but if it is a venture firm like Union Square Ventures, Kleiner Perkins, or DFJ looking to find an alternative path to liquidity, they can always call up their friendly investment banker and place the stock through them. Bankers can do the job of price discovery just like a listed market, and the prices will be much more reflective of the kind of size the sellers want to move than a shallow indicative level that doesn't do the venture firms much good. It will take years to cultivate a truly new investor base, e.g., high net worth retail, to take up the stock. Moving large size in private companies tends to be an institutional phenomenon, those same institutions that are currently no bid in the largely dead IPO market.

Depth in Demand Does Not Exist

The investors that generally drive the IPO market - not high net worth individuals but mutual funds, hedge funds and other institutional investors - are largely on the sidelines. There is a massive emphasis towards liquidity in today's environment, and private company stock is not high on most institutional investors' shopping lists. So in the absence of these key players, are accredited investors (in Securities Act of 1933 terms) really sufficient to pick up the slack? It's not as if angel investors have been deploying large amounts of capital, and those "super angels" that have been bridging the gap between founders and institutional rounds are primarily "first-money-in" investors; they are not looking for Facebook stock at $4 billion or Twitter stock at $350 million. So the fact that there isn't a vibrant IPO market says to me that there isn't a deep private company stock market, either. In the absence of real demand, all the recent buzz in this space appears to be a solution looking for a problem.

The Regulatory Environment is Hostile, and the Trend is Not Your Friend

All of these private markets are predicated upon either the Accredited Investor or Qualified Institutional Buyer (QIB) rules; these provide safe harbors from a host of SEC reporting and disclosure requirements, on the assumption that investors in these buckets are sufficiently sophisticated to make investments in risky, unregistered securities. These restrictions, coupled with the 500 investor limitation pursuant to the Securities Exchange Act of 1934, sharply limit the potential parties that can underpin the demand for these private markets. In effect, for the volume of these markets to scale, the same institutional investors mentioned above need to participate. And if they won't buy shares of more profitable, less risky IPO companies that will provide detailed SEC-compliant disclosures, then why would they be motivated to invest in less profitable, riskier private markets companies with limited disclosure requirements? Answer: they wouldn't. Further, in order for these markets to truly flourish, rules such as the 500 investor limitation would need to be relaxed. But with today's environment awash in scandals, trillions of losses due to illiquid and non-transparent asset portfolios and the taxpayer and Congressional backlash arising from the bailout, is anyone really in a position to ask for relaxation of rules that are designed to protect investors? Good luck. The timing could not be worse.

Private Markets Could Work - Someday

The key needed for these markets - any private market - to succeed is real and durable demand. When that will emerge I do not know, but I am pretty confident it won't be for another 18-24 months, at best. Another factor are the public company listing, filing and compliance requirements. Sarbanes-Oxley (Sarbox) has certainly raised the bar for companies going public, and represented one of the key motivations for markets such as GSTrUE and Opus-5 to emerge. But if Sarbox were rolled back or recast in such a way that compliance was less complex and cheaper to implement, then the need for private markets might go away. I don't buy the argument that a "long tail" of demand exists for non-brand name private companies, except insofar as these companies are raising capital, not for investors who are looking to sell out. Just as with GSTrUE, the companies that were able to be placed were top-shelf names with big brands and significant pent-up demand. This kind of dynamic does not exist in the long tail. It seems to me that Internet investors are seeking to apply web logic to a Wall Street phenomenon. Sometimes characteristics of the online world don't necessarily apply to the offline world. I could be wrong here, but I doubt it.

The Bottom Line

I appreciate the desire for a third path to liquidity, and acknowledge its importance, but you can't manufacture demand where none exists. Demand will pick up at some point and these markets will be viable, but their growth will be sharply capped due to both the "brand name" and "head of the tail" phenomena and the regulatory environment. So this is one to keep an eye on, but my sense is that this third path simply won't become viable for a long, long time.

Note to the Administration: The AIG Flap is Because of YOU

The AIG bonus kerfuffle is beyond absurd, but what else would you expect from a flawed bailout program with conflicted motives littering the landscape? Congress and the Treasury should be ashamed of themselves: they've committed hundreds of billions of taxpayer dollars yet work to undermine its value and efficacy, in real time. A casual observer from another planet looking at the recent flap would invariably say: short the US - or at least its legislators.

Consider a few observations:

• They (Congress, Treasury and the Administration(s)) entered into a bailout program with the stated (and reiterated) idea that sick institutions must be kept alive, e.g., preserving value for common stock and debt holders;
• They initially worked to minimize the Government ownership associated with bailout funds, hurting the US taxpayer's return on investment while ostensibly allowing the recipients free rein over how to deploy the funds;
• When it became clear that the capital injections were insufficient for the largest and most troubled institutions, more funds were committed on the same unstructured basis as before;
• When even these amounts were deemed inadequate, either more money was put in (AIG) or senior claims were converted to subordinate claims (Citigroup's investors' conversion of preferred shares into common stock);
• As ownership in bailed out instituions crept up, notwithstanding the earlier desire not to have the Government involved in the management of bailed out firms, Congress decided it was time to pass judgment on how the businesses were being run; and
• Now we have a Congress smelling blood (and a PR opportunity), passing odd and abusive legislation to convey their moral outrage (hypocracy, anyone?), while simultaneously damaging the US taxpayers' massive investment in the bailed out firms (and any firm either forced or desperate enough to take Government money).

President Obama, Congress and our friends at Treasury, you can't have it both ways. Either you are making investments and letting the private sector decide what to do with it or you are taking control and restructuring troubled businesses. By choosing a middle-of-the-road strategy, you have guaranteed failure. Troubled institutions are not getting fixed, and you have wasted US taxpayer money and damaged investor sentiment. All of this could have been avoided by supporting a Good Bank/Bad Bank initiative from the outset (one Government-controlled Bad Bank; many Good Banks). This would have enabled you to:

• Clearly segregate illiquid bad assets from the sound operating businesses, focusing US taxpayer dollars on bridging the liquidity gap for the Bad Bank while raising private capital for the Good Banks;
• Replace legacy managements and Boards of Directors to avoid the PR damage and ongoing concerns about the stewardship of restructured institutions;
• Hire a team to work out the Bad Bank over months and years, paying a small management fee and carry on the assets sold while staying out of the management and compensation policies of the privately-funded Good Banks;
• Avoid micro-managing private institutions with massive public ownership and driving the value of the public stakes into the ground.

I'm hoping it is abundantly clear that the Government's plan for handing sick institutions has been an unmitigated disaster. The primary argument against Good Bank/Bad Bank - the difficulty valuing the illiquid, bad assets - almost looks like a joke today. Yes, it would have been difficult. But yes, it could have been done. The collateral damage associated with the Administration's handling of AIG and Citigroup is only just beginning to be felt. What is now a public relations circus which makes for entertaining reading is anything but funny: it threatens the value of the bailout funds already deployed and has boxed the Government into a corner. Congratulations on showering your moral outrage on AIG; the fact that this issue could have arisen is simply indicative of your ongoing failure.

Regulatory Litmus Test: Can the "Four Horsemen" Ride Again?

As noted in my recent post with Matt Harris, the venture industry has massive problems of scale. Large investments from even larger funds are weighted down by a dark feature of the past decade: limited opportunity for exits. Venture-backed companies, if they go public at all, do so at much greater scale than they used to, necessitating many rounds of venture investment. It used to be that companies could go public on the NASDAQ much earlier, often brought by a host of middle-market investment banks like the "Four Horsemen" (Alex.Brown, Hambrecht & Quist, Robertson Stephens and Montgomery). Young growth companies could raise $20, $30, $50 million, at valuations in the $100 million range. It set the stage for subsequent share offerings as growth opportunities warranted, and the investment banks provided research on the young companies to keep investors informed of their progress. While many parts of Wall Street and our financial markets are broken, this was one area that functioned quite well and fueled the engine of innovation that led to the technology revolution. Yet in a classic case of unintended consequences, onerous regulations such as Sarbanes-Oxley have served to squelch the fires of creativity and capital formation to the detriment of our economy, our environment and our society.

Our regulators, Congress and yes, President Obama, need to take a big step back and ask the following question: what re we trying to accomplish with our regulatory framework? As with most things, regulations involve a trade-off: impose too many, stifle growth and innovation; impose too few, provide the basis for fraud and mismanagement. My fear is that our regulations have gotten both more strict and less effective, causing the venture business itself to be on life-support. Is this what regulators set out to do? I'm sure not. But here we are. Even a $250 million venture fund has a hard time returning carry - remember, you need $250 million in exits just to break even on a nominal basis, $500 million if you want a decent track record and return for your investors. Tallying up a cool half-billion in exits is no mean feat. Think about the $500 million fund that needs to return $1 billion: where is that coming from without an IPO market or corporate acquirers with huge financial capacity? This is why we need a vibrant middle-market investment banking function to help bridge the gap between A/B round investment and later-stage investment. 

The only other way around the problem: later-stage venture funds becoming a proxy for the IPO process, providing outside investors with an exit, letting the founders take a little off the table and re-incentivizing them to take the business to the next level. This way, the original outside investors don't have a massive layer of preferences on top of them, the founders are happy for partial liquidity, greater financial stability and a nice incentive package, and the later-stage fund gets to put big dollars to work efficiently. While this is fine, it is not a substitute for financial markets and structures that support the kind of growth needed to prepare this country, and the world, for the challenges of the 21st century.

Let's accept the fact that it is impossible to eradicate fraud. Some degree of fraud has to be acceptable, because the costs of 100% regulatory effectiveness would be to stop commerce altogether. The question is, how much bad behavior can we live with to support flexible and inclusive capital markets?And what kinds of policies do we need to support an active growth-company financing environment? Here are a few observations:

• Sarbox doesn't work. It is a tax on all companies, but is massively regressive (as smaller companies have far higher percentage compliance costs than larger companies). Therefore, it is the worst kind of legislation for a country built on small businesses and innovation. It needs to be scrapped and re-conceived.

• Accounting rules need to be simplified with an emphasis on transparency. We should move away from rules-based and towards principles-based standards. Enforce bad behaviors through regulators and the courts, and have companies submit grey-area issues for interpretation as they arise. The regulatory apparatus needs to be set up to handle these policy clarifications in a timely manner.

• Tax policy must be simplified, with incentives provided for start-up investment and R&D spending. Corporate taxes should be kept low and easy to compute. Tax shelters should be wiped away except for explicit policies geared towards investment. Forget about Sarbox: the cost of tax compliance (and tax "optimization") for public companies is a massive and rising expense due to increasingly labyrinthine tax rules. This is wasteful and has to stop.    

• The theory behind separation of banking and research needs to be revisited. In middle-market growth company underwriting, it is very hard to get third-parties to publish research on nascent companies. It is generally the role of the underwriter to keep investors current on the company's business and prospects. While conflicts of interest can certainly exist, and principles-based regulations should be applied (e.g., if you are "talking your book," you can get fined, censured, etc.), this is a model that can and does work for financing and supporting trading of growth company stocks.    

These are four of perhaps ten or more steps that need to be taken to address this issue. Bottom line: without the ability to take younger companies public as was done for decades, the large-scale venture business is not a viable business model. Too few exits. Not returning carry. Disenchanted LPs. Period. 

Advice for Transitioning from Wall Street to Start-ups

In my last post, I talked about some the challenges and barriers to success facing Wall Streeters interested in the start-up world. Difficult doesn't mean impossible - it just means that you are going to need the same passion, intensity, steely resolve and thirst for learning for transitioning from Wall Street as you'll need for either founding or working in a start-up. So it is actually a pretty healthy and necessary self-selection process, in my opinion. Over the last 4+ years I've done stuff that I couldn't have imagined that made all the difference in my acclimation to the start-up/technology world. The thing that will be difficult for most Wall Street refugees to understand is that being at a technology start-up, whatever your capacity, isn't a job: it's a way of life. Because success is partly dependent upon being an active learner, opening both your mind and your heart to new and non-intuitive things on a daily basis.

While I am only one data point, I will share some of the steps I took to make the transition from Wall Street to Silicon Alley, and continue to make every day.

• Reach out to friends who either work in or are investors in start-ups. Duh, obvious, right? One of the guiding principles on Wall Street is using data to make decisions, and it should be no different when making this transition. You need to speak to lots and lots of people who have either gone through what you are contemplating, or who have experience with those who have attempted the same. I was lucky to have guys like Fred Wilson and Jeff Stewart as early resources, both as data points and as connectors to others who gave me even more data. While your experience, personality and skill sets are unique, those of others can be very, very instructive.

• Immerse yourself in the start-up ecosystem. This means going to relevant Meetups, presentations offered by law and accounting firms, select conferences, etc. Subscribe to Gary'sGuide.org and other meeting notification services in order to keep your finger on the pulse of the technology and start-up scene. See, be seen, collect business cards from both investors and entrepreneurs, and hand out zillions yourself. Eventually you will become a fixture in the community. And this is a good thing.

• Become a "Let's go out for breakfast" and a "Let's grab a coffee" madman. Network, network, network. Entrepreneurs. Venture capitalists. Angels. Potential clients. Potential partners. Smart people in your domain of interest. These meetings exhibit exponential - not linear - benefits upon your networking and data collection process, as people in this realm tend to be incredibly helpful and introduce you to lots of other people who become nodes - offering new connections - themselves. Once you get this ramped up your learning absolutely skyrockets, and the contacts you make can help land a job, locate a business partner or de-risk a new venture through an advisory or commercial relationship.

• Read lots of good blogs. There is so much great content out there, stuff that seems like it is written JUST for you given your areas of interest. Take advantage of this. It is also a great way to meet people with common interests with whom you can start a dialogue, out of which might come - who knows? I've commented on people's blogs, sent them emails and built dialogues that evolved into great relationships. Becoming an avid consumer of the medium is very important from both knowledge and networking perspectives but also for getting your head around being a start-up guy.

• Start a blog yourself. I know, it's not for everyone. But if you fancy yourself a start-uppy kind of person, then you must have the ideas necessary to populate a blog. The value, however, is well beyond that. It is a place you can refer people for greater insight into you both as a person and as a professional. It is a platform for igniting conversations around topics of interest to you. And it brings with it a certain aura of engagement, of caring enough to set it up and maintain it. This is pretty important cred when interacting with technology types, many of whom have blogs and use them to great effect. While it takes a meaningful amount of time to do a blog and do it well, it is a valuable mechanism for getting fully ingrained into the technology ecosystem.

• Join and use Twitter, Facebook and LinkedIn. While I've been on LinkedIn a long time, I find myself spending the most time on Twitter, followed by Facebook. LinkedIn is a distant third. While I think it is important to have a presence on all three, Twitter is clearly the most dynamic, fastest moving, and most powerful vehicle for getting a grip on the conversations happening in your areas of interest. Twitter and blogs. Choose the Twitterers and bloggers you follow well and it will pay off in spades. You will be extremely well-informed, on the cutting edge of information, and have a circle of influencers with whom to interact. It's all good.

• Separate - really separate - from Wall Street. It is really, really hard to sever the spiritual umbilical cord. The political machinations that were irritating while you were on the inside are a compelling soap opera once you go outside. Resist the Siren's Song. Also, it can make the fear even greater when you stay close to people still on the (albeit smaller) gravy train while you've made the break. Don't hang out with them. Spend the time getting acclimated to your new world. This doesn't mean saying goodbye to friends; it just means having a clear delineation between personal and professional boundaries, and refusing to allow yourself to live in the past. Making the break is hard. Once you've done it, DO IT. Don't let yourself get sucked back in. Because you will end up depressed and frustrated, and further way from your goal of being a different kind of person, a different kind of professional. You deserve better. Move on.

• If you can, do a little angel investing and/or advising start-ups. I am strongly against "dabbling" in the angel investing domain, but I view this as a little pocket money akin to going to Vegas or AC to play poker. Becoming an angel, getting to see how others start companies, pitch ideas, interact with investors and staff their firms is invaluable education, well worth the price of admission. I'm not suggesting spending a material amount of your net worth doing this, but enough so you are able to see some deal flow and perhaps use a more experienced friend to help select a few small-ticket investments. Also, putting yourself out there as a potential adviser to start-ups is a great way to learn about how they work. With your domain expertise from Wall Street, you could add a lot of value to a nascent company. Get engaged. Help out. And learn, learn, learn.

• Acknowledge the challenges but don't be daunted. If you come into this transition with humility, excitement, intensity and focus, you can make it happen. Invariably the road will contain some potholes (if my own experience is any guide), but persistence is what makes great entrepreneurs and great partners, and what makes victory at the end of the day just so sweet.

Don't worry, be happy? Not at all. There is plenty to worry about. But there is a lot that you, former Wall Streeter, can do to make your move into the world of start-ups a much more satisfying and successful experience. Best of luck and get on with it.