Opinion

Felix Salmon

The SEC’s important case against Stevie Cohen

By Felix Salmon
July 21, 2013

Stevie Cohen is one of the greatest stock-market traders of all time. Indeed, there’s a strong case to be made that he’s the greatest. Cohen is not the greatest investor — he doesn’t really go in for buy-and-hold positions which steadily accumulate enormous value over decades. He’s not even the greatest hedge-fund manager: he doesn’t go in for the big macro bets (Soros vs. the pound, Paulson vs. mortgage-backed securities) which are the stuff of legend. Instead, he’s a trader, and while normal people pretty much understand what someone like Warren Buffett does, or what someone like John Paulson does, it’s much harder to understand what a trader does, or what differentiates a good trader from a bad trader.

Trading isn’t usually about making bets, and then cashing them in when things go as you thought they would. It’s more about understanding probabilities, seeing when securities are mispriced, taking advantage of fleeting arbitrage opportunities, being paid for providing liquidity to the markets (selling when others are buying, buying when others are selling), and, most importantly, “reading the tape” — understanding the way that money is flowing around the market, and how those flows are going to manifest themselves in securities prices.

Being a great trader is hard work: you’ve got to be constantly aware of subtle price actions in dozens of different markets and thousands of different securities. (Jim Cramer is a great example of a trader: he doesn’t have a deep understanding of any particular stock, but he knows where thousands of them are trading, and how their movements relate to each other.) What’s more, trading is hard to scale effectively. You need to be a certain minimum size in order to be effective, but there’s a maximum size too: you have to be able to get in and out of positions without moving the market so much in doing so that you end up erasing all of your profits.

Being a great trader is also increasingly difficult. 30 years ago, for instance, you could make surprisingly good money with very, very basic strategies. You could buy convertible bonds at issue, for instance, and hedge by shorting the underlying stock; or, even more simply, you could just pick a set of stocks and buy consistently at the bid while selling consistently at the ask. The buyers and sellers would pretty much cancel each other out, and you’d pocket the bid-ask spread, which, in the years before decimalization, was often substantial.

Today, however, all of those strategies have been arbitraged away by algorithms, and the result is that markets are faster and more treacherous than ever. Strategies which seem as though they’re work very well often have enormous and unforeseeable fat tails: look at the monster losses during the quant meltdown of 2007, for instance, or JP Morgan’s crazy London Whale trade.

And yet there’s still one thing which can scale, and which will never be competed away by algorithms, and where the upside is much larger than the downside: black edge.

Cohen has never been easy to invest with. He deliberately charges some of the highest fees in the industry — his 3-and-50 makes the standard 2-and-20 seem downright generous. And even then it has historically been very hard to get him to agree to manage your money. Cohen makes his fund inaccessible for a reason: he knows how hard it is to scale the astonishing results he’s been posting, year after year, and that at the margin, the bigger he gets, the lower the returns he’s likely to see.

But at the same time, there’s no way that he can run a $15 billion trading book on his own. He has roughly 1,000 employees, of which about 300 are investment professionals. And if you’re one of those professionals, you have one of the hardest jobs in the business.

The way that SAC works is that Cohen gives his individual traders, and teams, their own trading accounts, with millions or billions of dollars: the traders who make the most money get the biggest allocations. Traders get paid a percentage of the profits they make, which makes them compete against each other: in order to be successful at SAC it isn’t good enough to make good profits. Instead, you have to make better profits than any of the other traders — who themselves are some of the best in the business. If you can’t do that, you get fired. If you can do that, you get to manage ever-increasing amounts of money — plus, Cohen will mirror your positions in his own account, the largest at the firm, giving you a shot at extra profits over and above the ones generated by your own positions. In the immortal words of David Mamet, first prize is a Cadillac El Dorado. Second prize is a set of steak knives. Third prize is you’re fired.

While Cohen does still generate his own ideas, then, most of the time he outsources that function to his employees. There’s a relatively static allocation of capital between the various traders, but then there’s a dynamic overlay as well: Cohen “tags” the positions in his own account with the names of the traders whose trades they are, thereby giving every trader the opportunity to see his positions multiplied in size at any time. While his traders are moving money in and out of stocks, Cohen can be thought of moving his money in and out of his own traders’ positions. He’s not betting on stocks so much as he’s betting on individual employees, in one big zero-sum game.

As such, Cohen is much more than a simple employer/supervisor. He’s constantly sending clear and public messages to his traders, about what he likes, what he approves of, and what he disapproves of — and he’s sending those messages in the most unambiguous way possible, in the form of extraordinarily large sums of money. If he wanted to, he could withhold money, and even employment, from anybody who was working with black edge. Alternatively, he could manufacture a spurious layer of deniability, while actively encouraging, in terms of financial incentives, the one kind of trade which has the very best risk-adjusted returns.

The SEC’s decision to charge Cohen with failing to supervise his employees is, yes, a clever way to try to put together the most winnable case before the statute of limitations runs out. But it’s also a serious charge which goes straight to the main way in which Cohen makes his money. Cohen’s returns come directly from the way that he supervises and incentivizes his employees, and once you’ve read the complaint, it’s pretty clear that Cohen loves any trade which makes money, and has no particular compunctions when it comes to whether or not the trader in question is behaving in an entirely legal manner.

It’ll be interesting to see Cohen’s defense to these charges, but he has an uphill task ahead of him — especially given that the hearing will be held in front of the SEC’s own judge. The SEC has home-field advantage, here, while Cohen oversees a firm which has seen four different traders already plead guilty to criminal insider-trading charges. It’s good that the SEC has finally managed to charge Cohen personally, rather than just his traders. The only pity is that we’re still a long way from a criminal case. That might yet come, but I’m not holding my breath.

Comments
7 comments so far | RSS Comments RSS

So let’s say I have $5 billion is assets that I made by selling some company, and I don’t want to spend much time figuring out how to manage or grow that pile of wealth. So I hire a couple dozen or so advisers, allowing each of them to invest hundreds of millions of dollars, and I ultimately allocate the largest amounts of money to the best ones. They tell me who they are speculating in, but they don’t get into the details. Am I guilty of not supervising them if one or more of them uses inside information to enhance their performance (we have PEDs for athletes, maybe we should call inside information PEI)? How is that different from what is happening to Cohen?

I’m not defending those who use private information to beat the system, I just don’t think it’s the biggest crime in the financial industry. It’s great for headlines, and for creating the illusion that the government is doing something for the “little guy”, but it’s really just shuffling deck hairs on the Titanic.

Posted by KenG_CA | Report as abusive
 

You want to define “black edge” a little better?

Do you mean “insider trading” only?

Or is “the trader understands this better than others for some special but legal reason” included in this same idea?

Posted by BryanWillman | Report as abusive
 

Ken – I am not an attorney, so take my perspective with a grain of salt.

Regarding the basic question, “could the SEC come after you under the same failure to supervise provision as Cohen”?, the answer is no. The complaint against him is under the Investment Advisers Act of 1940, which only applies to those managing 3rd-party money. That wouldn’t apply to you since you shouldn’t need to be a registered investment advisor to manage your own money. I also believe that a manager of third-party money has to meet a higher legal standard regarding regulatory compliance with all securities laws – not just insider-trading law – than someone in the position that you describe.

That said, there’s a lot of caveats to which I don’t know the answer. Would there need to be a firm that’s a registered investment advisor somewhere in the chain to employ these people hired to manage your money, or can you just hire them directly? If you just hire them directly, do you face other sorts of civil liability such as a greater presumption that everything that they do is on your behalf? (The latter being similar to the way that companies face civil liability for the actions of their employees.) At a minimum, I think – though I’m not certain – that it would be fairly easy for the government to win a civil case forcing you to disgorge any profits from insider trading done under this arrangement.

Posted by realist50 | Report as abusive
 

It is really difficult to reconcile Cohen’s value to anything positive. Forget the technical and legal aspects of this particular case. This is skimming. No value is added. The concept of market liquidity is spin. Black edge? Wow the rebranding of pure cheating, insider trading, is loathsome in and of itself. Let’s do this, tax “traders” at 79% and forget the oversight and prosecution.

The planet is overdue for a de-worming.

Posted by rlindsl | Report as abusive
 

The set up it one that provides protection to the QB. Cohen is aware of everything going on, he sets the tone everyone working with him all have their eye on the same ball , make all you can ,play on the edge , do not get caught , protect the firm and especially the boss. No different than most organizations , the players know what is accepted what not to run by the boss. The boss knows the climate and avoids asking some questions ,which is part of his own protection.
The SEC has no choice , they must go right to the top or look completely ineffective

Posted by william117 | Report as abusive
 

I wonder whether, if he’s fined, he’ll be able to claw back commissions from the employees responsible for the trades that looked profitable at the time but proved very, very costly.

Posted by dWj | Report as abusive
 

While the government can show a clear pattern of abuse by at least 3 of his 300 investment professionals, he can dump reams of legally justifiable securities research of why they entered and exited every one of tens of thousands of positions.

In my view this gets back to the difference Felix often points out between US and UK laws:

Did Cohen violate the spirit of the law by hiring well connected individuals, strongly encourage them to use and even create expert networks which by their nature were on the edge of the law while at the same time force them to sign ironclad code of conduct contracts swearing never to use insider information. Absolutely he violated the spirit of the law.

When you get to the technicalities none of it sticks to him. After reading the complaint I think he’ll walk if he is tried by a jury of his peers.

Posted by y2kurtus | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •