Chinese Walls in Investment Banking

The nature of investment banking is such that investment bankers are supposed to work very closely with their clients. In due course of their work, they are often exposed to information that is not public. This material information is not known to the larger public. Hence, this creates a situation in which investment bankers have an informational advantage over their counterparts in the public. This can lead to insider trading, which is a crime.

In order to prevent investment banks from indulging in insider trading, regulatory bodies have mandated that the flow of information within the investment bank be regulated. This is done by a mechanism that is informally known as the Chinese Wall. In this article, we will understand what the Chinese Wall is and how it impacts the operations of an investment bank.

What is a Chinese Wall?

We already know that investment banks are composed of several distinct departments. The working of one department is not completely connected to the working of the other. For instance, the tasks performed by the underwriting department have little or no bearing on the tasks performed by the advisory department.

The main assumption behind the Chinese Wall strategy is that since the functioning of these departments is not interconnected, it is possible to create an artificial information barrier between them and not impact their smooth functioning in any way. This is why the Glass-Steagall Act has allowed commercial banks to undertake investment banking activities as well. The caveat is that the two different activities will be divided by a Chinese wall.

A Chinese Wall means that the free flow of information between the different departments of the investment bank is curbed. This means that any employee of the investment bank who has any information about the client will reveal it to his/her colleagues strictly on a need to know basis. The free dissemination of this information is legally considered to be a crime for which an employee can lose his/her job and also end up in prison.

There are certain exceptions to the Chinese Wall. They are employees who hold high ranking positions in the investment bank. This would include officers like the Chief Executive Officer, Chief Financial Officer, etc. They are privy to all the information about the clients. However, there are restrictions placed on the activity which they can undertake. For example, they are not allowed to buy and sell shares freely in the open market. The financial activities of their family members may also need to be disclosed in certain countries. These same rules apply to the employees who have been given an exception and to whom information is passed on since it is believed that they have a genuine need to know.

What Would Happen if the Chinese Wall is not Present?

The modern securities trading system relies upon the Chinese Wall system to a large extent. This is because, in the absence of Chinese Walls, there would be chaos in the market. Some examples are given below:

It is highly likely that the information obtained by the different departments of the investment bankers will first be passed on to their trading desk. The trading desk will be able to make an informed decision based on an informational advantage. Hence, they would consistently make more profitable trades as compared to the public at large.

Investment bankers would typically refrain from taking the straightforward approach mentioned above. This is because the profits will be traced back to their proprietary trading operations, and then there will be legal consequences. Instead, investment bankers pass on this information to their favored clients in the form of buy/sell recommendations. In lieu of these recommendations and research reports, they ask their clients, such as hedge funds and mutual funds, to route their investments from the desk of the investment bank bringing in huge commissions.

When investment banks trade with an informational advantage, they often trade with the market-maker on the other side. Hence, whatever they gain is often at the expense of a market maker. Over time, the market maker realizes the risk inherent in an informed counterparty. Hence, they increase the bid-ask spread. Now, this bid-ask spread is applicable to all the players in the market. Hence, in a way, the market maker passes on their losses to all the participants. A higher bid-ask spread is an indicator of high levels of insider trading going on.

Allegations Against the Chinese Wall

Critics of the Chinese Wall theory have called the argument ridiculous. Many of them do not believe that a set of procedures can regulate the behavior of individuals when they stand to gain financially from them. For instance, information may not be shared formally over e-mail but can be shared informally over water cooler conversations in code language.

On the other hand, they believe that the entire construct of Chinese Walls is only a legal defense to prevent firms from being held legally accountable for the actions of their employees. The Chinese Wall legal defense states that the firm has taken all the necessary precautions to create a Chinese wall and hence should not be held accountable. Since the individual has made efforts to circumvent the Chinese Wall, they should be prosecuted and not the firm.

The bottom line is that the Chinese Wall construct does exist in all major investment banks today. These banks are supposed to create rules and regulations prohibiting the free flow of regulated information between departments. The effectiveness of the Chinese Wall construct is questionable at best.