MONDAY APRIL 19, 2010

Definition of a Market Maker

If you think about it, every trade on Wall Street is a bet on the direction of the price of something.  And there is always two sides to a trade, bullish and bearish.  The underlying security, whether it is a commodity (oil),  a stock (IBM), a bond (Treasuries or Mortgages) or some derivative of these securities, is not important.  The job of a market maker is to get both sides of the trade together.  The market maker doesn't and shouldn't really care what side of the trade an investor takes.  Their job is to match one investor with an opposing trader.  For that service, the market maker collects a fee.

Most markets like the NYSE and the Chicago Board of Exchange exist for this very purpose, creating one location where buyers and sellers can gather and trade.  One of the explicit benefits of these exchanges is the lack of transparency.  That is, one's identity is unknown to the other side of the trade.  Indeed, if the NYSE exposed the indent of its traders, it would be breaking the law.

The same rules apply to the over-the counter (OTC) markets, such as the NASDAQ for stocks and the derivatives markets.  On Friday, the SEC announced it was filing a civil complaint against Goldman Sachs involving the trading of synthetic Collateralized Debt Obligations (COD's).  CDO's are "structured" products," meaning they can be manufactured to make very specific bets on a particular security, asset class or commodity.  Goldman Sachs was a market maker in these products.  One of the SEC's complaints is that Goldman failed to disclose that the now famous hedge fund manager, Paulsen & Co. was involved in the "structuring" of a CDO that was sold to another institutional investor.  While this may sound scandalous, it is pretty standard. An investor approaches a market maker looking to make a bet using a structured product.  In this case Paulsen was bearish on the subprime mortgage market.  Goldman would need to find another investor that was bullish on the subprime market, which by the way, was performing well at the time.  That investor was ACA Management, which was ultimately owned by the Royal Bank of Scotland.  Yes, Paulsen was involved in the structuring of the CDO.  But so was ACA.  This was standard operating procedure in the structuring of these products.  Indeed, it appears there was a great deal of horse trading on the underlying securities in the deal and that ACA had the greater say in the structuring largely because they required the deal to receive a particular investment grade from the rating agencies (sound familiar?).  And if they were bullish on real estate, they had an incentive to structure the deal with the weakest securities, as their bet was that real estate would perform well and it would garner the most upside. 

Now, after the fact, Goldman is accused of hiding the Paulsen presence in the deal.  The presence of the now famous Paulsen name is scandalous.  We now know that Paulsen made $1 billion on his correct bet against subprime.  Yet, my guess is very few knew the Paulsen name at the time of the case.  In my opinion, Goldman, as a market maker, had an obligation not to disclose the Paulsen name.  This is clearly standard operating procedure for a market maker, even in the sophisticated world of structured products.  The horse trading that occurred was also standard operating procedure.   Ultimately, AKA was a big boy, a large institutional player in the structured CDO market.  The notion that Goldman Sachs and Paulsen & Co hoodwinked poor AKA is silly and, in my opinion, detrimental to the market.  Goldman Sachs performed its duties as a market maker.  The fact that there was a big winner is not relevant.  Indeed, I believe that the moral of this story is that the institutional investors have a duty to conduct proper due diligence.  In this case, AKA clearly didn't fulfill that obligation.

In my opinion, the SEC is barking up the wrong tree.  In this case, Goldman acted as a market maker.  Where I have a problem is that market makers, Goldman and many others, not only acted as market makers but also as a player, often taking sides on these structured products.  It is hard to be both player and referee at the same time and it is unimaginable that the NYSE would take positions.  At a minimum, it has the potential for conflicts of interest and this needs to be addressed.  Ironically, Goldman Sachs is said to have lost $90 million on this particular transaction.  If they were purposely structuring a losing product, it is hard to explain why they would have taken a long position on this deal.

POSTED AT 1899-12-30 09:01:00.0

KEN ENTENMANN, CFA
SENIOR VICE PRESIDENT AND
THE DIRECTOR OF INVESTMENT MANAGEMENT SERVICES

Ken is a Senior Vice President and the Director of the Trust and Investment Services at Alliance Bank, N.A. He has 23 years of investment experience and oversees the management of assets totaling $1 billion. He holds a B.S. in Applied Economics and Business Management from Cornell University and an M.B.A. from the William E. Simon Graduate School of Business Administration at the University of Rochester. He has also earned his Chartered Financial Analyst designation. He is a member of the Executive Committee of the Trust Division of the New York Banker's Association. He is also a director of the Central New York Community Foundation.

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