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CAPITAL MARKETS AND INSTITUTIONS

Ethics

Vs.

Lets consider Ethics leading to GFC


A short review on sub-prime

http://www.youtube.com/watch?v=2CVqwoN5dJg

So what happened?
Non-creditworthiness people were given loans that cannot be paid back
High risk loans were packaged into CDO and got insurance to make it high rating
CDOs were sold to various investors
Why did they do this?

By mortgage brokers
By banks & structured
financiers

Everybody else are doing it


By insurance & credit
agencies

It needs to be done
By investment banks

No one will get hurt

Even by investors

Meanwhile, all got paid well!

Fast tracked to now

What happened since GFC?


Recent significant fines for unlawful and unethical behaviour:

So, What is Ethics?


Ethics
A set of guiding moral principles or values

Ethical Behaviour
Refers to behaviour that conforms to those values

Both terms are often used to imply


good ethics and good behaviour

Why ethics and ethical behaviour in especially investment industry is


good business?

Ethics is not a new concept


There are no new sins; the old ones just get more publicity.
Cited in Ethics and Financial Markets: The role of the Analyst by Marianne Jennings

The Code of Hammurabi for Ancient Babylon (bc. 1800):


If a builder builds a house for a man and does not make its construction firm, and
the house which he has built collapses and causes the death of the owner of the
house, the builder shall be put to death

Tulip Speculation 1636 (Holland)


Market bubble Futures of tulip were traded when physical tulips were no longer
available. It went up to 10k in present day USD. Investors took the word of those
who promised future delivery and then realised that there is no delivery. The
collapse impacted on Holland economy.

Ethics is not a new concept


Charles Ponzi (1882 1949)
Promised his investors 50% return within 45 days. All started with arbitrage of
coupons between Spain and U.S bought for 1cent in Spain and redeem in U.S for
6 cents. But the arbitrage window closed. He continue to pay investors with funds
from new entrants whilst taking his usual cut.

Recent example (2009) - Bernard Madoff promised 12% return.

(1994) Rogue Trader: The man who brought down Barings


Derivative trader Nick Leeson covered up losses up to USD1.4bn (2x the banks
trading capital). Brought down the oldest English bank (1762-1995)

What is the common theme here?

Ethics is not a new concept


Charles Ponzi (1882 1949)
Promised his investors 50% return within 45 days. All started with arbitrage of
coupons between Spain and U.S bought for 1cent in Spain and redeem in U.S for
6 cents. But the arbitrage window closed. He continue to pay investors with funds
from new entrants whilst taking his usual cut.

Recent example (2009) - Bernard Madoff promised 12% return.


(1994) Rogue Trader: The man who brought down Barings
Derivative trader Nick Leeson covered up losses up to USD1.4bn (2x the banks
trading capital). Brought down the oldest English bank (1762-1995)

What is the common theme here?

Aligning interests to gain trust


Global survey by CFA Institute and Edelman Berland in 2013 revealed that trust
among institutional and retail investors has eroded.
48% said they do not trust financial services investors do what is right
Only 15% has great deal of trust in investment management industry
When it comes to the attributes that investors value the most:
35% said acting in the best interest of the client
17% - ability to achieve high returns and commitment to ethical
conduct
Only 7% - amount / structure of fees

Investors have moved beyond just good performance and are more interested in
trustworthy behaviours

Restoring trust
First Embrace transparency
Clearly articulate investment success and missteps
Disclose conflicts of interest, quickly address problems
Fully disclose fees and impact
Second Demonstrate Integrity
Resolving conflict of interest in favour clients
Structure fees to align with clients risk/return objectives
Third Improve communication
Communicate with clients early and often throughout investment process

Fairly represent the investments made, risk, expenses


Avoid ambiguity in communications

Restoring trust
Sounds easy, but why havent we effectively implement?

A crisis of culture
A global survey of 382 financial services executives in Sept 2013 shows:
Most firms have attempted to improve adherence to ethical standards
Industry executives champion the importance of ethical conduct
But, executives struggle to see the benefits of greater adherence to ethical
standards
Needs to address knowledge gaps
Lack of understanding and communication between departments
continues to be the norm

We all need to do our part

CFA Code of Ethics


Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients
above my own personal interests.
Use reasonable care and exercise independent professional judgment when
conducting investment analysis, making investment recommendations, taking
investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner
that will reflect credit on ourselves and the profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve my professional competence and strive to maintain and
improve the competence of other investment professionals.

Standards of Professional Conduct


There are a total of 7 standards:
I.

Professionalism

II.

Integrity of Capital Markets

III. Duties to Clients


IV. Duties to Employers
V. Investment Analysis, Recommendations, and Actions
VI. Conflicts of Interest

VII. Responsibilities as A CFA Institute Member or CFA Candidate

Standards of Professional Conduct

I (A) Knowledge of the Law


As an investment professional, your conduct is determined by
these organizations:

Government and regulatory agencies


Licensing agencies
Professional associations

As a member of CFA Institute or candidate in the CFA Program,


you must

understand and comply with all applicable laws.


comply with the stricter of applicable law or the Code and Standards.
not knowingly participate in any violation.
dissociate from any violation.

Dissociation from violation


Was the activity
illegal or unethical?

No

I dont
know

Yes

Dissociation from violation


Was the activity
illegal or unethical?

No

I dont
know

This is the ideal situation. If not already in place,


encourage your firm to develop and/or adopt a code
of ethics and to establish procedures for reporting
violations. Remember, sound ethics is fundamental to
capital markets and the investment profession

Yes

Dissociation from violation


Was the activity
illegal or unethical?

No

I dont
know

Yes

Ethical dilemmas are not always easy to interpret, so it's okay to


be unsure whether an activity is illegal or unethical. If you're
unsure, seek the advice of your firm's compliance department or
legal counsel. Remember, inaction combined with continued
association with those involved in illegal or unethical conduct may
be construed as participation or assistance in the illegal or
unethical activity.

Dissociation from violation


Was the activity
illegal or unethical?

No

I dont
know

Yes

If you've recognized that an illegal or unethical activity


has occurred, you must take action to avoid being
associated with that activity
Dissociate

Report

Stop

I (B) Independence and Objectivity


Avoid situations that could cause or be perceived to cause a loss of independence
or objectivity in recommending investments or taking investment action.
Maintain your professional integrity by remaining independent and objective at
all times.
Avoid compromising your own or anothers independence and objectivity.
Ways in which your independence and objectivity may be compromised or
perceived to be compromised include the receipt of:
Gifts
Invitations to lavish events
Tickets
Favours
Job referrals
Additional compensation

I (C) Misrepresentation
Must not knowingly make any misrepresentations relating to investment analysis,
recommendations, actions, or other professional activities.
A misrepresentation is any untrue statement or omission of a fact or any
statement that is otherwise false or misleading.

To avoid misrepresentation, consider the following action items:


Be honest about your professional credentials and your firms performance
Exercise care and due diligence when relying on third-party information

Disclose the use of external managers


Be forthcoming with the risk and unpredictability of investments
Acknowledge sources of ideas and materials that are not yours

I (D) Misconduct
Avoid dishonest, fraudulent, or deceitful conduct that reflects adversely on your
professional reputation, integrity, or competence.
Trust is the epicenter of the operations of the financial market as a whole.

Your professional reputation, integrity, and competence are the starting point
on this critical path to trust.

III Duties to Clients

III (A) Loyalty, Prudence and Care


What it means to have a duty of loyalty, act with reasonable care, and exercise
prudent judgment.

III (B) Fair dealing


Deal with clients fairly with respect to investment recommendations and
actions.
Recommend policies and procedures that will help to ensure that investment
recommendations or changes in prior recommendations are disseminated to
clients fairly and objectively.
Recommend policies and procedures to ensure that all individual and
institutional clients are treated in a fair and impartial manner when taking
investment actions.
Some suggested actions for fair dealing compliance
Limit the number of people involved.
Shorten the time frame between decision and dissemination.
Publish guidelines for pre-dissemination behaviour.
Disseminate investment recommendations simultaneously.
Maintain a list of clients and their holdings.

Develop and document trade allocation procedures.

III (C) Suitability


In an advisory relationship, make reasonable inquiry of your client situation to
make suitable investment recommendations.
Document the clients needs, circumstances, and investment objectives in an
investment policy statement.
Client identification
Investor objectives

Investor constraints
Performance measurement benchmarks
Review and update the investment policy statement regularly.
Document attempts to carry out the review if circumstances prevent it.
Develop test procedures for choosing investments that include
an analysis of the impact on the portfolios diversification.
a comparison of the investment risks with the clients assessed risk
tolerance.
the fit of an investment with the required investment strategy.

III (D) Performance Presentation


Give a fair and complete presentation of performance information by:
applying the Global Investment Performance Standards (GIPS), or

without the GIPS standards:


considering the knowledge and sophistication of the audience to
whom a performance presentation is addressed,
presenting the performance of the weighted composite of similar
portfolios rather than using a single representative account,
including terminated accounts as part of performance history with a
clear indication of when the accounts were terminated,
including disclosures that fully explain the performance results being
reported, and
maintaining the data and records used to calculate the performance
being presented.

III (D) Preservation of confidentiality


Maintain client confidentiality related to information
1. you receive as a result of your ability to conduct a portion of the clients
business or personal affairs and
2. that arises from or is relevant to that portion of the clients business that
is the subject of the special or confidential relationship.
Disclose client information when
1. the information concerns illegal activities on the part of the client;
2. disclosure is required by law; or
3. the client or prospective client permits disclosure of the information.

III (D) Preservation of confidentiality


What is the simplest and the most effective way to comply to Standards III (D)
Avoid disclosing any information received from a client except to
authorised fellow employees who are also working for the client.
If you want to disclose information received from a client that is outside the
scope of the confidential relationship and does not involve illegal activities, first
ask yourself the following:

In what context was the information disclosed? If disclosed in a discussion


of work being performed for the client, is the information relevant to that
work?
Is the information background material that, if disclosed, will enable you to
improve service to the client?

Disregard this slide

CFA Case Study Buying Lubrizol


What happened?

What are the ethical issues?

If you were David Sokol and Warren Buffet, how would you do it differently?

Summary: Good ethics in finance and investment industry


In finance and investment industry, opportunities to be unethical arise every
day.
Ethical behaviour among investment and finance professionals is critical to
maintaining public trust
Day-to-day dilemmas, simple questions to ask yourself:
Does this violate the law?
Is this honest?
What if I were on the other side?

Conduct yourself with integrity and dignity and act ethically in all dealings

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