Chinese Wall
A barrier between departments to block any exchange of information
What Is A Chinese Wall?
A Chinese wall, also known as an ethical wall, is a barrier between departments to block any exchange of information. This is in an attempt to prevent conflicts of interest within the organization. However, these barriers are legal requirements, and firms can be severely punished for not following the correct protocols.
Although these protocols are in place in many industries, from journalism to law to finance, it is most commonly found in investment banks. As a result, some departments may be privy to information that could influence those making investments, creating a direct conflict of interest.
A Chinese wall is primarily an ethical concept. Nothing concrete in place can stop a worker from talking about non-public information to those who are not privy to such information.
However, many firms take the step of making employees sign contracts or non-disclosure agreements to attempt to legitimize this process. As a result, employees within the same department or those serving the same client can freely discuss the material.
However, discussions with other departments or banks would be strictly prohibited under this non-disclosure agreement.
The information in question may, for example, be about to become public through a company's initial public offering. Access to this information before this stock issuance may change the way investors buy the upcoming stock or any other asset.
It may be created to protect sensitive information regarding a merger or acquisition process.
One section of the investment bank may be planning a client takeover of another firm performing poorly. Another section of the bank has financial services that advise clients on what stocks to buy and sell. Insider information that the takeover might inspire clients to change their behavior.
Clients may now buy stock of the failing firm in recognition that it will be taken over. The standard pattern of behavior before accessing private information may have been to sell the company stock.
Ultimately, this creates conflicts of interest and illegal trading practices, particularly insider trading.
Key Takeaways
- A Chinese wall, also known as an ethical wall, acts as a barrier between departments to prevent the exchange of information. Its purpose is to avoid conflicts of interest within the organization.
- While used in various industries, Chinese walls are most commonly found in investment banks where different departments may have access to information that could influence investment decisions, creating potential conflicts of interest.
- Chinese walls are primarily an ethical concept, but firms often use contracts or non-disclosure agreements to formalize the process. Violations can result in legal consequences.
- Chinese walls can prevent sharing sensitive information like pre-IPO details, merger plans, or acquisition processes. This safeguards against clients acting on insider information.
- Chinese walls were introduced after the 1929 stock market crash to prevent speculative trading and conflicts of interest. While they have shown effectiveness, instances like the dot-com bust and the 2008 financial crisis highlighted challenges and the need for continued vigilance in preventing unethical activities.
When was the Chinese Wall introduced?
Chinese walls were introduced after the stock market crash of 1929. In 1933, Congress passed a bill known as the Glass-Steagall Act. This act separated investment and commercial banking activities.
This was a response to the notion that investment banking activities had contributed largely to the stock market crash of 1929. This is because the mixed nature of commercial and investment banking was seen as too speculative and risky.
The act left a year for firms to decide whether to pursue commercial activities or investment activities. This directly affected many banks. A famous example is JP Morgan and Company, which broke into another subset, Morgan Stanley, to deal with brokerage operations.
However, for the most part, the act aimed to prevent conflicts of interest. As a result, firms could now pursue many forms of banking with stricter restrictions.
This ethical restriction was now something that all banks were expected to comply with. Nowadays, this is further enforced by the SEC.
Separating departments within banks led to a phrase: 'brought over the wall.' The metaphor of 'being brought over the wall' is commonly used when an external member of those serving the client is brought to work with the team.
Therefore, they become privy to sensitive information and are bound by the same ethical code that the other team members are bound by. Commonly, this member is a research analyst brought over the wall to work for the underwriting department to add opinion to decision-making processes.
When a worker or research analyst is brought over the wall, they commonly have a unique or specific skill set that is useful to another department.
This is a fairly common practice, as it is unlikely that the initial group privy to confidential information is fully equipped to deal with potential problems. However, the dot-com boom and bust of the 1990s made people wary of this practice, as will be discussed in a later section.
What is the SEC?
The SEC stands for the U.S. Securities and Exchange Commission. This department aims to maintain fairness and order in the securities market. Their aim, according to them, is to have a 'positive impact on America's economy, our capital markets, and people's lives.'
It was created in 1934, following the first implementation of Chinese walls in business under the Glass-Steagall Act. Primarily, the SEC oversees transactions in the securities market but also promotes fair actions and protection from fraud.
The commission only has the power to bring civil cases to court, not criminal ones. They work with the Department of Justice to bring criminals to justice.
The SEC can be split into the following six divisions:
- Corporation Finance - ensures investors are provided with correct material information.
- Examinations - ensures market integrity through risk-focused strategies.
- Economic and Risk Analysis - involved in integrating financial economics and data analytics into their core mission statement
- Investment Management - develops regulatory policy for investment companies.
- Enforcement - conducts investigations into possible breaches of the law.
- Trading and Markets - regulates the major market participants.
More information can be found directly on the SEC's website under divisions. Considering it can only make civil cases, the SEC attempts two types of sanctions.
The first is to lay injunctions on the lawbreaking party. Ignoring an injunction can result in fines or imprisonment.
The second method is via disgorgement: the legally mandated repayment of monetary gains made through unethical or illegal means.
Does Chinese wall work?
The metaphorical wall represents a barrier designed to ensure that sensitive information from one department, say corporate advisory, does not flow freely to another, like trading.
But as global finance becomes more interconnected and complex, questions arise: Is this still effective? Can it prevent undue influence and the misuse of insider information?
In order to determine this efficacy, we will look at several cases where these ethical walls were involved.
The stock market crash of 1929
The stock market crash of 1929 was when fast-selling investors sent the Dow Jones Industrial Average plunging by 11%, leading to the Great Depression. This followed a prolonged half-decade of growth, which saw the index increasing vastly.
This was because of bullish investing, which means investors who thought that the overall market, or a particular stock, would increase in value.
As mentioned in earlier sections, the implementation of the Glass-Steagall Act was a response to the Great Depression. With free communications between commercial and investing divisions of banks, speculative operations became commonplace.
The conflicts of interest between the different bank departments led to speculative trading and unprofitable loans, as Chinese walls did not control the information.
Following the implementation of this act, banks could no longer engage in these activities. This meant the deeply risky and unethical trading activity that was a primary cause of the 1929 stock market crash could no longer occur.
This is a strong case in favor of Chinese walls. However, the implementation was not entirely ps witnessed in the following crashes.
Dot-com boom and bust
The dot-com boom is another situation of bullish investor behavior. There was rapid inflation of internet-related company assets due to excessive speculation amidst widespread internet adoption.
While the NASDAQ index rose five-fold between 1995 and 2000, in 2001 and 2002, the Nasdaq fell by over three quarters. By the end of 2001, most dot-com stocks were bust, leading to billions of dollars in losses.
At this time, some stock analysts were household names. However, these analysts' predictions on specific securities could cause the stock to increase or plummet massively.
These big-name analysts were pressured into giving certain stocks good ratings, and the analysts would promote these stocks regardless of credibility. The analysts would also own these stocks and, therefore, stood to gain from selling them at higher prices.
Top analysts would also own pre-IPO shares and display favoritism to certain clients, encouraging them to buy the same stock.
Although the Chinese wall implementation of the 1930s protected against interdepartmental activities, it did not protect against the activities of individual analysts.
Analysts had free reign under this system to manipulate ratings and clients as they pleased.
Often, analysts would deliberately favor the stocks they were most involved with. The aftermath of the activities of these analysts was a separation between analysts and the underwriting practice.
Many large firms, including Citigroup, Morgan Stanley, and Goldman Sachs, separated research and, investment banking divisions. This meant that the process of being 'brought over the wall' became much more heavily legislated.
It could no longer be done simply at the whims of the team and was done by regulations set out by the National Association of Securities Dealers and the New York Stock Exchange.
The financial crisis of 2008
Soon afterward, another issue with Chinese walls became apparent. A combination of factors caused the financial crisis of 2007 to 2008, but one of the most pertinent was the subprime mortgage crisis.
This crisis was triggered by the bursting of the housing market bubble, which led to a large-scale collapse of the global financial market.
Rather than the shortcomings being the issue, rating companies and client companies likely did not follow the rules. In this case, credit rating agencies were fraudulently selling BBB or lower securities as AAA.
There is very little that these can do in this case, as, although there was a separation between rating companies and client services, these rules were likely being flouted.
However, it is also possible that the Chinese walls hindered the ability of investors to make consistently informed decisions.
For example, some clients may have been advised to buy into securities known as CMOS or collateralized mortgage obligations. Others were advised to short these same securities, even within the same firm.
Due to the lack of information flow, investors conflicted with each other. In this case, Chinese walls may have been too stringent or lenient, playing a part in the financial crisis. However, it isn't easy to evaluate the policies of Chinese walls and their current impact on the financial system.
New policies have been introduced, such as not tying the salary of an analyst to the success of IPOs or conducting trades in securities they own. These policies, however, may not be able to solve some ethical problems that induced the financial crisis of 2008.
These require self-regulation, which is difficult to monitor and even more difficult to enforce. Although we can ethically recognize their importance, it isn't easy to evaluate if firms work within limits.
They help provide clear ethical boundaries. However, as witnessed in 2008, they are difficult to use when attempting to prevent fraud. They work on an honor system rather than a strict, technical system.
public vs private sides in investment banking
One method of splitting investment banks is to split between the public and private sides of the firm. The private side of investment banking firms includes groups that have access to private company information.
They comprise industry groups (healthcare, energy, TMT), who become experts in a particular industry but cover a wide range of products and product groups that focus on specific sectors, like M&A. Both of these groups have information that other sections or groups cannot access within the firm.
This is in contrast to the public side of investment banks. Public-side investors work with annual reports, press releases, and SEC filings that any public member can access in the public sector can still be part of the same investment bank as the private sector.
The purpose of the Chinese wall is to strictly prevent the movement of information within the private sectors of the firm and between the private and public sectors.
The separation of the two helps prevent insider trading. Insider trading is a financial crime involving trading public securities based on information not available to the general public.
In many developed countries, activities that constitute insider trading are strictly illegal, with mainly financial punishments, but occasionally, they result in jail time. This is because the information given to potential investors is not public and can affect their decisions to buy or sell public securities.
These help prevent insider trading by removing the ability to gain private insider access to information on:
- Bonds
- Stock options
- Other marketable securities
Trading securities based on information available in the public domain is not illegal. It is, however, illegal to trade based on information that is only accessible to members of a team in the private sector of an investment bank and their clients.
Is the use of the term "Chinese wall" offensive?
In recent years, the term has gradually been phased out in favor of the ethical wall. The term stems from the Great Wall of China, erected in China over two millennia ago. It works as a metaphor for barriers.
However, considering that it refers to people of a specific race, the term is generally no longer favored. Moreover, this pressure to abandon the term has increased over time, accelerating with the inclusion of China as a major player in the global financial market.
In 1988, a justice known as Justice Law suggested ethical wall as an alternative term. He mentioned how the metaphor was both offensive and metaphorically inappropriate. For example, the Great Wall of China was designed to keep intruders out, while an ethical wall involved sealing both parties on either side.
Therefore, the term ethical wall is favored because it is offensive to Chinese culture. However, in 2021, the Financial Conduct Authority (FCA) in the United Kingdom scrapped the use of the term Chinese wall.
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