Stepping Stones to Fraud
Fraud is a persistent obstacle in the functioning of the financial sector in all countries. Certain themes like defrauding of ignorant investors, sale of securities based on false disclosure, market manipulation, abuse of settlement procedures, trades at unusual prices in order to do transfer pricing, and cartel formation, recur again and again across countries and across the years.
In this article, we will examine a stylised set of `stepping stones' in financial fraud. Many major frauds in recorded history go through some or all of these steps. Knowing these steps will help us understand and anticipate fraud. From a policy perspective, these steps focus regulatory attention on weak links in the financial system. From an individual perspective, awareness of these steps will help avoid being defrauded.
The `canonical fraud' goes through six steps:
- I. Promises of high return with low risk
- One common starting point of a great deal of fraud are promises of high rates of return. Such promises were present in the case of CRB and in the famous real estate fraud of Prudential-Bache in the US.
- II. High risk investments
- The only way any financial company can give such high returns is by taking high risks. Hence many firms which have collected funds based on unrealistic promises are tempted to take massive bets of obtaining supernormal returns by taking high risks. High leverage (i.e. purchases of assets financed by borrowings) is a common feature of almost every financial crisis.
- III. Failure of high risk investments
- Most high risk investments fail to generate the desired returns. Even if these poorly thought out strategies work for a month or two, they do not continue to work for long. Some of the most dangerous investments here are in real estate, financed by bank loans, where the pressure of daily valuation (as in the stock market) is absent, and where the illiquidity of the assets inhibits counteraction.
- IV. Ponzi Schemes, or Pyramiding
- At this point, many scamsters embark on pyramiding, where investors of last week are paid high returns out of fresh capital obtained from the investors of this week. The original Ponzi scheme, of 1920, consisted of promising investors 50% returns in 45 days. This works well in the early phases, attracting investors by the dozen who are impressed by the success stories that are visible. As intelligent a man as Isaac Newton lost 20,000 pounds in the South Sea bubble. This is obviously not a sustainable state of affairs - after two or three iterations, a ponzi scheme requires a massive scale of interest to sustain itself. Showmanship and high publicity are used in every ponzi scheme, but new avenues for fund raising are soon imperative.
- V. Crime
- Criminal alternatives are vigorously explored at this stage. A fair amount of opportunism is displayed here; criminals are rational in the sense of investing their efforts where the regulatory apparatus is the weakest. Financial markets where anonymity is lacking are often easy targets of crime.
- VI. Exposure
- Every scam breaks at some point; some take longer than others. The fixed income scam in India seems to have started in 1985 or so but was exposed in 1992. Exposure has been associated with catastrophic consequences for key personnel of the scandal, including escape to foreign countries, imprisonment and suicide. Charles Blunt, insider to the South Sea Company, cut his own throat in 1720 following exposure.
Steps I - VI are a commonly observed sequence, but the script varies with many scandals. Some scams start off directly into criminal activities. However, it may be useful to point out that many scams originate with fairly honest people who make promises of returns which cannot be met; this leads to pyramiding and/or crime.
What can investors and regulators do to combat these rungs of the ladder of fraud?
- Promises of high returns will be less successful if investors understand the relationship between risk and return better. Investor education is the most powerful weapon in deterring this fraud. Modern finance is very aware of the ability to produce high returns through leverage (i.e. borrowing to invest in the market index), though this only works reliably in the long run. A host of other schemes which purport to produce phenomenal returns should be shunned. The role for regulation here is fairly limited, apart from rigorously enforcing promises e.g. the case of Canstar.
- High frequency disclosure of leverage (i.e. beta) is a simple way of making sure that investors are aware of the true risks that they have walked into. This also presupposes that investors understand the term `beta'.
- High frequency disclosure of portfolio value and composition will also help make investors more aware of the instruments that they have walked into. In this day and age, there is no reason why SEBI cannot insist on daily disclosure of NAV and of the full portfolio of every fund manager over the Internet.
- Ponzi schemes critically hinge on investors not understanding the source of high returns. Good disclosure, and investor education, would greatly reduce these uncertainties.
- The probability of swift enforcement and prison sentences is the most powerful deterrent to crime. A good regulatory apparatus would naturally help prevent crime, but this is difficult because of the `arms race' between criminals finding loopholes and regulators plugging them, where criminals generally have an upper hand. Protection of criminals by regulators sets the worst possible incentives here; once precedents of this exist, then myriad criminals would be careful to first subvert key regulators before embarking on criminal activities.
Anonymity in trading is a vital principle in reducing the probability of fraud. When buyer and seller know the identity of each other, as in OTC transactions, a variety of pressures surface, like transfer pricing, abuses of settlement procedures, bribes paid into dealing rooms, etc. The transparency of anonymous trading at the modern securities exchange is a powerful device to reduce the incidence of dealing room crime.
- Exposure is greatly assisted by a free and competent media. The role of the press in exposing the scam of 1992, or CRB, etc. is tremendously important.
Journalists are often afraid of taking on politically powerful figures. Additionally, as with investor education, journalist education is extremely important. All too often, persuasive figures in the financial sector are able to sway journalists away from accurate reporting when journalists lack analytical clarity.
A gentleman from the World Bank once commented to me that India has fared better than many east asian countries on the subject of financial fraud thanks to the fear of the free press, and thanks to the greater success at obtaining prison sentences in India for white collar crime as compared to that seen in many countries. Similarly, the US has a very good track record of imprisoning individuals exposed in financial scandals, e.g. Ivan Boesky, Michael Milken, etc. These institutions - a strong and competent media, and a high probability of imprisonment deriving from exposure - are the foundation of a well functioning financial sector.
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