A recent comment: …but the (sellside) industry is bullish!!!
But of course, they are bullish. They (We) need to be bullish because that’s the way their (our) bucks are made. Commissions and fees (miscellaneous fees—management, subscription, public speaking, seminars, et.al.) happen mostly when the market have been on the rise. In the local milieu, since short facilities have been nothing more than symbolical, during bear markets, where losses dominate, it would be famine as volume dries up.
So when one follows the money trail, the (our) industry will not (or hardly ever) bite the hand that feeds it! [That exception would be me]
Yet anyone who gives a serious thought would come to realize that the interests of the (our) industry (commissions, fees) are not the same as the interest of an investor (returns). And the interests of the industry are not necessarily compatible with that of the interest of an investor. In fact, the structure of such relationship has an innate conflict. This conflict is known in economics as the principal agent problem or the agency problem.
A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem is that the agent who is supposed to make the decisions that would best serve the principal is naturally motivated by self-interest, and the agent's own best interests may differ from the principal's best interests. The agency problem is also known as the "principal–agent problem."
In the past I wrote, [bold mine]
This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem
Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.
To show you a good example, let us examine the business relationship between the broker and the client-investor.
The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.
How do they conflict?
The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.
Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.
How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.
In the movie Wolf of Wall Street, this conflict of interest or agency problem has been demonstrated in the conversation between Wolf of Wall Street Jordan Belfort and his mentor Mark Hanna at the start of the show.
(Some caveats: Do away with the drug embellishments. The dialogue comes with expletives. Bold mine)
(Some caveats: Do away with the drug embellishments. The dialogue comes with expletives. Bold mine)
Jordan Belfort: Mr. Hanna, you're able to...to do drugs during the day and still function, still do your job?
Mark Hanna: Well, how the fuck else would you do this job? Cocaine and hookers, my friends.
Jordan Belfort: Right.
[Jordan laughs awkwardly]
Jordan Belfort: I gotta say, I'm incredibly excited to be a part of your firm. I mean...the clients you have are absolutely...
Mark Hanna: Fuck the clients. Your only responsibility is to put meat on the table. You got a girlfriend?
Jordan Belfort: I'm...I'm married. I have a wife, her name is Teresa. She cuts hair.
Mark Hanna: Congratulations.
Jordan Belfort: Thank you.
Mark Hanna: Think about Teresa. Name of the game, move the money from your clients pocket into your pocket.
Jordan Belfort: Right. But if you can make the clients money at the same time, it's advantageous to everyone, correct?
Mark Hanna: No. Number one rule of Wall Street. Nobody, I don't care if you're Warren Buffet or if you're Jimmy Buffet, nobody knows if a stock is gonna go up, down, sideways or in fucking circles, least of all stock brokers, right?
Jordan Belfort: Mm-hmm.
Mark Hanna: It's all a fugazi. Do you know what fugazi is?
Jordan Belfort: Fugazi, it's a fake...
Mark Hanna: Yeah, fugazi, fogazi. It's a wazi, it's a woozi. It's...fairy dust. It doesn't exist, it's never landed, it is no matter, it's not on the elemental charge. It's not fucking real.
Jordan Belfort: Right.
Mark Hanna: Alright?
Jordan Belfort: Right.
Mark Hanna: Stay with me.
Jordan Belfort: Mm-hmm.
Mark Hanna: We don't create shit, we don't build anything.
Jordan Belfort: No.
Mark Hanna: So if you got a client who brought stock at eight, and it now sits at sixteen, and he's all fucking happy, he wants to cash it and liquidate and take his fucking money and run home. You don't let him do that.
Jordan Belfort: Okay.
Mark Hanna: Cause that would make it real.
Jordan Belfort: Right.
Mark Hanna: No, what do you do? You get another brilliant idea, a special idea. Another situation, another stock to reinvest his earnings and then some. And he will, every single time.
Jordan Belfort: Mm-hmm.
Mark Hanna: Cause they're fucking addicted. And then you just keep doing this, again, and again, and again. Meanwhile, he thinks he's getting shit rich, which he is, on paper. But you and me, the brokers?
Jordan Belfort: Right.
Mark Hanna: We're taking home cold hard cash via commission, motherfucker.
Jordan Belfort: Right! That's incredible, sir. I'm...I can't tell you how excited I am.
Mark Hanna: You should be.
While this may be just a movie, the missives from the conversation which deals with the conflict between client and agents resonates reality; the agency problem.
In short, it is not in the interest of the (our) industry to take risk seriously, for the simple reason that there is no moolah to be made!
In short, it is not in the interest of the (our) industry to take risk seriously, for the simple reason that there is no moolah to be made!
Anyway, the problem has hardly been in (our) industry, who have just acting based on what motivates them, the problem instead falls on the shoulder of the market participants who blindly buys into what the industry sells.
Of course, the industry has been supported by media and by the politicians where the latter has the major beneficiary of asset inflation. Moreover today’s asset inflation has been a product of zero bound financial repression policies—designed for easy access on the private sector’s resources via the credit markets and taxes from inflated assets and economies.
So when one uses the ‘appeal to the majority to defend’ or rationalize the status quo or one’s current pumping action, when the tide turns, there is no one to blame but themselves.
Here is more.
I have not encountered any data that shows of the extent of leverage exposure by the domestic sellside industry.
But like everywhere else (China, US or even Bangladesh in 2011), surely a significant degree of leverage has been acquired for local stocks to have reached stratospheric nose bleed record levels.
The industry’s exposure on leverage can be though margin trades (levered trades extended to clients) or dealer accounts—direct exposure by brokers on the markets perhaps financed via bank loans or via different sources such as intercompany loans, placements, client’s money etc...
Because markets have been rising, these debt based stock market pump party goes on. Remember volume has been incrementally rising on lofty price levels.
But what happens when the market reverses?
Losing positions will mean margin calls, and margin calls may exacerbate liquidations leading to a feedback loop.
Unless the members of industry would have the self-discipline to close (liquidate) any losing position, an extended stock market rout would most likely impair the balance sheets of many, if not most, firms in the industry. The impairment will be accentuated to entities with high degree of exposure to leverage.
Crashing markets has always been accompanied by big name collapses. For instance, the recent crash in commodity markets have bankrupted major commodity broker MF Global. MF Global reportedly used client money to finance the company’s shortfall. From Wikipedia: On October 31, 2011, MF Global executives admitted that transfer of $700 million from customer accounts to the broker-dealer and a loan of $175 million in customer funds to MF Global’s U.K. subsidiary to cover (or mask) liquidity shortfalls at the company occurred on October 28, 2011.
The ramifications of the 2008 crash has been the numerous closures or bailouts of major financial institutions (banks, investment houses, brokers, etc…)
Recently amidst record stocks UK bank, Standard Chartered, reportedly closed and exited from the equity business.
From Reuters, Standard Chartered (STAN.L) Chief Executive Peter Sands moved aggressively on Thursday to reverse the Asia-focused bank's fortunes by closing the bulk of its global equities business and axing 4,000 jobs in retail banking. The lender said it was dismantling its stockbroking, equity research and equity listing desks worldwide, becoming one of the first global banks to get out of the equity capital markets business completely. The decision to close the loss-making division will lead to 200 job cuts, almost all in Asia.
No stock market crash yet, but an exit from equity markets by a major bank.
How much more when the stock market collapses?
My guess is that the incumbent blindness and the asset inflation worship will hurt the sellside industry a lot.
In the local setting, perhaps some may even close.
Caveat emptor.
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