Peter Szilagyi: “This scandal is yet another case of banks arbitraging weaknesses in regulation and oversight”
In the aftermath of the "Cum(s)" scandals - cum-cum, cum-ex and cum-fake - we've asked Peter G. Szilagyi, Professor at EDHEC Business School, a few questions about these schemes, the regulation of the financial sector and the ethics revolution he calls for.
16 judges, 150 investigators: the PNF has striken a blow in the cum-cum and cum-ex scandals. Were you surprised?
I was surprised by the scale of the operation, it was the biggest bank raid ever in France. Otherwise it was really only a matter of time. Germany, where the scandal had broken in 2018, had also had raids (1) and already made the first convictions. Some 100 banks reportedly remain under investigation worldwide. The estimated tax revenue losses since 2000 are extraordinary at €36 billion in Germany, €33 billion in France, €27 billion in the Netherlands, €19 billion in Spain and so on. This is according to CORRECTIV, the investigative reporting center that broke the scandal in Germany (2). They came up with the estimates with Christoph Spengel, an economics professor at the University of Mannheim whose team helped analyze global stock trading data (3).
These scandals mix legal, grey and illegal practices. What does it tell us about Finance in 2023?
There are three trading schemes that employ grey and illegal tax evasion practices to varying degrees. Cum-cum schemes evade withholding taxes on dividends through short-term stock lending from offshore to onshore around dividend payment dates. The constituent stock trades are technically not illegal, but they have no economic substance and most certainly violate the spirit and intention of market legislation and regulation. Cum-ex and cum-fake schemes constitute outright tax fraud. In cum-ex trading, traders and intermediary institutions collude to claim multiple refunds of withholding taxes paid only once. Here, the colluders exploit ambiguities in stock ownership due to the non-instantaneous settlement of stock trades. In cum-fake trading, tax refunds are claimed without withholding taxes paid at all. In this case, refunds are claimed using pre-release American Depositary Receipts (ADRs) that the depositary bank has issued without the underlying French or German stocks actually filed. Cum-ex and cum-fake are more complex but also much more profitable than cum-cum trading. How far you can go in each country is dictated by legal, regulatory and market conditions.
The scandal rivals and, as the global scale of the government tax losses unfolds, may well eclipse the recent FX and LIBOR rate manipulation banking scandals (4). This is basically yet another case of banks arbitraging weaknesses in regulation and oversight, despite the potential criminal penalties. The stock trading data analyzed by Professor Spengel suggest that the trading schemes are still being deployed, despite the legal and regulatory efforts to combat them.
How could we bridge the gap between ultra-rapid and complex practices, and the limited time and resources of the regulators?
The scandal once again serves to highlight that financial misconduct cannot be prevented or even adequately detected by the current top-down approaches to market regulation, surveillance and enforcement. This is not necessarily a function of regulatory capacity. Like market manipulation and insider trading, tax evasion is perceived to be a “victimless” crime. If there are loopholes and ambiguities coupled with ineffective operational surveillance and limited information sharing among national and international regulators, they will be exploited however much creativity this requires. People who commit or facilitate tax evasion do a cost-benefit analysis, and act when the probability and size of penalties is sufficiently low. In financial institutions they can rationally act for both personal gain and corporate interests. Their conduct is also shaped by a competitive organizational culture, and behavioral biases such as tribalism and loyalty.
The interesting thing about the German cum-ex scandal is that the authorities played right into the hands of the banks. CORRECTIV discusses the chronology of events that made large-scale cum-ex trading possible, with an active push from the banking lobby. Successive whistleblowers were not incentivized, taken seriously or protected enough. As we discuss in our work on the FX and LIBOR scandals, whistleblowers – whatever their incentives - are absolutely critical for the prevention and detection of financial market misconduct (5).
To you, the ethics (r)evolution should mainly come from inside, i.e from a culture shift in finance and trading, away from tribalism, a sense of impunity or worse. Could you elaborate?
In our work on the FX and LIBOR scandals we advocate for the addition of a bottom-up approach to the current top-down approach to disciplining markets. Authorities should rely on not just deterrents and whistleblowers, but an active instigation of lawful and ethical conduct at the personal as well as organizational level. Financial institutions already have internal ethical codes and rules in place (6). These come from national regulations, industry organizations and trade unions such as the French Banking Federation, as well as guidance from international institutions such as the Bank for International Settlements. However, these scandals continue to show a circumvention of rules and codes, whether they are prescribed externally or self-imposed.
Are these repeated scandals a good signal – the sector is less opaque, less unreachable – or a bad one – the permissive culture will always bring new schemes, new frauds?
Financial institutions are very innovative and sophisticated when it comes to revenue and profit generation. The cum-cum, FX and LIBOR schemes all flew under the public radar, despite persistent rumors and allegations, for decades before anything meaningful was done to stop them. In this sense the globalized financial system is “permissive” by nature. Hence the importance of authorities cooperating domestically and across borders, acting in concert and reimagining the current regulatory approach to market discipline. Now that investigations are in full swing worldwide, prosecutions will offer some scope for retribution. But, I expect that once again the fines and criminal penalties will inevitably be pocket money compared to the profits that the banks involved have made over the last two decades. I find it unlikely that the penalties would be so drastic that authorities would seriously risk endangering the banks and screwing up financial markets. Not after Credit Suisse was sunk by its long series of scandals.
(1) August 2019, Reuters, “Prosecutors raid Deutsche Boerse offices over share-trading scam” - https://www.reuters.com/article/us-deutsche-boerse-raids-idUSKCN1VH15W
(2) Oct. 2021, CUMEX files, correctiv.org - https://correctiv.org/en/latest-stories/2021/10/21/cumex-files-2/
(3) Feb. 2021, “Public Hearing of the Subcommittee on Tax Matters of the European Parliament on the Cum-Ex/Cum-Cum Scandal. Statement by Prof. Dr. Christoph Spengel” - https://www.europarl.europa.eu/cmsdata/230392/Christoph%20Spengel%20statement.pdf
(4) Jan. 2020, The Guardian, “Libor scandal: the bankers who fixed the world’s most important number” - https://www.theguardian.com/business/2017/jan/18/libor-scandal-the-bankers-who-fixed-the-worlds-most-important-number
(5) Oct. 2021, ABACUS, “Financial Market Manipulation, Whistleblowing, and the Common Good: Evidence from the LIBOR Scandal” - https://onlinelibrary.wiley.com/doi/abs/10.1111/abac.12245
(6) Jan. 2022, EDHEC Vox, “After Milken, Keating, Madoff, Kerviel... New paths to ethical practice in the Finance industry” - https://www.edhec.edu/en/research-and-faculty/edhec-vox/after-milken-keating-madoff-kerviel-new-paths-ethical-practice-finance