Kamakura Blog: The Myth of Chinese Walls in Finance

“The Great Wall of China” is often invoked via the phrase “Chinese Wall” when people in finance want to describe, convincingly, the fact that there are barriers in place to prevent the flow of information from one part of an organization to another, no matter how great the financial incentive is for that information to make the move the Chinese Wall in intended to prevent.  Ironically, the Chinese Wall concept didn’t even work in China, for the same reason that they don’t work in finance: when two people on either side of the Chinese Wall want to render it ineffective, the Wall fails.  In 1644, for example, Beijing fell soon after “the gates at Shanhaiguan were opened by Wu Sangui, a Ming border general who disliked the activities of rulers of the Shun Dynasty” as noted in this Wikipedia entry:

http://en.wikipedia.org/wiki/Great_Wall_of_China

Assertions of working Chinese Walls, presumably with no gates, are legion in finance.  Years ago there was allegedly a barrier between research and investment banking on Wall Street, but this “Chinese Wall” is so diminished in height that is rarely mentioned today.  Research analysts’ stock assessments are so positively biased that independent websites like http://stock.ly have arisen to democratize research analysis on individual stocks.

The one area where assertions of a Chinese Wall are still strident is the “Chinese Wall” between risk advisory services and fund management at some very large investment management firms.  Twenty five years ago, when Salomon Brothers first launched its product “Yield Book” to help clients manage their portfolios, my colleagues and I at First Interstate were rendered speechless.  We thought it was like asking a shark to take care of your gold fish, and we couldn’t imagine why investors weren’t worried about the intense conflict of interest, contained only by a Chinese Wall with lots of gates in it.  As China learned the hard way in 1644, it only takes one person to render the Wall useless.  For this reason, my firm Kamakura Corporation offers risk management services and software but owns no securities other than a money market fund because we want no hint of conflict of interest with our clients, who manage more than $5 trillion in assets using our risk management products.

Over the years, I’ve come to the conclusion that people who believe in Chinese Walls are very sincere and unbelievably honest people.  I like to think I am one of those people too. Too often, however, someone who is scrupulously honest is like Virginia’s friends: “They do not believe except they see. They think nothing can be which is not comprehensible by their little minds.”  If you are honest yourself, the odds are very high that your friends and co-workers are as well.  It can be incomprehensible that someone you regard as a peer can look you in the eye, tell you that there is a Chinese Wall, and then have that turn out not to be true.  Alas, it only takes one person to open the gate in any Chinese Wall. In China, it only took one person out of hundreds of millions to be dishonest and to destroy what the Wall was intended to protect.  That’s why Chinese Walls that are formed of human beings, not bricks, rarely work for long.

Michael Lewis has spent 25 years chronically the fact that, just because people on Wall Street wear suits, it doesn’t mean they’re not crooks.  Take, for example, The Big Short, which has been topping the non-fiction best seller lists for most of 2010.  Independent investors who believed that home prices were going to crash and take mortgage-backed securities down with them bought credit default swaps on these securities before the market plunge was widely recognized.  What happened?  For months and months and months after the market plunge started, these investors were told that their credit default swaps were not showing a gain.  Why?  The reason with hindsight should have been obvious.  The institutions which sold them the credit default swaps initially had the opposite view of the market—otherwise they would have done the trade for their own account.  Within any large financial firm, there is supposed to be a Chinese Wall between traders and those who mark to market their positions, but once more it did not work.  The traders were long mortgage-backed securities, and if the correct market value were put on the independent investors’ credit default swap, the investors would show a gain and the traders would show a loss. The traders, obviously, had a huge financial incentive not to show a loss, and some little birdy must have carried that information over the Chinese Wall to the valuation group. As The Big Short relates, the independent investors were unable to get a fair valuation put on their credit default swap until the position held by the traders finally switched from long mortgage backed securities to short mortgage backed securities.  All of a sudden, the traders had a huge financial incentive to show a gain on the CDS position held by the independent investors and they did.  A little birdy carried that information over the Chinese Wall again.

“Oh, that couldn’t happen at ABC Company.  The valuation and advisory group is a different group of people sitting in a different building.  They wouldn’t do anything like that.”  Hello?  Alexander Graham Bell patented the telephone in 1876.  People go out to lunch.  In one of my favorite scenes from Lawrence G. McDonald’s story of Lehman, A Colossal Failure of Common Sense, he and a colleague at Lehman were able to get valuable information on Lehman’s mortgage backed securities underwriting standards simply by hanging out at the right restaurant bar in Newport Beach, California, close to the headquarters of that “different group of people sitting in a different building” 2,500 miles from where Larry McDonald’s office was.  They didn’t even have to buy the guys’ lunches.

“No, really, I know the people at ABC, Really, they’re not like that.”  I used to think like that too.  Then over the course of my career, I saw things like this happen before my very eyes at the hands of people I initially though were “not like that”

• Mr. X, a prominent fund manager at a blue chip investment banking firm, stole the Empire State Building with his wife.  30 seconds on google will convince you I’m not making this up.
• Mr. Y, a prominent investment banker in New York and London for two firms whose names you know, spent 10 years in prison.  I found that out after using the internet to understand that gap in his resume
• Mr. Z, a former co-worker with a Ph.D. in physics from one of the best universities in the United States, was convicted of insider trading after moving into the risk management function at a listed financial services firm

Last but not least,

• Mr. XXX, a very talented IT professional from a prominent financial firm, went to prison for black-mailing the chief aide to a governor of one of the 50 states in the U.S. because the aide had been, um, impolite to an internet “girlfriend” that Mr. XXX cared for but had never met.  I’m not making this one up either.

Some readers are still shaking their heads, saying “Just because I show them my portfolio doesn’t mean they are doing to trade against me.”  Kind reader, I hope you are not really sincere in that belief.  If so, you need to read this blog entry from a few months ago:

van Deventer, Donald R. “Mr. Smith goes to Wall Street and Buys a Rolex,” Kamakura blog, www.kamakuraco.com, May 25, 2010. Redistributed on www.riskcenter.com on May 26, 2010.

“But you’re wrong.  There is a Chinese Wall.  It’s working.”  Right, just like the Great Wall of China worked until 1644, when one person opened the gates and Beijing fell.  When you are playing cards with card sharks, they let you win the first few hands.  My best advice is to remember this phrase from Larry McDonald’s fine book.  “If you look around the poker table and you can’t find the sucker, it’s probably you.”  Virginia, there is no Chinese Wall.

Donald R. van Deventer
Kamakura Corporation
Honolulu, August 23, 2010