U.S. Justice Dept is split over charging Binance as crypto world falters, sources say
WASHINGTON, Dec 12 (Reuters) - Splits between U.S. Department of Justice prosecutors are delaying the conclusion of a long-running criminal investigation into the world's largest cryptocurrency exchange Binance, four people familiar with the matter have told Reuters.
The investigation began in 2018 and is focused on Binance's compliance with U.S. anti-money laundering laws and sanctions, these people said. Some of the at least half dozen federal prosecutors involved in the case believe the evidence already gathered justifies moving aggressively against the exchange and filing criminal charges against individual executives including founder Changpeng Zhao, said two of the sources. Others have argued taking time to review more evidence, the sources said.
The inquiry involves prosecutors at three Justice Department offices: the Money Laundering and Asset Recovery Section, known as MLARS, the U.S. Attorney's Office for the Western District of Washington in Seattle and the National Cryptocurrency Enforcement Team. Justice Department regulations say that money laundering charges against a financial institution must be approved by the MLARS chief. Leaders from the other two offices, along with higher-level DOJ officials, would likely also have to sign off on any action against Binance, three of the sources said.
Through interviews with almost a dozen people familiar with the case, including current and former U.S. law enforcement officials and ex-Binance advisors, along with a review of company records, Reuters has pieced together the most comprehensive account so far of how the investigation developed and how Binance has sought to keep it at bay. Prosecutors' deliberations on charging Binance have not been previously reported.
The stakes are high for the deeply troubled crypto sector. If the investigation goes against Binance and Zhao, it could loosen Binance's grip on the industry. Its hold has been strengthened by the recent collapse of rival exchange FTX.
Binance's defense attorneys at U.S. law firm Gibson Dunn have held meetings in recent months with Justice Department officials, the four people said. Among Binance's arguments: A criminal prosecution would wreak havoc on a crypto market already in a prolonged downturn. The discussions included potential plea deals, according to three of the sources.
A Binance spokesperson said, "We don't have any insight into the inner workings of the US Justice Department, nor would it be appropriate for us to comment if we did." The Justice Department declined to comment.
The charges under investigation are unlicensed money transmission, money laundering conspiracy and criminal sanctions violations, the four people said. No final charging decisions have been made, though prosecutors consider Zhao and some other executives to be subjects of the investigation, one source familiar with the situation said. Ultimately, the Justice Department could bring indictments against Binance and its executives, negotiate a settlement, or close the case without taking any action at all.
Little has been revealed about the case. Reuters reported previously that in 2020, prosecutors requested extensive internal records from Binance about its anti-money laundering checks, along with communications involving Zhao and other executives.
The new reporting shows that the case has shadowed Binance for most of its five years in existence, shaping Zhao's management of the company while he drove its explosive growth around the world. He instigated a recruitment spree last year that led to the hiring of officials from the Internal Revenue Service's Criminal Investigation division, the U.S. government agency that was investigating Binance. He enforced strict secrecy rules on employees, telling them to use email as little as possible and to communicate using encrypted messaging services, according to company messages that Reuters has previously reported.
Reuters has investigated Binance's financial crime compliance over the course of 2022. The reporting showed that Binance kept weak anti-money laundering controls, processed over $10 billion in payments for criminals and companies seeking to evade U.S. sanctions, and plotted to evade regulators in the United States and elsewhere.
Binance has disputed the articles, calling the illicit-fund calculations inaccurate and the descriptions of its compliance controls "outdated." The exchange has said it is "driving higher industry standards" and seeking to "further improve our ability to detect illegal crypto activity on our platform."
Launched by Zhao in Shanghai in 2017, Binance now dominates the crypto industry. The exchange processed trades worth around $1.6 trillion in October, about half of the entire crypto market's trading volume. That sum dwarfed its former challenger FTX, which handled $230 billion in trades that month, according to data site CryptoCompare.
FTX imploded in early November, triggering a wave of public demands for greater regulation of the cryptocurrency industry. Founder Sam Bankman-Fried had boasted his exchange was the "most regulated," but he based it in the Bahamas, where oversight was light, and secretly used customer deposits. The Justice Department has opened an investigation into FTX's handling of company funds, Reuters has reported. In a bankruptcy hearing, attorneys for FTX said the exchange was run as a "personal fiefdom" of Bankman-Fried. Bankman-Fried says he didn't knowingly commit any wrongdoing.
Sources familiar with Justice Department operations said it is as yet unclear whether this new probe will add impetus to the investigation into Binance or slow it down.
Zhao, who declines to disclose the location or entity behind his own exchange, accelerated his rival's fall by announcing that Binance would sell its holding of FTX's digital token. This sparked a surge of user withdrawals, ultimately forcing FTX to file for bankruptcy.
In a blog post several days later, Zhao wrote that Binance "must lead by example" going forward. "We cannot let a few bad actors sully the reputation of this industry," he wrote.
"LAWYER UP"
Prosecutors in the U.S. Attorney's Office in Seattle began investigating Binance in 2018, following a wave of cases that saw criminals use Binance to move illicit funds, the four people familiar with the probe said.
The Seattle office partnered with MLARS to pursue the case, along with agents from the IRS Criminal Investigation division.
Binance began to address the chances of U.S. enforcement action that year. A summary of a company meeting in October 2018, attended by Zhao, said, "Lawyer up in the US, address regulatory risks."
The U.S. Bank Secrecy Act, designed to protect the U.S. financial system from illicit finance, requires crypto exchanges to register with the Treasury Department and comply with anti-money laundering requirements if they conduct "substantial" business in the United States. Binance has never done so, despite almost a third of its users being U.S.-based the year of its launch, according to a company blog post.
Instead, Zhao approved a proposal from a person providing advice to Binance to "insulate" Binance from U.S. scrutiny by setting up a new American exchange that would draw regulators' attention away from the main platform, as reported by Reuters in October. Zhao became concerned about U.S. authorities gaining access to Binance's internal records, company messages show.
A guide issued to employees for one encrypted messaging service listed its "automatic self-erasing messages" as a benefit.
Until 2020, Binance's legal department operated on bare bones. Its head of legal, Jared Gross, was a former mergers and acquisitions lawyer with little experience in dealing with authorities, according to two people who worked with him. Faced with the Justice Department investigation, Binance hired an external lawyer from U.S. law firm Paul Weiss, Roberto Gonzalez, who was previously Treasury's deputy general counsel. Gross, who left Binance last year, did not respond to messages and phone calls. Gonzalez and Paul Weiss didn't comment.
In December 2020, two MLARS attorneys and a Seattle prosecutor sent the DOJ's request for documents to Binance, addressed to Gonzalez. The letter sought any records containing instructions that "documents be destroyed, altered, or removed from Binance's files" or that "information should not be committed to writing." The request asked for communications involving Zhao and 12 other Binance executives and advisors.
Several days later, an advisor to one of the people named in the letter received a panicked phone call from this person. The caller told the advisor that Binance was struggling to respond to the DOJ because many of the records relevant to the Department's request had already been erased due to Zhao's secrecy rules. This extended, the person told the advisor, to Zhao's approvals for financial decisions at Binance.US, the separate American exchange which publicly says it is "fully independent" of the main Binance platform.
A Binance.US spokesperson said Reuters' questions were "fueled with false insinuations," and Binance.US was a separate entity with its own leadership team who are "solely responsible for overseeing decisions and activity across the business."
Text messages and phone records reviewed by Reuters confirm the call took place and that it concerned the Department's December 2020 letter. The advisor described the contents of the call on the condition that Reuters not identify the advisor or the caller.
Reuters, which was the first to disclose the request publicly, could not determine how Binance ultimately responded to the DOJ letter.
NEW TASKFORCE
The following year, Binance began a recruitment blitz. It hired at least five ex-officials from the IRS Criminal Investigation's Cyber Crime Unit, including a new global head of investigations called Tigran Gambaryan. Binance said Gambaryan's team would detect and prevent crimes on the platform and work closely with law enforcement.
As an IRS-CI special agent, Gambaryan had helped lead investigations into several notorious crypto crime operations, such as the Silk Road darknet drugs marketplace and a child abuse site called Dark Scandals, whose operations Reuters detailed in an article last month. Gambaryan was not involved in the Binance investigation at IRS-CI, but was close to agents that were, according to two people who worked with him.
His hiring was part of a recruitment program by Binance among law enforcement officials in the United States, offering salaries that far exceeded what was available at many other finance and crypto firms, according to four people familiar with the outreach.
Gambaryan didn't respond to a request for comment. Binance told Reuters, "We are proud to have in our ranks some of the most celebrated cyber investigators representing virtually every single major international law enforcement agency across the globe." Binance said they have around 300 investigators working "to protect users from illicit actors."
In August 2021, Binance ended a policy that allowed users to open accounts with solely an email address. Reuters has reported previously that criminals ranging from Russian drug traffickers to North Korean hackers had exploited this feature to move money anonymously through Binance.
But even after Binance required all users to submit identification, gaps remained in its compliance programme. For example, between then and this November, Binance processed over $1 billion in trades for Iranian crypto firms, putting the company at risk of violating U.S sanctions, Reuters reported last month.
In October 2021, Deputy Attorney General Lisa Monaco announced the creation of a National Cryptocurrency Enforcement Team (NCET) to tackle investigations of "criminal misuses of cryptocurrency, particularly crimes committed by virtual currency exchanges." Monaco, in a separate speech that month, said the Justice Department's "first priority in corporate criminal matters" was to prosecute individuals who profit from corporate wrongdoing.
The Justice Department appointed Eun Young Choi, previously Monaco's senior counsel, as NCET's first director. Under Choi, NCET began coordinating the Binance investigation, joining the U.S. Attorney's Office in Seattle and MLARS, according to the four people familiar with the case. Agents gathered evidence from former Binance employees and business partners, they said.
In recent months, prosecutors at NCET and the Seattle office concluded they had sufficient evidence to prepare charges not only against Binance, but also against Zhao and some other executives, the people said. However, MLARS leadership has been hesitant to move forward with an indictment, leading to frustrations within the investigation team, the people said.
MLARS has a reputation in the Justice Department for moving slowly in reaching prosecution decisions, people familiar with its activities said. In October, however, the Department appointed a new MLARS chief, Brent Wible, who previously worked in the Fraud Section and before that as a prosecutor in the Southern District of New York. Both of those offices are known, among current and former law enforcement officials, for pursuing cases more aggressively.
Binance has hired a former chief of MLARS, Kendall Day, a partner at Gibson Dunn, to engage in discussions with the Justice Department. Day met with Justice officials in Washington in recent months, three of the people said. Officials discussed with Day a possible resolution to the case out of court, whereby suspects would potentially plead guilty or pay a fine, the three sources said. Day didn't comment.
ECB warns of higher loan losses and funding squeeze for eurozone banks
Regulator plans more frequent inspections of bank offices and will carry out ‘targeted reviews’
The European Central Bank has warned that eurozone banks are at risk of mounting bad loans and a funding squeeze due to rising interest rates, higher inflation and a likely recession.
Supervisors at the ECB plan more frequent inspections of bank offices and will carry out more “targeted reviews” of the largest lenders in the 19-country single currency zone to push them to address these growing risks, the regulator said on Monday.
Publishing its priorities for banking supervision next year, the ECB said lending to energy-intensive sectors, residential mortgages and commercial property was particularly vulnerable to the deteriorating economic environment.
Some banks could also struggle to replace the cheap funding the ECB has provided to help the sector through the coronavirus pandemic, which is now being withdrawn as the central bank tightens monetary policy to tackle high inflation, it said.
“While the banking sector has thus far proven to be resilient to the fallout from the war in Ukraine, downside risks have increased as a result,” said Kerstin af Jochnick, an ECB supervisory board member, and Mario Quagliariello, its director of supervisory strategy and risk.
“In the near term, we are concerned about the repercussions of the macroeconomic environment and financial market dynamics for asset quality and banks’ funding,” they said in a blog published on Monday.
The increased pressure from the ECB over banks’ preparation for a potential increase in bad loans and funding squeeze could increase tensions with executives in the sector, several of whom have already complained about its heavy handed approach to supervision.
The banking sector’s performance has picked up this year, as rising interest rates have boosted profit margins on loans while government measures to support companies and households with high energy costs have helped to keep defaults low.
However, the ECB warned that the good times looked unlikely to last due to a probable increase in bad loans and rising funding costs for banks.
The central bank is expected to raise interest rates on Thursday by at least 0.5 percentage points to 2 per cent, which would be the highest level since the 2008/9 financial crisis, while most economists expect the eurozone to enter a recession this winter.
“Higher interest rates and a sluggish or possibly recessionary growth outlook may challenge the debt-servicing capacity of borrowers going forward,” the ECB officials said in their blog. “This may particularly be the case for highly indebted households and corporates.”
The central bank said a recent supervisory review had identified shortcomings in how banks control their risks, “especially in relation to loan origination and monitoring, classification of distressed borrowers and provisioning frameworks”.
Some banks have also become “more vulnerable to market disturbances” because of a heavy reliance on ultra-cheap funding from the ECB itself, the central bank warned.
Last month, the ECB changed the terms of its targeted longer-term lending operations, under which it lent €2.1tn to banks at a rate as low as minus 1 per cent to encourage them not to cut their lending during the pandemic.
The TLTRO rate was raised to the ECB’s deposit rate from last month and since then banks have repaid nearly €800bn of their loans under the scheme ahead of schedule.
The central bank said some banks would need to “further diversify their funding sources and replace part of their central bank funding with more expensive and possibly shorter-term alternatives, which will put pressure on their prudential ratios and profitability”.
Thoma Bravo snags Coupa for $8B despite activist pressure to hold off for higher price
When news surfaced last week that activist investors were taking the unusual step of pressuring Coupa Software to not sell for less than $95 a share, it got our attention. You don’t normally see investors sending a letter asking a company to hold off on a sale. It’s typically the opposite.
But today, the company announced that Thoma Bravo was acquiring it for $8 billion. That works out to $81 a share, which still represents a 77% premium for shareholders, but well below what HMI Capital was asking for in a letter made public earlier this month.
The letter believed published rumors that another private equity company, Vista Equity Partners, was in the hunt to buy it, but in the end, Thoma Bravo was the buyer along with a wholly owned subsidiary of the Abu Dhabi Investment Authority (ADIA) also participating in the deal as a minority investor. Thoma Bravo has a long history of acquiring mature enterprise software companies and taking them private.
Coupa, which makes spend management software for large businesses, has been having a rough year in the stock market, like many SaaS companies, feeling the wrath of investors looking for profit over growth. The company’s stock price was down 64% year-to-date and was down over 2.5% in pre-trading, suggesting that perhaps investors aren’t happy with the deal.
Company CEO Rob Bernshteyn put a happy face on the deal as you would expect, saying that customers can expect a similar level of service, regardless of who the owner is signing the checks.
Roger Siboni, Coupa’s lead independent director said that the company took into consideration the current economic climate and decided it was a deal worth taking. “The Board evaluated the transaction against the company’s standalone prospects in the current macroeconomic climate and determined that the compelling and certain cash consideration in the transaction provides superior risk-adjusted value relative to the Company’s standalone prospects. The Board is unanimous in its belief this transaction is the optimal path forward and in the best interest of our shareholders,” he said in a statement.
While the board of directors has unanimously agreed to the terms, it should be interesting to see if the shareholders are as friendly to the deal when they meet early next year. It would seem that HMI Capital, which owns 4.8% of the Coupa stock, will lead the charge against the deal if the letter the firm published is any indication of its feelings about the company being undervalued at this price.
Should the deal pass muster with stockholders and regulators, it is expected to close in the first half of 2023. Surprisingly, given HMI’s letter, there is no go-shop provision with this deal, which would allow Coupa to keep looking for a better deal.
Inside Celine’s New Paris Boutique
The brand expanded its haute parfumerie to create a sleek space dedicated to accessories and high jewelry.
Inside the new Celine boutique on Rue Saint-Honoré.
PARIS — Celine has unveiled its new boutique on Rue Saint-Honoré.
Hedi Slimane’s brutalist vision is brought to life with sleek brass and slick marble, a wall of mirrors and art installations. Located at 384 Rue Saint-Honoré, the shop is devoted to accessories, fragrance, leather goods and high jewelry, sitting catty corner from its ready-to-wear boutique on Rue Duphot.
The smaller space located at 390 has housed the brand’s haute parfumerie since 2019. Celine took over the old Loewe space next door to create a showcase for its classic Triomphe bags, leather goods and jewelry. In Slimane’s rock-‘n’-roll style, a sparkly gold version of the bag is exclusive to this location, as well as made-to-order pieces.
The new address marks the brand’s sixth stand-alone store in Paris, alongside spots in four of the city’s department stores. The brand says it is embarking on an expansion plan for 2023, and will activate several pop-ups worldwide. There are 180 Celine boutiques across the globe.
The second story private shopping apartment.
Up a gleaming curved staircase, the second floor houses a private salon with cozy chairs and a fireplace for VIP clients. In Slimane style, the boutique showcases several stunning artworks — paintings by Will Boone, sculptures from Ian L.C. Swordy and carved wooden pieces from Augustas Serapinas dot the space.
The 1,400-square-foot space has double-height windows, and beams of sunlight dance off the art pieces Slimane selected. Hanging in the main room is a version of Virginia Overton’s Skylight Gems, a mobile made of three glass ornaments, commissioned by Slimane after he saw the original in New York’s LaGuardia airport.
Virginia Overton’s “Skylight Gems” for Celine.
Taking cues from Art Deco and French Modernism, the now-connected boutiques sourced their black marble floors from France’s Pyrenees mountains, and Slimane selected several brutalist slabs and stumps for seating and decor.
The opening on Dec. 2 was timed just ahead of the brand’s big return to the womenswear runway. Celine closed Paris Men’s Fashion Week in June. It will stage a show at Los Angeles’ Wiltern Theater Thursday to present its fall 2023 collection, giving the brand a jump on February’s fashion season. If Celine will present at Paris Men’s Fashion Week in January has yet to be decided.
Research Calls
- Upgrades:
- Becton Dickinson (BDX) upgraded to Neutral from Sell at Citigroup; tgt raised to $250
- Best Buy (BBY) upgraded to Neutral from Sell at Goldman; tgt raised to $83
- Box (BOX) upgraded to Overweight from Neutral at JP Morgan; tgt raised to $34
- CAE (CAE) upgraded to Overweight from Equal-Weight at Morgan Stanley
- Crane (CR) upgraded to Overweight from Equal-Weight at Morgan Stanley; tgt raised to $129
- Glaukos (GKOS) upgraded to Buy from Neutral at Citigroup; tgt $57
- Lam Research (LRCX) upgraded to Buy from Hold at Deutsche Bank; tgt raised to $520
- Monday.com (MNDY) upgraded to Overweight from Neutral at JP Morgan; tgt raised to $140
- PerkinElmer (PKI) upgraded to Buy from Neutral at Citigroup; tgt raised to $170
- Pulmonx (LUNG) upgraded to Buy from Neutral at Citigroup; tgt lowered to $10
- QuidelOrtho (QDEL) upgraded to Buy from Neutral at Citigroup; tgt raised to $125
- Southern (SO) upgraded to Outperform from Peer Perform at Wolfe Research; tgt $76
- Downgrades:
- Accenture (ACN) downgraded to Underweight from Neutral at Piper Sandler; tgt $268
- llogene (ALLO) downgraded to Underperform from Buy at BofA Securities; tgt lowered to $9
- Baxter (BAX) downgraded to Neutral from Buy at Citigroup; tgt lowered to $58
- Boyd Gaming (BYD) downgraded to Mkt Perform from Mkt Outperform at JMP Securities
- Brinker (EAT) downgraded to Sell from Neutral at Goldman; tgt lowered to $28
- Cheesecake Factory (CAKE) downgraded to Sell from Neutral at Goldman; tgt lowered to $29
- Curtiss-Wright (CW) downgraded to Equal-Weight from Overweight at Morgan Stanley; tgt raised to $188
- Genuine Parts (GPC) downgraded to Sell from Neutral at Goldman; tgt raised to $147
- HEICO (HEI) downgraded to Equal-Weight from Overweight at Morgan Stanley; tgt lowered to $172
- Illumina (ILMN) downgraded to Sell from Neutral at Citigroup; tgt lowered to $180
- Johnson Controls (JCI) downgraded to Neutral from Buy at BofA Securities; tgt lowered to $72
- KLA Corporation (KLAC) downgraded to Hold from Buy at Deutsche Bank; tgt raised to $400
- Laboratory Corp (LH) downgraded to Neutral from Buy at Citigroup; tgt lowered to $250
- Leggett & Platt (LEG) downgraded to Underweight from Neutral at Piper Sandler; tgt lowered to $24
- Micron (MU) downgraded to Hold from Buy at Deutsche Bank; tgt lowered to $55
- Moog (MOG.A) downgraded to Underweight from Equal-Weight at Morgan Stanley; tgt raised to $89
- Nevro (NVRO) downgraded to Equal Weight from Overweight at Wells Fargo; tgt lowered to $43
- OceanFirst Finl (OCFC) downgraded to Neutral from Overweight at Piper Sandler; tgt $25
- Qualcomm (QCOM) downgraded to Underweight from Equal Weight at Wells Fargo; tgt $105
- RH (RH) downgraded to Sell from Neutral at Goldman; tgt lowered to $215
- RxSight (RXST) downgraded to Equal Weight from Overweight at Wells Fargo; tgt lowered to $14
- Spire (SR) downgraded to Underperform from Neutral at BofA Securities; tgt lowered to $61
- Others:
- Affimed Therapeutics (AFMD) initiated with a Buy at H.C. Wainwright; tgt $6
- Ageas SA/NV (AGESY) initiated with a Sell at Goldman
- Ambarella (AMBA) initiated with a Positive at Susquehanna; tgt $90
- Analog Devices (ADI) initiated with a Positive at Susquehanna; tgt $205
- Coinbase Global (COIN) initiated with a Sector Weight at KeyBanc Capital Markets
- Elekta AB (EKTAY) initiated with a Sell at Citigroup
- Essilor International (ESLOY) initiated with a Buy at Citigroup
- Kinsale Capital (KNSL) initiated with a Hold at Jefferies; tgt $295
- Palomar Holdings (PLMR) initiated with a Hold at Jefferies; tgt $55
- Smith & Nephew (SNN) initiated with a Buy at Citigroup
- Sonova (SONVY) initiated with a Sell at Citigroup
Gapping down
In reaction to earnings/guidance:
- NOTV -24.8%
Select biotech/pharma related names showing weakness after ASH presentation or other data release:
- ACET -36.4%, AFMD -15.2%, ONCT -6.5%, IGMS -2.7%, GRPH -1.5%
Other news:
- ABCM -8.4% (provides update on AIM Delisting)
- IDYA -4.2% (submission of IND Application to the U.S. FDA for PARG development candidate IDE161)
- AMGN -3.1% (confirms it will acquire HZNP for $116.50/share in cash)
- RIVN -2.5% (pauses partnership discussions with Mercedes-Benz on electric van production in Europe)
- NOAH -2.4% (recently received a civil judgment from the Bozhou Intermediate People's Court of Anhui Province)
- HP -1.1% (increased the maximum number of shares authorized to be repurchased in calendar year 2023 to five million common shares)
- ACI -0.8% (Issues Statement Regarding the Denial of a Request for Preliminary Injunction by the Attorney General of the State of Washington and Extension of the Temporary Restraining Order on its Special Dividend Payment)
Analyst comments:
- ACN -2% (downgraded to Underweight from Neutral at Piper Sandler)
- BYD -0.8% (downgraded to Mkt Perform from Mkt Outperform at JMP Securities)
Gapping up
Select biotech/pharma related names showing strength after ASH presentation or other data release:
- GRCL +6%, ARGX +4.2%, ALVR +3.8%, PSTX +3.5%, DTIL +3.4%, CNTA +3.1%, ADPT +2.1%, BEAM +1.6%, IMGN +1.4%, CTIC +1.1%, COGT +1.1%, GLYC +1%
Other news:
- COUP +26.8% (to be acquired by Thoma Bravo for $81/share, enterprise value of $8 billion; also issued earnings)
- WEBR +21.5% (to be taken private by BDT Capital Partners for $8.05/share; deal expected to close in 1H23)
- HZNP +15.4% (Amgen (AMGN) confirms it will acquire HZNP for $116.50/share in cash; no longer in merger discussions with Sanofi (SNY))
- BVH +10.4% (Amendment of Tender Offer to Increase Offer Price to $25.00 per Share and Extend Tender Offer Until December 23)
- CNX +2.5% (provides update on Appalachia-Focused strategy)
- BSX +1.2% (announces strategic investment to acquire majority stake of Acotec Scientific Holdings)
Analyst comments:
- BOX +3.7% (upgraded to Overweight from Neutral at JP Morgan)
- GKOS +1.9% (upgraded to Buy from Neutral at Citigroup)
- BBY +1.8% (upgraded to Neutral from Sell at Goldman)
- CR +1% (upgraded to Overweight from Equal-Weight at Morgan Stanley)
- BDX +0.9% (upgraded to Neutral from Sell at Citigroup)
Early premarket gappers
- Gapping up:
- COUO +26% GRCL +17.9%, HZNP +13.7%, BVH +6.8%, ALVR +5%, ARGX +4.8%, DTIL +3.4%, CNTA +3.1%, BEAM +2.1%, FATE +1.6%, BSX +1.2%, COGT +1.1%, OCUL +1.1%, CTIC +0.9%, REGN +0.7%, VRTX +0.6%, GMAB +0.5%, MSFT +0.5%
- Gapping down:
- ONCT -14%, ACET -13.7%, LVTX -9.5%, ABCM -6.7%, RIVN -4.8%, IDYA -4.2%, AMGN -3.1%, IGMS -2.7%, GRPH -2.7%, ACI -2.3%, AFMD -2%, ADPT -1.8%, IMGN -0.8%, SGMO -0.6%
Has the index effect evaporated?
Featuring Lloyd Blankfein cameo appearance
Can those lamenting/celebrating/gawping at the not-so-slow-motion car crash of Elon Musk’s Twitter ownership really blame the benchmarking wizards of S&P Dow Jones Indices for the whole debacle?
That’s what a lot of people reckon. When Tesla finally managed to notch up four consecutive quarters of profit in the summer of 2020 and became eligible for inclusion into the S&P 500, it helped spark a wild ride that made it one of the world’s most valuable companies. That transformed Musk into the world’s wealthiest edgelord and allowed him to buy Twitter.
It’s easy to forget that at the start of 2020 Tesla was valued at just $77bn (which even at the time felt punchy). By the end of the year Tesla’s market capitalisation had exploded to $669bn. A year ago it had reached a peak of $1.2tn, and even after the tech wreck of 2022 Tesla is still worth $565.4bn.
This is why a new NBER working paper from Robin Greenwood and Marco Sammon from Harvard Business School is so interesting (it also thanks Lloyd Blankfein, among others, for “helpful comments”). Here is its main findings:
- The abnormal return associated with a stock being added to the S&P 500 has fallen from an average of 3.4% in the 1980s and 7.6% in the 1990s to 0.8% over the past decade. This has occurred despite a significant increase in the percentage of stock market assets linked to the index. A similar pattern has occurred for index deletions, with large negative abnormal returns on average during the 1980s and 1990s, but only -0.6% between 2010 and 2020.
In other words, the impact of index inclusions and deletions is pretty much statistically indistinguishable from zero. This runs completely counter to popular perception. It obviously makes intuitive sense that several trillion dollars worth of price-insensitive funds suddenly having to buy an included stock would lift it higher.
It should also be pointed out that although all perceived market evils are laid at the feet of index funds, indices have a powerful sway over traditional active funds as well. In fact, we suspect that stockpickers are on average nowadays far more “index aware” than they were back in the day. Even if there were no passive funds, benchmark changes would therefore probably have a big impact (and let’s not forget the impact of index derivatives).
Just to take the Tesla example, S&P Dow Jones itself estimated that index funds would have to dump about $51bn worth of other stocks to make way for Tesla’s inclusion. We’ve even had the first case of alleged index inclusion insider trading.
But Greenwood and Sammon corroborate similar findings by Benjamin Bennett, René Stulz and Zexi Wang in 2020, who found that the long-run impact of inclusion into the S&P 500 had actually become negative.
So what’s up? Greenwood and Sammon explore five possible explanations:
1) The fading effect is caused by different types of companies being included and excluded in recent years compared to the past.
2) The stock market is more liquid nowadays and trading costs are lower, so the impact of index changes becomes more muted.
3) Changes in net demand are much lower than they might seem because companies typically migrate from one index to another. For example, the S&P MidCap index has become a far more popular index.
4) Benchmark changes have become more predictable, and attracted arbitrageurs who front-run buying and selling by index funds.
5) The stock market has become more efficient overall, and liquidity has migrated towards dates where index changes happen, and especially at the end of the day when index funds do most of their trading.
Related to that, here is a gif showing how the “liquidity smile” has turned into a lopsided “liquidity smirk” over the past decade.
Greenwood and Sammon favour the last two explanations, with most of the emphasis on the final one. Here is their tl;dr:
- Overall, the findings suggest an account along the following lines. In the 1980s, index changes were unanticipated, index funds were small, and there was mispricing in the market. As index funds grew larger, the mispricing deepened and turned into an opportunity. As a result, the market adjusted to take advantage of this opportunity, in part by better anticipating inclusions, and in part by creating arrangements where other institutions stood ready to sell to indexers upon inclusions. This worked to eliminate the anomaly on average, in spite of demand shocks that continued to grow in magnitude over the 2000s and 2010s. In this sense, the decline of the index effect is much like the evidence for other anomalies, that they decline once they are well recognized by the market.
This makes sense, even if the researchers might be underestimating the arbitrage aspect a little. We wonder if the index inclusion effect would look more meaningful if one tweaked the time parameters. Index arbitrage has become a more popular hedge fund strategy in recent years, and that implies the inclusion effect is simply getting spread out over a longer time period.
Some final thoughts on the Tesla saga though, as it would seem to undermine the whole “disappearing index effect” argument. As with everything Musk-related, this is probably just a very idiosyncratic situation, with limited read-through elsewhere.
There are so many hardcore Elon stans and Tesla fans that have repeatedly seized on any excuse to pump shares in the company, from Mars mining to Tesla becoming an insurance giant. Even aside from how owning Tesla has made many rich, Tesla stock ownership has become an extension of their identity. And probable index inclusion is as good a reason as any to buy more.
A large part of the massive ramp-up in Tesla’s market cap was therefore probably the collision of a retail investor buying frenzy with a limited free-float, given a chunk of the Tesla investor base didn’t want to sell.
But here is what Tesla has done compared to Apartment Investment and Management — the company that was ejected from the S&P 500 to make way for Elon’s carmaker — since December 21, 2020, when the change went into effect: