Saturday, February 26, 2011

Ouch! Deutsche Bank Sanctioned by the Korea Exchange (KRX)

Deutsche Bank AG Fined by the Korea Exchange (KRX)
The Korea Exchange has levied a record KRW 1 Billion fine against Deutsche Bank AG, one of the world's leading global investment banks.  The reason?  Program trading during the last minutes of November 11, 2010, when the KOSPI sank by over 2.5% within the last 10 minutes of trading.  Why is that date important?  It is important because certain financial contracts (futures, options, and options on futures) all expired on that date.  The alleged misconduct was due to the fact that Deutsche Bank failed to report its activity within the allotted time near the market close.  It is alleged that Deustche Bank's proprietary trading group sold a great amount of equity which triggered a rapid, unexplained decline in the overall market, and Deutsche Bank profited for its own account during that time.  There are multiple lessons to be gleaned from the event, and the punishment.

Program Trading Exists in Every Large Equity Market
Large banks, hedge funds, and other money managers actively use program trading, which are computer-generated actions that result from a simultaneous scan of the entire market at once.  Every firm's program trading algorithm, or set of trading rules, uses a slightly different set of factors in making buy or sell decisions.  Some have suggested that program trading gives an unfair advantage to the firms that deploy such tactics.  Guess what?  That happens in every market, and in every business.  The most profitable grocery store is the one that has the best prices for the supply of goods that it sells.  It isn't program trading, per se, that is the culprit here.  However, as readers will see below, that is, in fact, what is being indicted.

Late Reporting of the Activity is the Cause of the Fine.  This Matters?
Now this is pretty flimsy.  It is said that the KRX has fined Deustche Bank for filing its disclosure of activity one minute late.  This leaves more questions than answers.  Does this mean that market participants are watching the disclosures themselves for information regarding whether or not there are these automated programs at work?  In other words, lets say you are an investor.  Are you looking to the KRX for the disclosures in order to get an advantage in the market?  Let's say now that the market begins to move in one direction or the other.  You ask the KRX for the information, and it says that there is no report of a large program trading execution in the market.  You as the investor have three choices.  Buy, sell, or hold.  But, those are the same three choices the investor had 10 minutes ago.   By the way, does anyone believe that Deustche Bank was the only active, competent participant in the market at that time?  There is zero chance that the answer is yes.  There is fierce competition all the time among market participants.  In other words, there are equally smart and qualified people at other companies, in Korea, that would have had the ability to buy what Deustche Bank was trying to sell.  Did Deutsche Bank break a rule by being one minute late in its report?  That is a matter of fact, so you would have to presume the answer is yes.  Did the one minute late report cause the market decline with no other buyers?  Not unless everyone in the Korean equity market only looks for program trading execution to get its clues, i.e. the short answer is no, it is highly improbable.

This Boils Down to Bad Rules and Illiquid Markets
When there are many buyers and sellers, and you can buy or sell securities rapidly in large amounts, it is called a liquid market.  It is most likely that the KRX is using the 1 minute violation to fine Deustche Bank for taking advantage of an illiquid market.  That is what they are supposed to do.  If you were a stockholder of Deutsche Bank, then you would have been happy to know that Deutsche Bank was smart and fast enough to do this.  You don't hear about Hyundai-Kia shareholders complaining about the fact that Hyundai has gained market share as Toyota is suffering from quality problems, do you?  Deustche Bank should have followed the rule of giving the information one minute earlier.  There is no doubt about that.  Is that what is being punished here?  No.  This is another rule on markets which is being used against a large bank when governmental officials discover a weakness in the market structure.  Again, that activity happens all the time in every financial market and every other type of market.  It is the fact that Korean regulators deemed it inappropriate activity, and found the loophole by which it justified the punishment.  One minute late.

The Punishment is Onerous, the Deterrent Hurts Who?
It is not the USD $1 million fine that matters in the least.  It IS the six months' time when Deustche Bank must cease proprietary activities in Korea.  Now that is a large problem.  That will clearly cost Deutsche Bank.  Their financial reports do not itemize the source of revenues, but the lost revenue will be many, many times the paltry $1MM fine.  The question that remains is whether or not there is a deterrent?  Well, certainly no firm will report one minute late to the KRX.  However, the real question is whether or not advanced financial firms will want to continue to pursue their activities which support the advancement of the financial industry in Korea.  It is suspiciously convenient that the KRX has used the "one minute late" reasoning to punish Deutsche Bank.  If there are position sizing limits that have been violated, then that is another matter.  However, that has not become public record as yet.  "Naked" or unhedged positions does not seem to part of KRX' charges.  Let's put this another way:  if the market went up by 2.5% during those 10 minutes, would there be this type of charge?
The Seoul Gyopo Guide has been created to pursue the central theme that as Korea matures, the rules and the effects will be different, and Korea must adjust to a larger world with competent, global competition.  In this case, the KRX has proven that it can hand down harsh punishment.  The question is whether or not it can prove that it is a justified punishment.  "The market went down" isn't a defensible reason, so this story is nowhere near being completed.  It will be very interesting to see how the facts get told and how the fines get justified.


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