Rent-Seeking vs. Outright Fraud
Joe Haykov
Preface
In the movie Margin Call, the lead character makes a statement about trading securities, including mortgage-backed securities, on exchanges like the NYSE and CME. He says, “There are three ways to make money in this business: be smarter, be first, or cheat. Now, I don’t cheat.” What does this mean?
This statement emphasizes that success in trading often depends on information asymmetry—having better or faster information than the person you're trading with. Whether by being smarter (using superior analysis), being first (acting on new information before others), or cheating (manipulating or deceiving), all three strategies involve one party holding an informational advantage over the other.
As Akerlof famously explained in his market for lemons model, when two parties engage in trade, the less informed party is inherently at a disadvantage—especially in unfettered markets. In voluntary markets, such as those on exchanges like the NYSE, this information gap often leads to the exploitation of less informed traders. As the lead character bluntly puts it, they "get screwed."
A modern example of this dynamic can be seen in the practice of hedge funds, such as Citadel, paying brokers like Robinhood for "dumb retail flow"—an industry term referring to uninformed orders from retail clients. Hedge funds profit by trading against these orders, leveraging their superior information.
The statement highlights that in markets driven by information asymmetry, the party with more knowledge or faster access to information consistently profits at the expense of the less informed. But this raises an important question: What’s wrong with cheating?
The issue with cheating lies in the consequences—it’s illegal and can result in severe penalties, such as imprisonment. In financial markets, engaging in deceptive or illegal practices, like insider trading or market manipulation, can lead to prosecution, fines, and incarceration. This makes cheating a risky and unsustainable strategy.
That’s why the lead character in Margin Call dismisses cheating as an option, opting instead for the legal and sustainable methods of making money—either by being first or being smarter. Both strategies hinge on holding an informational advantage. Being first is often a byproduct of being smarter or quicker in analyzing and acting on information. These methods gain an edge without crossing into illegal behavior.
However, any profits derived from superior information are economically and mathematically equivalent to arbitrage, which is akin to finding $100 on the street. Such wealth allows the individual to consume goods and services without making any reciprocal contribution to productivity. This aligns precisely with the definition of rent-seeking in public choice theory. Thus, while the legality may differ, income derived from being smarter, faster, or cheating is economically equivalent.
Introduction
Rent-seeking involves leveraging political or regulatory advantages to gain economic benefits without creating new value. This typically includes legal, though ethically questionable, activities such as lobbying for special privileges, regulatory capture, or monopolistic practices. While detrimental to economic efficiency, rent-seeking generally remains within legal bounds and is not punishable by imprisonment—though arguably, it should be, given the welfare losses and inefficiencies it creates.
In contrast, outright fraud involves deliberate misrepresentation or deception to achieve economic gain at the expense of others. Examples include falsifying financial records, insider trading, and embezzlement. Fraud is illegal and punishable by imprisonment because it violates legal statutes and ethical norms by actively deceiving others for personal gain.
Understanding the distinction between rent-seeking and outright fraud highlights both the moral and legal differences between the two. There is ongoing debate about whether rent-seeking should be more heavily penalized, given the comparable harm it inflicts on societal welfare and market efficiency.
Expanded Definition of Rent-Seeking
For this discussion, we broaden the definition of rent-seeking to include agency costs, such as a CEO using the company’s private jet for personal vacations, as well as all forms of fraud, including insider trading and accounting fraud. All these behaviors allow individuals to extract wealth without making any reciprocal contribution to productivity. This broader interpretation aligns with public choice theory, which defines rent-seeking as any action that extracts economic gains without generating new value.
The Rent-Seeking Lemma: An Overview
The Rent-Seeking Lemma posits that in situations where there is an opportunity to extract economic rents—such as through managing agents breaching their fiduciary duties by falsifying financial records—a subset of individuals will reliably engage in fraudulent behavior, especially when the perceived costs of doing so are low.
Most individuals engage in a cost-benefit analysis when deciding whether to commit fraud. People with fewer ethical reservations are more likely to exploit opportunities for rent-seeking if the perceived risks, such as getting caught, are low. Thus, reducing fraud prevalence requires increasing the perceived costs of committing fraud. According to the rational utility maximizer axiom in mathematical economics, individuals aim to maximize their welfare and will engage in fraudulent activities if it appears advantageous and low-risk.
Accounting Fraud as an Inevitability
According to the Rent-Seeking Lemma, accounting fraud—where companies misrepresent their financial records—is an inevitable outcome under the rational utility maximizer assumption. This use of asymmetric information to extract unearned wealth constitutes a market failure. Such behaviors resemble those of "economic parasites" as described by Lenin, or successful rent-seekers in public choice theory.
Public Choice Theory and Rent-Seeking Behavior
Public choice theory, developed by Gordon Tullock and James Buchanan, explains how rent-seeking behavior diverts resources for personal gain without contributing to productivity, leading to inefficiencies and welfare losses. This parallels Lenin's critique of economic parasites: individuals who consume goods produced by others without making any productive contribution.
Preventing such exploitation is crucial for maintaining a fair and efficient economy. Accurate pricing of market information is central to achieving this, especially for beneficial owners, such as stockholders, who need reliable information about their agents' actions.
Accurate Pricing and Fraud Detection
Accurate market prices are vital for enabling beneficial owners to gain parity of information with their managing agents. Without accurate prices that reflect all available information, malfeasance like accounting fraud can go unnoticed, leading to inefficiencies and increased fraudulent activity.
Sudden price drops or persistently lower price-to-earnings ratios compared to industry peers may signal fraudulent activity. Ensuring accurate financial reporting helps investors assess companies based on their true ability to generate free cash flow, reducing opportunities for fraud.
Conclusion
By addressing agency costs, achieving accurate market prices, and minimizing the cost of fraud detection, we can mitigate the principal-agent problem and reduce rent-seeking behavior. The TNT-Bank system enhances transparency, encourages whistleblowing, and empowers shareholders, leading to a more efficient and fair market system.
The Cost of Fraud Detection and Accurate Pricing
Achieving accurate pricing while minimizing the costs associated with price discovery is an essential objective. Although beneficial owners are the primary beneficiaries of accurate financial reporting, they do not bear these costs alone. Government agencies, despite their inefficiencies—such as bureaucratic delays—play a crucial role in mitigating fraud through regulatory oversight, thereby sharing the burden of fraud detection costs with the public.
However, government agencies alone have proven to be insufficient, as evidenced by the Bernie Madoff scandal, which went undetected for years despite multiple warnings. Therefore, our focus must extend beyond simply achieving accurate pricing to also include reducing the overall costs associated with fraud detection.
Minimizing the Cost of Fraud Detection
Fraud is often signaled by sudden price drops or persistently lower price-to-earnings ratios compared to industry peers, which can indicate issues such as perks and inefficiencies. Eliminating accounting fraud ensures that financial reporting is reliable, allowing investors to assess companies based on their actual ability to generate free cash flow.
The TNT-Bank Fraud Detection System
A more effective fraud detection mechanism could be the TNT-Bank software system—a trustless, permissionless, and fully AML-compliant system that empowers whistleblowers to report fraud. Whistleblowers would report fraud allegations directly to independent auditors paid by shareholders. The system incentivizes auditors and whistleblowers to detect fraud while filtering out unjustified accusations.
With TNT-Bank, whistleblowers report fraud to independent auditors, who are collectively paid by shareholders. The allegations are assessed, and credible accusations are forwarded to shareholders for a vote on whether to escalate the matter to the SEC. This ensures transparency and minimizes the likelihood of false claims.
Formal Proof of TNT-Bank Fraud Detection System
Given:
Shareholders require a system to detect and investigate accounting fraud by management or the board.
Whistleblowers need a secure mechanism to report fraud and be rewarded.
The system should allow accused parties to defend themselves.
The system must minimize false accusations while ensuring credible fraud claims are investigated.
To Prove:
Shareholders can vote to have the SEC investigate accounting fraud.
A mechanism exists to determine the credibility of the accusation.
Whistleblowers are rewarded for credible accusations.
The system disincentivizes false claims and promotes credible allegations.
Proof:
1. Fraud Reporting Mechanism:
Premise: Fraud may be committed by management or the board.
Solution: TNT-Bank allows whistleblowers to report allegations anonymously to independent auditors.
Conclusion: Whistleblowers have a secure and anonymous mechanism to report fraud involving management or the board.
2. Credibility Check by Independent Auditors:
Premise: The system must filter out unjustified accusations.
Solution: Independent auditors assess the credibility of allegations. Auditors forwarding false claims risk replacement, loosing a steady income stream, deterring false accusations.
Conclusion: Independent auditors ensure only credible allegations proceed, minimizing false claims.
3. Shareholder Voting Process:
Premise: Shareholders must determine whether to escalate credible fraud allegations.
Solution: Verified allegations are presented to shareholders, who vote on forwarding them to the SEC.
Conclusion: Shareholders are involved in deciding on credible claims, ensuring transparency.
4. Defense by the Accused:
Premise: The accused must have an opportunity to defend themselves to ensure fairness in the process.
Solution: The accused are allowed to present a defense before shareholders. If an allegation is found to be baseless, the independent auditor who forwarded the claim risks being replaced. This mechanism operates similarly to a "loser pays" system, which has been effectively used under U.S. federal law and in the state of Florida to successfully minimize frivolous lawsuits.
Conclusion: By allowing the accused to defend themselves, the system ensures procedural fairness while the risk of auditor replacement discourages the forwarding of baseless claims, thereby maintaining integrity and reducing frivolous accusations.
5. Reward Mechanism:
Premise: Whistleblowers should be rewarded for providing credible information regarding fraudulent activities.
Solution: The TNT-Bank system offers financial incentives for both whistleblowers and auditors who report credible claims. The effectiveness of this mechanism is influenced by the size of the rewards; substantial rewards create a strong motivation for uncovering fraudulent behavior. As Warren Buffett famously noted, "You never know who’s been swimming naked until the tide goes out"—in this context, high and lucrative rewards ensure that fraudulent activities are exposed more reliably, as individuals are incentivized to reveal malfeasance.
Conclusion: Financial incentives for whistleblowers and auditors effectively promote the reporting of credible fraud while simultaneously discouraging false claims, thereby enhancing the system's overall integrity.
Final Conclusion:
The TNT-Bank system provides an effective mechanism to detect accounting fraud by management or the board. It:
Allows anonymous whistleblowers to report fraud.
Uses independent auditors to assess the credibility of claims.
Involves shareholders in deciding on forwarding credible allegations.
Ensures fairness by providing a defense for the accused.
Offers financial incentives for whistleblowers and auditors.
Thus, the system minimizes false claims, promotes transparency, and empowers shareholders to address fraud effectively.
Summary
By addressing agency costs, achieving accurate market prices, and minimizing the cost of fraud detection, we can mitigate the principal-agent problem. The TNT-Bank system enhances transparency, promotes whistleblowing, and empowers shareholders, thereby ensuring that fraudulent activities are detected and addressed, leading to a more efficient and fair market system.