Relationships and Transactions, Clients and Markets
The Goldman Sachs story, such a headliner only weeks ago, is suddenly yesterday’s news, swept away by news of oil slicks, a trillion-dollar Euro bailout, and a hung jury in the UK.
Too bad, because I think there’s a deep lesson for us to learn. I for one haven’t figured it out. So I really want your help here. Those of you with a talent for economics and social sciences, please log in and comment on the following: I’m still trying to work this one out.
Trading Business is Crowding Out Client Business
Goldman Sachs went public in 1999. Many of us still think of it as an investment bank, involved largely in M&A work, advising companies on strategic decisions, and managing assets.
But in recent years, the company has become dominated by the business of trading. In 2009, 76% of its revenue came from its trading group. (Not coincidentally, so did its CEO Lloyd Blankfein). Investment banking revenue was only 10.6% of revenue last year, having declined in dollar and percentage terms the last two years.
Goldman Sachs is not mainly an investment bank, and hasn’t been for some time now. It’s mainly a trading organization. Yet it hasn’t come to grips with that fact—nor have the rest of us.
Goldman’s Annual Report proudly lists its 13 Business Principles. The very first of them is: “Our clients’ interest always come first. Our experience shows that if we serve our clients well, our own success will follow.”
A lofty principle indeed. But how well does it apply to a trading business? Let me suggest—not well indeed. Goldman’s answers under oath in front of Congress showed their discomfort with the conflict between their past principles and their current business model. To a great extent, their answers about trading business boiled down to ‘caveat emptor.’ Which, I would argue, is not such a crazy answer at all when it comes to a trading business.
Goldman has gotten a bum rap for being accused of violating its client-focus principles in its trading business. The fact that they can’t articulately defend themselves doesn’t make them any less prescient than the Senators who berated them with equal lack of clarity.
Relationships vs. Transactions
In Sergio Leone’s The Good, the Bad and the Ugly, Eli Wallach’s character Tuco was fond of uttering statements beginning with, “There are two kinds of people in this world, my friend—those who __, and those who ___.”
To borrow Tuco’s construct, there are two kinds of businesses in this world: transactional, market-based trading businesses, and relationship-driven, client-focused businesses. Wall Street trading of CDOs, derivatives and SUV’s are of the former type; investment banking is (used to be, anyway) of the latter.
A friend tells me how he was recruited from college to trade bonds on Wall Street:
"There were 20 of us in the room. The recruiter came in and yelled in a loud voice, “Who here runs on fear and greed?’ Me and my pal timidly raised our hands; the rest were shocked. ‘The rest of you can leave,’ the guy said; ‘I’ve got my boys right here,’ pointing to me and my buddy. And I never looked back."
Most of the massive growth in the share of GDP that the financial sector has claimed in recent years—I think—has come from trading. (Data, anyone?). But it’s not Wall Street alone.
The ‘trading’ model has been the darling of Chicago economists, CNBC commentators, corporate strategists, ideology-driven MBAs and at least one major US political party for several decades now. It has been applied, with varying degrees of success, to running social institutions from prisons to elementary schools to public sector pension funds. Monetize it, put it out for bid, incentivie it, and let the cleansing forces of markets work their magic.
At the same time, we have become much more aware of the importance of ongoing relationships in business. Concepts like loyalty, holistic supply-chain management, CSR and corporate culture are moving us in the opposite direction—humanizing business, or least trying to connect society with business.
The Model of the future: Trading? Or Client-based?
What happens when these two worlds collide? Think of Match.com–a market-driven approach to highly personal relationships.
As the world becomes more interconnected, these two views of the world come into conflict. In finance—in which innovation has been forgiven if it increases ‘liquidity’—interdependence has come to be a curse. Push on one block in an interlinked trading world, and you get systemic chaos. The liquidity isn’t always worth the stress.
On the other hand, if you’re not careful about client-based industry models, you get corruption, sloppiness and lack of innovation.
I’m trying to figure out the principles that suggest when we need one, and when the other. It’s got me a bit stumped, to be honest.
But here’s what I do know. Market-based, trading-based industry models should never again be confused with free-range, unregulated operators. No doubt there were peddlers of poisonous snake-oil who thought the creation of the FDA was a major step toward socialism. They were wrong, much as the laissez-faire critics of financial reform are wrong now. Their argument is always the same: the public just needs more education.
No, it doesn’t: it needs fairly regulated casinos, lotteries, markets and trading exchanges. Nothing wrong with caveat emptor as long as the rules for entry to the casino are clear. (Don’t forget: the natural and quick result of an unregulated market is a monopoly. Pure competition is highy unstable.)
But even more, the pendulum needs to swing. Trust in trading businesses is limited to things like transparency of data and track records. Quantifiable, metricizable trust has got its limits, humanly and economically. Useful? You betcha. Plenty of legitimate business operations need clean markets to hedge plenty of business uncertainties. But that’s still pretty narrow trust.
Trust in relationship businesses is far richer and deeper, because it deals with the people for whom business is supposed to be operated. Here you’re talking about motives, relationships, connections, synergies, collaboration. Not only more meaningful, but economically far richer than the zero-sum I-win-you-lose nature of trading transactions.
We need more of that kind of trust.
You’ve squeezed a bunch of different ideas in here.
With investment banking trading is a necessary part. The bank will advise the company on structuring and then help sell those securities. For an IPO, they help structure the company and prepare the disclosures. Then they sell the shares. You get advise + trading. The I-bank will help make the market for those securities, and stay active in the trading for liquidity.
Goldman’s failure was that they helped structure junk and then sell the junk. They knew the stuff in the Abacus CDO was junk and it was structured to fail. You can argue whether there was adaequate disclosure and whether the buyers were sophisticated enough to take their own view on the quality.
If the CDO was an operating company, would Goldman help it sell shares in an IPO if they knew the company was designed to fail? Definitely not.
Just because you CAN sell something it does not mean that you SHOULD sell something. Goldman Abacus transaction was definitely a failure of trust, perhaps unethical, maybe even illegal. (The latter two are much more dependent on exactly who said what to who.)
There is inherent conflict in whether someone is selling you something or advising you to buy something. Sometimes the buyer does not know the difference. Sometimes the seller does not know the difference.
I was going to protest that trust in transactions and relationships need not be mutually exclusive. That’s the enternal optimist in me. Then I read the last three paragraphs of your post and got thoroughly disabused of my convictions. I may have to admit you are right; it is pretty narrow trust on the transaction side.
A good friend who understands this stuff much better than I pointed out that Goldman’s behavior is nothing new. They got in trouble for the same type of activity in 1920. Even today they have a lot of company with Merrill Lynch, Morgan Stanley, Lehman and UBS engaged in the same type of transactions. The stark reality is that they get paid to make these transactions; they don’t get paid to worry about the impact on their clients. The markets are, and have been for decades, stacked against the non-institutional investor, so there is little history for generating trust.
Anytime you trade for your own account while managing money for clients, there is going to be a conflict of interest. That inevitable conflict will challenge one’s moral view of themselves and their commitmemnt to trust – if they have any. One additioal factor, at least for Goldman, is that they are also a market maker, creating and selling and then hedging their own positions. This is where the conflict and moral issues reach their heights and the abuse often surfaces.
The only waty to stop the potential for abuse – and it is aguable that it is such a mess it can’t be stopped – is to (a) require fuller disclosure each trading day, and (b) force the "players" to separate their market maker activities from the rest of the business. Even then, conflicts will likely arise, but maybe with less severe consequences.
Bottom line (again from my friend): For the transactional business there is too much mony at stake to let morals or trust be a roadblock. Buyer beware is the railroad that Wall Street rides and that makes everything OK in their eyes.
Just shows that we have a lot of work to do and blogs like this are a starting point along with the MBA oath and a host of other things we have yet to discover.
In spite of it all, I intend to stay optimistic and cling to my belief that trust does not have to be mutually exclusive when dealing with transactions and relationships.
Make it a great day.
Doug, Lance, Jim–
Thanks, I learn from all of you. Keep on talkin’.
Great post and discussion. I am not sure I have insight into the economic data. But, I have observed the dialog around the move to transactions vs. relationship (and the pendulum swing back).
I have had several conversations over the years regarding the idea of moving my business on "rational terms" to the best quality at best price. Begining with the move to