of Cornell University Library. MAUREEN OHARA: Thank you all

for coming out this afternoon. And thank you for inviting me

to give a Chat in the Stacks. I think its a neat idea. And when I was asked, I

about modern finance and what has been described to

me as an ethically challenged field. And its hard to

in this years global ranking of trust in industries. A recent Harris poll found

68% of people surveyed disagreed that, in general,

moral as other people. Bloomberg, in a poll that

just came out in July, found only 32% viewed Wall

Street banks favorably. We were delighted to see that

Congress came in below us at 29%. But insurance companies

oh, thats not true. But after a while, when you

started seeing poll after poll, you begin to wonder if theres

not something out there. Heres another one

survey fell back down. Were at 27%, which,

might beat us on this one. So its disconcerting. And its one of the reasons

two issues that I think are reflected in this. The first one is the one that

is a bit trickier to deal with. But I think most

people dont actually understand what modern

finance is and how it works. And I think modern

finance, in many ways, really dates from the 1990s on. And as you think about what

we do in finance today, its not what people

a level that well call the educated layman

could read and really understand what we do. When you read that Goldman

Sachs get sued for fraud and they used something

called a synthetic CDO, what in the world did they do? Most people really

cant understand that. But actually, its

tried to do in the book was give people an ability to

be able to think about that. The second problem may be

theres too many finance practitioners who do not

understand or even recognize that there is an ethical

explanation because we teach finance like engineering. Its a tool. So you want me to build

a contract that does x? No problem. I will build that contract. You want me to

build something that can get around this pesky little

law that says you cant do x? No problem. I can build something

thatll go right around it, and no problem. And if you think about

that for a minute, its like, wait a minute. Maybe this has led

should do something. So I think weve begun, as the

finance academic community, to rethink this. I think the banks have begun to

rethink this because theyre up to $323 billion in fines

worldwide and $160-some billion in the US alone. So its gotten to be

the ethical issues. So you might ask, why? Why is this happening? And I just thought Id

share a couple of heres a theory that

the bad people theory. This is by Judge Richard Posner. He argued that basically, firms

that have short-term capital they have to

compete ferociously. They know that its

a jungle out there. And so as a result, the business

model of those sorts of firms, which he defines to be

individual financial consumers, difficulty so many ordinary

people have in understanding whats going on here facilitate

financial sharp practices, enabling financial fraudsters

to skirt criminal sanctions. So when you first read this,

its like, well, I dont know. And then the second

who work in finance as financial fraudsters. And I think that

an alternative view that I developed in this book. And its that arbitrage

explain arbitrage a bit more in a minute. But modern finance is not

really, as I mentioned, about traditional contracts. Its about cash flows. So whether those

on bonds, or theyre cash flows coming from

dividends on stock, or theyre cash flows coming

flows coming any I dont care where the

cash flows are coming from. Those are the building

blocks of modern finance. And we dont tend to look at

things as, lets take these think of this as taking these

cash flows and these cash flows. And we put them together. And maybe we added an option. And we added a

do that, and voila. We create something. So you tell me the

contract you want, and Ill create it using cash flows. The problem is, in the

process of doing so, the ethical dimensions get lost. And thats part of what I want

to try and do in this book is first make it

works and then talk about those ethical dimensions. And again, I particularly

like this little cartoon. I dont know if any

at a Mexican restaurant. Theyre the ones

giving the chips away. If they dont see the arbitrage

society only functions because we generally avoid

taking these people out to dinner. I really like this, right? Stealing chips from

Mexican restaurants is really theres

no law against it. But its just not done. And I think there are

lots of things out there that fit into that category,

and particularly in finance. And so as we think about this

role that arbitrage plays, I want to make it a little

bit clearer that arbitrage is more than just buy

arbitrage is you have the same good trading in two

places at different prices. So if you remember back some of you it will be easier,

some of your less easy some undergraduate

about gold in London having one price and gold in

New York having another price. So you sell where

its expensive, and you buy where its cheap. And thats an arbitrage. And when you have the same

good trading in two markets at different prices, then when

you sell it at the high price and buy it at the low

price, what have you done? You basically have gotten

something for nothing. You were able to arbitrage. And in the process, you bring

the market back in line. Thats certainly still true. Thats classic arbitrage. But its more than

that now because now what were going to do is in modern finance using the

tools of modern finance, which are things like swaps, which

are things like credit default swaps, which arent

actually swaps at all theyre actually options. But using derivatives

and other sorts of ways that we can change cash

flows, what we can do is we can look at something

synthetic version. So Ill give you an example. Suppose you wanted to hold

youre running a big insurance company, like TIAA. And you want to buy AAA bond as

an investment, nice and safe. great investment for

an insurance company. But whats the problem? We only have two AAA

companies in the entire United States now. Back when [? Jean ?] was in

school and others, we had 180. But we have two, right? Those are Microsoft

and Johnson & Johnson. So if every insurance company

wants to buy AAA bonds, the yields will be negative. But heres the good news. We can make more. We can synthetically

swap and a little bit of financial magic. So what you can do in this

new world of finance is great. It can do really neat things. It can create products

for a company like TIAA that allows us to better

hedge the risks over time so that when you retire, youre

going to have this big lump sum of money or big we hope

annuity that youll take. So the tools of finance

build synthetic versions of the contract that you want. So where does arbitrage come in? Im going to create

this synthetic IBM bond. And I have a real IBM bond. And arbitrage keeps the two

prices in the same place, just like the gold in London

and the gold in New York. So arbitrage is going

to be extraordinarily important in this world. Were going to build

synthetic world is everywhere. But the notion of arbitrage

theory is built on the concept of arbitrage. And when we teach our

students, we often are teaching them to look for

opportunities to arbitrage and make markets more

efficient and yourself richer in the process. So think about the

LEGO idea as were going to use these cash flows. All these little LEGO

pieces are cash flows. And were going to build

what it is that you want. But when you do that, its not

always easy to see the lines. For example, was

via financial engineering unethical? Its a really

these rather complex swaps to be able to take debt

underneath the rules that said a country couldnt have

more than this percent debt on their sovereign

a way to do that. Was that ethical or not? We can talk about that later. Whats that? AUDIENCE: [INAUDIBLE] MAUREEN OHARA: Well, well

talk about that one later. Its an interesting question. And well come

back because I know this is of particular interest. Heres one. Was JP Morgan manipulating

the California energy market? Or were they optimizing against

allow me to do it, so be it. If you dont like the

outcome, change the rules. I think thats missing

a lot of points. And were actually going to

look at the JP Morgan Chase in a minute to show you

through a variety of these. And we try and figure it out. Are HFT strategies designed to

take advantage of other HFTs ethical? Some of you may have read

Michael Lewiss Flash Boys. Michael Lewis was

should be banned from the face of the Earth. But whats interesting is that

most finance professionals like myself think that what

he picked on in the book isnt a problem at all. There are problems. He doesnt know them. So were going to come

back and talk about them. But the point of this is

that some of these things are tricky. Its not like if I said to you,

is it unethical go rob a bank? I think everybody

widow, an orphan a security thats worthless? Youd say, yeah, thats

probably unethical. Theyre easy ones. But once you get into the

world of natural securities and synthetic securities

and, tell you what well do. Well transform this cash flow. And well do that. And well move it over here. And well do that,

of what happened to the ethical guidelines. So what are we

or the weasels. Its not exactly illegal. Im actually teaching our MBAs. And the phrase, its not exactly

illegal, should be, I think, a red flag. Maybe this is not

your business. So whats our quest? Our quest is to eat all those

really good-looking cookies. But in the process,

were going to sort out the positive effects of when

finance actually generates something for nothing when we actually

can make everybody better off using these tools

lead to the opposite outcome, where the financiers take all

the gains and society pays the cost. And thats really what I think

finance has to strive to do. So whats the book do? Well, for those of

you who dont maybe know modern finance,

in about two chapters, it tries to tell you how

modern finance works. And as I tell friends of

mine who are not in finance in any way, shape, or form I say, look, if you

little lost, just keep going. Ignore the chapter for now. Youll come back to it later. And head into the

you what swaps are and all sorts of things. And then it sets

out some frameworks for evaluating the ethical

limits of arbitrage. And I think this is tricky

in that we dont normally think of ethical buying

low and selling high is not a moral decision. But using arbitrage to get

around legal rules, using arbitrage to be able to

take advantage of someone because its so

complex they have no idea what youre doing that has a moral dimension. And then what were

ventures into the gray. And so its a series

of chapters that looks at essentially arbitraging

the complexity, arbitraging for deception, arbitraging

for a variety of things. Theres a whole bunch, almost

like little vignettes and case studies, including

to make a confession. Im a big football fan. It just shows you what kind

of patience and forbearance I have. Im a Bills fan. I know. And its not been easy, has it? [INTERPOSING VOICES] MAUREEN OHARA: I

dont like hockey. So anyway, one of my favorite

things on TV in the old days was when you watched

Monday Night Football. They had those little segments

called You Make the Call. And theyd show this play. And they say, well, did

this violate the rules? And I loved that part. So I wrote this part of

the book thinking of that. You make the call. I tell you what happened and

then set out what happened. And then you make the call. Did this cross the line or not? And then I offer my

again, if its easy, you dont need to ponder it. And so thats part

fog and talk about how to make finance more ethical. So thats the

to give you a taste of what were doing today. Im not going to explain

because I have found thats a little dry

in a setting here. Im actually not going

because not everybody looks at the world the same way. But theres a surprising

bring that out in the book. And then what I am going

you make the call and explain a little bit about

some of these ethical issues and where they emerge. And then well briefly conclude. And then well open it up

and talk about whatever people want to talk about. So before I get

little bit about why. And again, why do we seem to

have these problems in finance? And I really dont

like the crappy people work in finance theory. It may be true. But I dont believe it because

Ive worked in a lot of places. And most of the people

view themselves that way. But why does it happen now? Why didnt it just happen

in the 1920s or whatever? Maybe it did. It might have. It might have. AUDIENCE: Wasnt there

the crash of 19-something? MAUREEN OHARA: There was. But I think some of

pretty unique to today. But let me talk about why

almost everything today takes place in markets. The largest lender in the United

States now for mortgage loans is Quicken Loans. You do that on the web. You dont meet anybody. You dont shake hands

have is that a lot of what happens in finance is complex. So you have what we call

delegated behavior agency problems. The quant who restructures

interacts with the client or the senior guy who put

the whole thing in place in the first place. And the question is,

the answer is none of them. The other problem are complexity

of products in corporate form. Goldman Sachs has 946

subsidiaries in tax havens alone. If you look at the structure of

a major financial institution, there are thousands

of subsidiaries. Its extraordinarily complex. And these things often

through whos doing what, it gets pretty tricky. AUDIENCE: Excuse me, can

you explain subsidiary? What do you mean by that? MAUREEN OHARA: So

other companies. They have other divisions that

are set up, in many cases, as separate companies. So Johnson & Johnson, for

example, has 286 subsidiaries. Some of them make this product. Some of them make that product. So you have a corporate

structure up here. And then you have all these

other little companies down here. And can you, as the

corporate structure, make sure that every one of

these little companies that you own at Johnson & Johnson

are behaving the way Johnson & Johnson wants? So in a bank, they have

professor, its something I worry about a lot. And then theres in personality. You never see anybody. Statistical victims

always seem a lot less compelling than real victims. So for a moment, lets

talk about, does it matter? So Im going to give

you something here you guys can think about. Isnt he cute? This is a mouse

experiment that was run. And this is an experiment

about how people change when they operate in markets. So heres the experiment. Hes awfully cute. So participants get

to decide between this is one in Germany. And the lab that

projects are gone now. Theyre over. And so now what do

experimental part of this, they had a group of people,

lets say all of you. And they offered each

person the following choice. You can have 10 euros,

but one of the little mice is going to be killed. Or you can forego

getting your 10 euros, and the mouse will be spared. So theyre going to

do that treatment. Then theyre going to do

a second experiment, where they take half the room. And they say that youre

going to be the sellers. And youre going

to be the buyers. And so were going to match

up each seller with a buyer. And were going to give the

seller the property rights to the mouse. So each seller has

owner of the mouse. If you and your buyer can agree

on how to split the 20 euros, you get 20 euros. And the mouse is killed. Or if you guys agree that

you dont want the money, then the mouse will be spared. Does everybody see

individual gets to decide. And in the second one, the buyer

and the seller together decide. Heres some interesting results. When individuals were given

this choice, 45% of them took the euros. And the mouse was toast. But on the other hand,

almost 55% spared the mouse. When you put those same

people in a market setting, the mouse is toast. 72% of the time, that

mouse hits the dust. In fact, to get individuals to

kill the mouse at the same rate that theyll do it in a market,

you had to pay them 47.5 euros. Now, what does that mean? I admit that mice

people or trading and various other things. But I think one of

into market settings, the immediacy of some of

these issues seem to fade. And in our case here, the

poor mice hit the dust. So what are the ethical

well, lets just rely on the legal boundaries

to determine when we cross the line. But thats probably

arbitrage around them. Thats what modern

the rule is, Ill create a way, using my cash

flow approach, to get around it. So you dont have to go

back as far as Aristotle. And this is the only

thing Im going to talk about the ethical limits. Im going to let you guys

decide on some of these things. Aristotle pointed out that

every action had technique and prudence and that

every technical action has a moral component. And so one way to

is a technical action, has a moral component. And that should

really be kept in mind as we think about these. So were going to run out of

time because were supposed to keep this to 35, 40 minutes. So let me just look at

that happened in markets. And the HFT ones are pretty

easy that Im going to show you, I think. Michael Lewis in Flash

Boys didnt like the fact that you could design

learning to try and see if you could predict where

the larger orders were going to trade and step

Lewiss book, think about the problem of a large

institution whos going to trade, say, 100,000 shares. In our current market structure,

we have 13 different stock exchanges. So typically what happens is

you chop them up in the order. And you start sending

them off to the exchanges. But theyre not all

a little bit longer to get to some down the road like milliseconds,

to go or the lowest latency. And then based on

the ones that are ahead in front of what they think

are the orders that are coming. Is that unethical? Whats interesting is almost

everyone I know in finance says no. People have watched

watcher and you say, every time I see the market

go over 60 three times a day I buy, thats kind

of the same idea of, Im training my machines

to watch for a pattern. And then Im going to trade. But you might disagree. Michael Lewis does. But here are some things that

are a bit more challenging. Heres what they do. So this is an algorithm thats

been written to take advantage of another algorithm. So see those blue dots? Thats an order that has

been placed by a broker dealer for a client. So this client wants to buy. And so you see the market opens. And over here,

youre going to see those green dots

to put it in order and cancel it, put it an order

and cancel it, put it an order and cancel it. That all happens

lines, theres an order. It gets canceled instantly. And then another order

is put one tick above, another a tick above that. You can see as you

go along at 30.08 this is at 9:30 in the

morning, eight seconds the blue order gets put. Thats an order to buy. There isnt a seller

going to sit there. But this quote dangler keeps

putting orders in and canceling them, putting them in

and canceling them. Whats he trying to do? Hes trying to fool

into thinking that there is a lot of interest out there. And theyre trying

to raise the quote. And so he wont be able to buy. And so the blue orders

actually is someone out there. And you can see that the

quote dangler is basically theres no trades actually

price all the way up there. This is three minutes later. And actually, the blue

order, and he quit. So the green guy didnt succeed. What he was trying

to do was induce him to bet against himself. And then when he

its almost impossible to catch. But its clearly

across the line. This guys manipulating

you into trading against him. Heres another type of strategy. This is called a momentum

ignition strategy. So again, this is all

done by computers. So whats happening here? The blue lines are

submitted and canceled, and submitted and canceled. And what theyre

trying to do is and actually, in this case,

these are tiny little trades, like trades of a share. So you can see

what theyre trying to do is theyre trying to

move the price up and down and up and down and up and

down, getting wider and wider. And why are they doing that? Because there are

orders in the book. And when the price hits

the stop order, when suppose you want to

protect yourself. You own IBM. You put a stop order in at 60. IBM is trading at 70 right now. So unless the price hits 60,

that order wont execute. And so what theyre

the stops in the book. And here they succeed. So you can see at some

point, all of a sudden the price just falls through the

floor because what theyve done is they triggered

all the stop orders. And what are they trying to do? Theyre trying to

buy at the low point. So is it ethical to write

algorithms to do that? I dont think so. Is it ethical to

where people are going and try and go there first? I think so. But others may disagree. But these markets are tricky. Were going to do one more. And then were

to the flash crash. But hes doing something

much like that first diagram I showed you. He used a layering

algorithm in futures. And what that means is he

put lots of sell orders at prices three, four, and

five ticks above the price. So hes trying to give you the

idea theres a lot of depth out there. But whats interesting

close to these things, cancel the orders. Now, to write an

can ever execute, has got to be unethical. It should be illegal. So in this brave

new world of the HFT and the world of modern finance,

the kind of behaviors you see are really remarkable. Let me give you one thats

them to do exactly this. So JP Morgan Chase became the

owner of 28 outdated power generating plants when

they took over Bear Stearns in the crisis. So some of you may remember

Bear Stearns failed. And the Fed got JP Morgan

Chase to take them over. But Bear Stearns was a big

electric generating plants. And theyre all outdated. And they dont make any money. So how do we make

them profitable? Well, what they realized was,

we could invest in those plants, spend lots of money, bring them

up to date, and go that route. But they dont want to do that. Instead, they

realized that the way we trade energy in the United

States is really complicated. But it involves an auction. And its an auction that is

the worlds most complicated auction involving theres a day-ahead

auction, and then theres the day-of auction, and

all kinds of things. And its run by a group called

CAISO, at least in California. And that stands for the

California Independent Power Authority or something

electricity in California. But some days its really hot. And everybody turns on

their air conditioning. And so were going to need

a lot more electricity. And heres the kicker electricity cant be stored. So in order to come up

with more electricity, were going to have to induce

some of these old power plants to ramp up and start

theyre expensive to run, were going to have to

have compensatory payments. So JP Morgan realized that lets not think

about the problem of generating electricity. Lets think about the problem

of selling it in the auction. And so they developed

these compensatory payments and, if possible, not

to actually ever have to sell the electricity. They came up with 11 strategies. And all of them were within

the rules of the auction. So what would they do? Well, heres an example. Basically, remember,

why is this arbitraged? Theyre arbitraging

the electricity market. Theyre arbitraging

the algorithm. So what would they do? Well, the way this market

works is you submit a bid in whats called the

day-ahead market so say Monday. So they submit a

bid on Monday to be willing to produce electricity

between the hours of 11:00 PM and 12:00 AM on Tuesday. And theyll sell it for

minus 30 a megawatt hour. And you say, minus 30? But the rules of

sometimes its better to just sell even at minus 30. So they bid minus 30. And their bid is accepted. So that means the

next day, theyre going to be producing this

electricity at night from 11:00 to midnight. And theyre going to obviously

not make any money at minus 30. But why would they do this? Well, heres the rule. It turns out that because power

plants cant come up and down overnight or, for that matter,

instantaneously, theres something called ramp

you have to allow a power plant to operate for

three hours at a stretch. So once their bid got

paid $999 per megawatt hour. Now, whats the normal

bid price that you get at this time in the morning? About $15 an hour. But this bid has to be

accepted because that bid was accepted because of

the contiguous ramp up, ramp down rule. So these are the kinds of

strategies that JP Morgan has come up with. Well put in a bid for minus 30. And now youre going to have

to accept our bid for 999 because the rules of the

auction say youve got to do it. So they had 11 of

money hand over fist. So what do you think? Did this cross the line? Anybody think it didnt? Well, JP Morgan

didnt think it did. However, the problem is, the

regulator thought it did. And the Federal Energy

market manipulation, arguing that they interfered

markets in CAISO. Now, I think not everyone

but most people looking at this go, are you kidding me? And people say,

would make is, yeah, but no one else was trying

to distort the market. I mean, this is a problem. They raised electricity

costs for everybody else. JP Morgans the only one who

train our finance students how to arbitrage in

particularly scary here is that the regulator, after JP

Morgan developed the first two strategies, said, dont do it. And so they go, OK,

develop another one and another one and another

one until finally they get them for manipulation. AUDIENCE: [INAUDIBLE]

from what MAUREEN OHARA: Enron did? AUDIENCE: Yes. MAUREEN OHARA: Yeah. One of the reasons

FRC was able to go after them for this behavior

was after Enron, which also manipulated everything

rule about what is manipulation in energy markets. And so they have a

they had stopped that until JP Morgan came in. And this was just last year. So Im almost out of time. So these are just some

examples of the sorts of things that we look at in the book and

think about where exactly does the weasel zone start. I dont think finance

is unstoppable. That is, I dont think that its

the case that you cant stop finance, that you can create

a law that well always get around. But I think you have to think

more carefully about how are you going to make

the culture in finance. Some of you may know the Dutch

were so mad after the crisis because they had to bail out

that says they wont take peoples money and

misbehave and things like that. Will that make Dutch

bankers better bankers? I dont know. Thats one approach. I think you change

to get around it because I can build a synthetic

way to get around that rule. I think we need to change

from a world of trying to be very specific towards

Morgan got caught. Because JP Morgan got caught

because the rule about what is manipulation was

they used was technically within the rules, the

overall intent was to manipulate the market. And they got them. And this flips the old rule that

says, use standards of people are trustworthy and

that you dont want to use rules in a modern market