published Jun 14th 2016, 8:00 am, by Matt Levine

(Bloomberg View) —

LinkedSoft.

The most terrifying slide in the investor presentation for Microsoft’s $26.2 billion acquisition of LinkedIn features this bubble: The archetypal joke about the deal is an image of the old Microsoft Clippy saying “I’d Like to Add you to My Professional Network on LinkedIn,” but Microsoft and LinkedIn, two companies that are impervious to humor, have embraced the same idea. That bubble is Cortana — Microsoft’s digital assistant, sort of a natural-language mobile Clippy — tapping into poor Jen’s LinkedIn network to advise her on her real-life work interactions. “I see you plan to interact with a human,” bleats Cortana. “Have you considered talking about your shared interest in sports?” It combines Microsoft’s legacy chirpy intrusiveness with LinkedIn’s grim determination to pester you with boring information about your acquaintances.

It’s such a good idea! Microsoft and LinkedIn are the great software companies of work, of boredom, of getting on the calendar to schedule a meeting. Work is an essentially social activity; it is among our most important social activities. But most work software — even collaborative interactive whatever software — does not fully honor that social component; it helps you share the slide presentation but not your love for the Huskies. Meanwhile, a lot of social networking software seems to be designed by, and intended for, people who have never had real jobs. “Make your selfie look like a cartoon dog” is a functionality that I suppose appeals to the tweens craved by advertisers. But, to a certain demographic, “chat up this stranger about Pac-12 football so that he signs a lucrative consulting contract with your company” is far more exciting. Of course you should read Paul Ford on Microsoft/LinkedIn: LinkedIn knows a lot about what people do and Microsoft builds tools for doing lots of specific, difficult things (I.e. programming, project management, making diagrams, managing databases). If there was a single LinkedIn API that let you do things like: Look up people in your company; find relevant consultants; identify the skills needed to solve problems, etc.; that’s a kind of raw power that we don’t really see inside of most software.

Meanwhile, the deal is a bit rich; here are Michael de la Merced and Leslie Picker, and Bloomberg Gadfly’s Brooke Sutherland, on the valuation, and Bloomberg View’s Conor Sen cautioning against interpreting that valuation as bubbly. But no one has ever bought a social media company to capture its next twelve months of earnings. You buy a social media company to take over the world.

Elsewhere, here is Bloomberg Gadfly’s Shira Ovide on Microsoft’s underwhelming track record with integrating acquisitions. Here is Kara Swisher on Microsoft’s promise not to continue that track record with LinkedIn. Here is Andrew Ross Sorkin on LinkedIn’s stock-based compensation, which might have been a factor in pushing it to sell. Here are the advisers. “Goldman Is Said to Have Advised Another Possible LinkedIn Bidder.” And Twitter was up because maybe there’s hope for it after all.

The Second Law of Insider Trading.

The Second Law of Insider Trading is of course: “If you have inside information about an upcoming merger, don’t buy short-dated out-of-the-money call options on the target.” If you bought LinkedIn stock on Friday — it closed at $131.08 — you made a lot of money over the weekend; Microsoft will pay $196 per share in cash. But if you bought short-dated out-of-the-money call options on LinkedIn on Friday, you made even more money. LinkedIn call options expiring this Friday, with a strike price of $150, traded for 2 cents a share last Friday. They’re now worth more than $42 per share. If you’re the lucky person who bought, say, the 77 contracts — 7,700 shares’ worth — that traded at 3:30:13 p.m. on Friday, you paid $154 for options that are now worth more than $325,000, for better than a 200,000 percent return in about 72 hours.

But there is no particular reason to think that those options violated the Second Law. Those options trade fairly frequently; a total of 237 contracts traded last Friday, compared with 307 the day before that and 562 the previous Friday. Those options were just normal, regularly traded options; most of the people buying and selling them presumably didn’t have inside information. Sure, last Friday, with the stock at $131.08 and just a week left to get to $150, those options were a wild gamble, but that’s why they only cost 2 cents. The fact that the gamble paid off doesn’t mean that anyone knew the outcome in advance.

More suspicious, according to Fortune’s Dan Primack and Stephen Gandel, is this trade: One of the LinkedIn options is a call with a strike price of $160 per share, which is the price at which an option starts to make money, that matures on August 19. They first began trading on Feb. 5, which also represented the day with the most contracts sold, at 121 (the only day of triple-digit action). Well, until last Friday when a whopping 621 contracts were traded.

That makes that option look much more suspicious than the more run-of-the-mill short-dated out-of-the-money call option. And it worked out pretty well too: It is, of course, possible that last Friday’s buyer (or buyers?) simply had remarkably fortunate timing. Just how lucky? According to data from Bloomberg, 600 options to buy LinkedIn shares at $160 were bought in two trades on Friday afternoon for a total of $135,100. Those same options are now worth just over $2 million, for a less than one trading day profit of nearly $1.9 million.

Nah. If you look at all of the August 2016 LinkedIn options that traded on Friday, a sadder story emerges. Of the 621 $160-strike call options that traded on Friday, 500 traded at exactly 1:40:39 p.m., along with 500 more call options (with a $185 strike price) and 1,200 put options, with $115 and $125 strike prices. Listed equity options are traded through market makers, principal traders who stand ready to buy or sell options from anyone who shows up. They make money on the spread: They’ll bid to buy options at one price, offer to sell the same options at a higher price, and keep enough room between the bid and the offer to make some money. Judging by where the LinkedIn options traded, versus the bids and offers at the time, it seems like our mystery trader sold the $160 call options and the $125 puts, and bought the $185 calls and $115 puts. (This is called, embarrassingly, a “broken wing iron condor.”) He got paid about $274,500 for doing that, and his payoff profile looked something like this:

That looked like a perfectly fine trade on Friday, with LinkedIn trading at about $132. If it stayed around there — above $125, below $160 — through August, nothing would happen, none of the options would pay off, and our trader would keep his $274,500 of premium. If it went down below $125, or above $160, the trader would make less money; below about $120, or above about $166, he would start losing money. But above $185, his losses would be capped, at just under a million dollars.

At the deal price of $196, our trader is just a little bit off the right side of that chart. Oops!

Of course the market-making firm who was on the other side of these trades — and who, in particular, bought those $160 calls — made a (quick, lucky) profit on the trade. Though it probably hedged, so its profit was probably nowhere near a million dollars. But the market maker, who just passively buys and sells options based on customer demand, is unlikely to have had any inside information. The market maker really did just get lucky.

Some of the other LinkedIn options that traded on Friday probably weren’t paired with other trades, and were just bets that LinkedIn would go up. Some of them paid off. Maybe some of them were made with inside information! Who knows. But this trade seems to have been a bet that LinkedIn’s stock wouldn’t go anywhere, and it’s hard to believe that the mystery trader who put it on — and lost almost a million dollars over the weekend — had any inside information.

Speaking of weird options.

The Bank of New York Mellon will pay $30 million to settle Securities and Exchange Commission charges over its “standing instruction” foreign exchange program. (We talked about this last year when it settled with the Justice Department.) Oversimplifying a bit, the way the program worked is that at the start of each day BoNY Mellon would put out a “daily schedule” of buy and sell rates, and guarantee that clients wouldn’t buy or sell at worse than those rates. (There was plenty of room between those rates.) Then client transactions would come in during the day, and BoNY Mellon would aggregate them, and then at the end of the day it would give clients more or less the worst rate of the day, as long as that rate was within the “daily schedule” rates. Generally this means that the client got a worse rate than it would have gotten by just executing the transaction in the spot market, and BoNY Mellon profited from the difference.

So is that profit: Fair compensation to BoNY Mellon for providing the client with a valuable option, the guaranteed “daily schedule” rates? (After all, if the exchange rate moved outside of the daily schedule band, the client would be able to buy at below the market rate or sell above it.) Fair compensation to BoNY Mellon for the administrative, etc., headache of aggregating a bunch of small foreign exchange transactions for its customers? Just gouging the customers?
I suspect it might be some combination of all three, and that it’s not as bad as it sounds. The problem is that it was advertised very poorly, with a lot of guff about how it was a “free” service offering “best execution,” and whatever it was, it wasn’t the best execution.

Do people read bond documents?

Yes, with an asterisk. Here’s a paper by Elena Carletti, Paolo Colla, Mitu Gulati and Steven Ongena examining whether anyone has read Venezuela’s bond documents:

Venezuela turns out to have three sets of bonds with different modification provisions–and these are all under New York law and largely identical in all other respects other than their CACs. Further, Venezuela is in deep crisis; as of this writing, its probability of default within the next six months is north of 90%. This is important because this is the scenario where, in theory, legal terms should be most important to market participants. And finally, given the politics of its current government and the general oil glut there is a very low expectation of a bailout from the IMF, any other Official Sector institution, or some rich nation such as China that desperately needs oil. Put simply, we have a country with multiple bonds under the same law (New York) that have small differences in their contract terms that should matter a great deal to the likely payouts that the holders of these bonds will receive in the event of a default.

And it turns out that the Venezuelan bonds with the most investor-friendly terms (that is, terms that empower holdouts: strong pari passu clause, no collective-action clause that would allow most bondholders to negotiate a binding deal) trade at higher prices (lower yields) than bonds with less investor-friendly terms (weaker pari passu clause, collective-action clauses that allow 75 or 85 percent of bondholders to agree to a restructuring):

Our estimates indicate that yields on a unanimity bond are 8.7% to 10.86% lower than yields on a 75% bond. Since the average yield on 75% bonds in our sample is 15.25%, the unanimity rule is associated with a 133bps to 166bps yield reduction. To put these numbers into perspective, the interquartile range of yields on 75% bonds is 527bps so that the average yield reduction we document for unanimity bonds corresponds to 25%-30% of the distribution of 75% bonds.

You can have two models of how investors read bond documents, or rather, when they read them. One model is that markets are efficient and investors digest all information as soon as it’s available; in this model, they read the documents when the bonds are issued, and discount for any investor-unfriendly terms from day one. Of course, before the issuer is in distress, that discount is small — it’s on the order of 1.5 percentage points of yield for Venezuela, which is in distress, so presumably it would be much smaller for a non-distressed issuer — but it exists, and moves smoothly as a function of the issuer’s likelihood of default.

The other model is that no one reads bond documents until things get really bad, so contract terms don’t matter when bonds are issued. If one bond has worse terms than another, they will trade at the same level until the issuer gets into distress, at which point the worse bond will jump to a lower price than the better bond.

The question of which model is right ought to be important to issuers. If the first model is right, then there is some tradeoff — though it might be small — between issuing bonds with issuer-friendly terms (that is, terms that make it easy to restructure the bonds) and issuing bonds with low cost. If you sell bonds with weak bondholder protections and easy-to-use collective-action clauses, then you can default without endless Argentina-style problems, but it will cost you a bit up front. If the second model is right, you can write whatever you like in the bond documents, and no one will care until it’s too late. Because the paper focuses on Venezuela, where it’s already too late, it doesn’t answer that question. “Our finding is that in a near-default scenario the markets do seem to be able to discern the difference between bonds that allow for a greater ability to hold out and the others,” write the authors, but I still am not sure whether markets can discern that difference in far-from-default scenarios.

Speaking of sovereign debt restructuring.

Puerto Rico lost its appeal in the Supreme Court over whether the Bankruptcy Code, which doesn’t allow Puerto Rico or its municipalities to use Chapter 9, also pre-empts it from writing its own bankruptcy law. The Supreme Court’s answer is that, while Puerto Rico is not a “state” for purposes of using the Bankruptcy Code, it is a “state” for purposes of being pre-empted by the Bankruptcy Code, so it is entirely out of luck with respect to restructuring its debt. That is harsh, and weird-sounding, but not necessarily all that surprising. Sometimes laws are kind of dumb! It’s not the Supreme Court’s job to fix them. Here is the opinion. “The end result,” writes Stephen Lubben, “is that Puerto Rico now faces the unattractive choice of attempting an Argentina/Greece style workout (with likely lesser sovereign immunity than either of those debtors had) or swallowing PROMESA, along with its oversight board.” And: “Puerto Rico Loss Is Bondholders’ Gain With Congress’s Path Clear.”

Crime and punishment.

I was not expecting this:

A New York hedge fund manager who at age 28 lost nearly all $57 million he oversaw in less than three weeks was spared prison on Monday, as the judge recognized how quickly and thoroughly the defendant owned up to his crimes.

Owen Li, the founder of Canarsie Capital LLC, was sentenced to probation by U.S. District Judge Robert Sweet in Manhattan, prompting gasps from spectators in the courtroom.

To be fair, it seems like Li engaged in a little light fraud, but that most of the $57 million he lost was due to dumb but non-fraudulent trading mistakes. It’s hard to untangle those things, though; if it weren’t for the fraud, maybe investors would have withdrawn their money earlier and avoided the losses? Anyway, that’s nice for Li.

Meanwhile in the U.K., “a former trader at Schroders was sentenced to two years in prison after he pleaded guilty to trading on inside information over a nine-year period, earning a profit of about £155,000.” One basic problem with white-collar law is that no one has any moral intuitions at all for which punishments ought to fit which crime. Is committing fraud and losing $57 million for investors worse than committing insider trading and making 155,000 pounds? Why or why not? How could you tell?

Elsewhere, in non-crime but still bad stuff: In an unusual case that underscores the complexity of overseeing commodities trading, the CME Group has sanctioned a former airline fuel executive for front-running his own employer’s exchange orders, among other things, and generating market gains of more than $3 million in the process.

And a guy was convicted of a felony for deleting e-mails at work.

People are worried about unicorns.

Here is an interview with Aileen Lee, who is generally credited with first using the term “unicorn” in the sense of “venture-funded private tech startup with a valuation of $1 billion or more,” and who has now joined the peak-unicorn consensus:

The Hive: You coined the term “unicorn” back in 2013, before Uber was raising billion-dollar rounds of funding, and before we really hit the unicorn craze. Do you think we’ve seen peak unicorn madness in the private market? If so, what was the top?

Aileen Lee: Last summer we updated our original analysis, and I think we may have been off by three months, but I think that zone was definitely peak unicorn season for this wave of technology companies. There’s that phrase that “X technology is short-term overhyped, long-term underhyped.” Well, I’m kind of a believer, and obviously this is partially why I do what I do: I just think the train of innovation and technology changing every industry on the planet is happening, and will continue to happen. Over the long term there will be many more billion-dollar technology companies than there are today.

The unicorns will retreat back into the Enchanted Forest, perhaps, but only for a time. Their day will come again.

People are worried about bond market liquidity.

Today they aren’t. I can’t find a thing. If we ever go three consecutive days without anyone worrying about bond market liquidity, I will retire this section permanently. Here’s hoping.

Things happen.

Germany’s 10-Year Bond Yield Declines Below Zero for First Time. Bitcoin Price Hits Two-Year High. Goldman Accused of Giving Libya Officials Gifts to Win Influence. Tamed China Stocks Await MSCI Decision. Banks open a new front in trading floor surveillance. Citi, Deutsche and JPMorgan censured for backing fossil fuel. Finra Names Robert Cook Its Chief Executive. PwC Independence Questioned in Dispute With Regulators. Trump Fundraiser Threatens Romney Republicans with Possibility of Gary Busey Being Nominated to the Supreme Court. Gang jailed over £7m Monopoly money scam. “There’s simply no way it would be selected by Bob Mankoff and his legion of helpers, then voted to the top by the attorneys that make up the bulk of The New Yorker’s readership.”

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net
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