The EconomistFebruary 6th 2021 Finance & economics 612
Buttonwood Shark attack
“T
here are noloyalties on Wall
Street. When you smell blood in
the water, you become a shark.” The
sentiment—or lack of it—would not look
out of place on r/wallstreetbets, the locus
for a new breed of stockmarket hammer-
heads, which has helped push up the
share prices of tech darlings and
bombed-out companies to nosebleed
levels, crippling professional short-
sellers in the process. But the quote
comes from a boomer, not a millennial:
“Confessions of a Wall Street Addict”, by
Jim Cramer, a trader-cum-tv-star. He is
describing the remorseless logic of pred-
atory trading.
It is something that is discovered
anew by each generation of traders—the
dark art of picking off investors who are
in distress, for profit. Every big market
meltdown is made worse by it. Every
melt-up—including the current one—
makes prey of those who are brave
enough to sell it short. Those schooled in
the idea of efficient capital markets will
be puzzled by the latest goings-on. The
textbooks say this sort of thing cannot
happen. They assume there is abundant
capital that can be put to work to correct
prices that have got out of whack.
But in the real world, and in the right
conditions, predatory trading is a profit-
able strategy. Prices can be pushed to
extremes before they are pulled back to
sensible levels. All it takes are illiquid
markets, traders that are bleeding and
other traders who can smell the blood.
To understand how this works, pic-
ture a world in which there are two types
of investor—fast and slow. The slow-
money investors are pension funds. They
eschew short-term trading. When they
enter the market it is in a measured way,
to buy and sell when share prices look
unduly cheap or dear. The fast-moneycrowd are hedge funds, which are happy to
trade every day. In this world there are only
two hedge funds. Each has ten shares in a
company. Each share has an expected
value of $150 in the long run, but in the
short run can trade at any price.
Say the stock falls to $100 a share—low
enough to force one of the hedge funds to
rush to sell its entire holding, perhaps
because its investors panic. The trouble is
the market for the stock is not very liquid.
The slow-money crowd will buy two
shares per day but the price must get
cheaper by $2 a day to induce them to
trade. In a world without predatory trad-
ers, the distressed hedge fund manages to
sell its stock over five days, with the last
share going for $90.
But the other hedge fund knows the
prey is wounded. So it becomes a predator.
It joins in the selling. With only a few
buyers, it now takes the distressed seller
ten days, rather than five, to get rid of its
shares. The final one is sold for $80. The
predator is then free to buy back shares at a
lower price than he sold them for. He buys
the shares as fast as he can, over five days,driving the price to $90.
This example is adapted from the
model in “Predatory Trading”, a paper by
Markus Brunnermeier and Lasse Pe-
dersen published in 2005 in the Journal of
Finance. The model elegantly highlights
the key features of financial shark attack.
Markets must be illiquid (ie, large trades
can move prices in the short run). Trad-
ers must have limited capacity, meaning
they cannot sustain losses beyond a
certain point—for regulatory reasons,
because of redemptions by investors or
because of the psychological pain.
The authors draw out some implica-
tions. The more illiquid the market, the
more scope for predators to profit: it
takes longer for the prey to escape their
positions, so the price falls by more. The
quicker the distressed trader sells, the
fewer losses it makes. Any delay allows
the predator to trade ahead of (front-run)
the prey. The more predators there are,
the less profitable predation is.
How does the WallStreetBets episode
fit this template? The predators are act-
ing in concert, so their strategy may be
more effective. Better still, the prey are
short-sellers, who bet on stocks falling.
They are especially vulnerable: the more
the price rises, the more they lose. Their
potential losses are unlimited. And their
positions are often common knowledge.
This is why a lot of hedge funds put
their trades through several brokers in an
attempt to mask them. Even so, the
incentive for brokers to front-run a
struggling customer is hard to resist—
and not always resisted, as Mr Cramer
recounts in his book. “There was some-
thing about a dying client that sent these
brokers to go to the untapped pay phone
downstairs—all brokerage calls are
recorded—and tell their buddies.” There
really are no loyalties on Wall Street.Why the WallStreetBets crowd are able to profit from predatory tradingThe finance minister wants to hire more
experts, in particular auditors: currently,
only five of the roughly 2,700 employees of
the watchdog are auditors. A “focused-
oversight body” is to supervise complex
companies in their entirety. (The supervi-
sion of Wirecard was split between BaFin
and other agencies, some at the state, rath-
er than federal, level.)
A task force will carry out forensic au-
dits of companies suspected of fraud. Ba-
Fin’s it system will be improved. Rather
than hanging up on calls, the reformed reg-
ulator will encourage exchanges with mar-ket participants and systematically regis-
ter complaints from whistleblowers.
Not everyone thinks Mr Scholz has gone
far enough. Fabio De Masi, a member of
parliament from the Left, a socialist party,
who sits on the Wirecard inquiry, argues
that Germany needs an elite forensic team
that is paid top euro. He also wants the
agency to be independent of the finance
ministry. Danyal Bayaz, a parliamentarian
with the Greens, finds the reform “a bit
thin”. He had been looking for a mention of
co-ordination with other European Union
members. Last year the European Securi-ties and Markets Authority criticised BaFin
for its “deficient” handling of Wirecard.
Mr Scholz did not announce BaFin’s
next boss; Mr Hufeld departs on April 1st.
Jörg Kukies, a junior finance minister and a
former banker at Goldman Sachs, has been
talked of as a candidate, but says he does
not want the job. Mr Scholz says he is look-
ing around the world for a top finance ex-
pert who can mark a new start at the regu-
lator. If they are to communicate with
employees manning the hotline, though,
any foreign appointees will need to brush
up on their German. 7