Few things in the news cycle generate more interest than a leak. It’s easy to understand why. A leak makes public what otherwise would be confidential. It is often illegal, which means the government official takes serious legal risks in disclosing the information.
But once it is out in the wild, the leaked information is fair game as the foundation for trade execution, because the information is now “publicly available.”
Generating alpha from leaks is far from straightforward. The policy process does not follow a linear path, and leaks only make policy trajectories more jagged. Why? Because making information available to the general public via the media before a final decision has been made opens up a window for a reaction function. Leaked information is rarely the final word.
Today’s post provides some guidelines for understanding how to assess the information value of leaks.
The Spectrum of Leak Activity
Let’s start by understanding the landscape of leak activity. When we use the word “leak,” most people jump to the conclusion that it refers to the unauthorized (and illegal) release of classified national security information to the media or a website, usually by a disgruntled lower level employee. Despite the media feeding frenzy over such inappropriate disclosures, this is actually a very small part of the leaking process.
Leaks occur for many other reasons with respect to non-classified, but still valuable non-public information. Policymakers themselves share information with the media; sometimes they authorize staff to share the information. When used in the manner described below, they are an element of statecraft that propels policy forward.
- Strategic Communications: The policy process requires multiple public officials to come to agreement regarding the next rule, law, communique, or public posture. But because the media and other observers follow policymakers so closely, the mere fact that two or more policymakers meet with each other can generate speculation about a deal under negotiation long before the policymakers are ready. In some instances (e.g., U.S. financial regulators), the law prohibits policymakers from meeting together privately.
A well-placed leak provides a mechanism for policymakers to talk to each other during negotiations without actually meeting. If the leaks also articulate a “red line,” they help minimize the risk of surprise at a meeting when –or if — one finally occurs. The policy process moves forward through the reaction function as reporters circle back to other relevant players to ask their opinion on the leaked information.
- Trial Balloons: Sometimes, leaks provide a way for policymakers to assess public reaction or other policymaker reactions to an idea. Because a leak is not attributed to a specific individual, the policymaker has maximum flexibility to take a different decision if the leak generates a firestorm of opposition. Elected politicians are particularly skilled at the artful use of leaks to help determine the direction of public sentiment; some use strategic leaks to generate momentum in the direction they would prefer.
- Reaction Function: Sometimes, a situation is developing so quickly that “no comment” in response to a reporter’s question would only add fuel to a very public fire. Rather than feed the fire, a spokesperson might be authorized to share some information with a reporter to ensure that the media depiction of a situation is at least not misleading.
- Minimize Surprises/Market Volatility: Policymakers, like market participants, loathe surprises and volatility. A leak regarding the main elements of major reports or decisions can help cushion the market blow and minimize related volatility.
- Self-Aggrandizement: It is human nature to want respect and be seen as a mover and shaker. This is of course particularly true of people involved in the policy process. Leaks can occur merely because the individual wants the reporter to believe that he or she is “in the room where it happens” and really knows what is going on.
- The Spin Cycle: Policymakers can — and do — seek to influence the perception of their actions by providing reporters with access to privileged information designed to either head off public outcry or build support for their position.
The motivation to share a leak with the media thus varies considerably across situations and individuals. The reader NEVER knows the motivation when seeing the information.
Yet all leaks are alike in one crucial respect. Leaks, by definition, do NOT represent a final official decision. This is not well understood by markets generally. Many market participants mistakenly believe that leaked information has a high predictive value of policy outcomes. Instead, leaks only represent an increase in volatility regarding an outcome; they do not determine the outcome.
Attempting to generate alpha by looking only at leaks is a very risky business strategy because the information does not represent a final decision and it likely only represents a part of a much bigger picture.
As noted above, a leak leaves room for a reaction function. It leaves room for decision-makers to change their minds. They can disavow the information. They can discredit the information. They can shift a negotiating stance. They can refuse to take a meeting.
A leak can change the trajectory of policy. But that does not mean that the leak provides all relevant information regarding the issue at hand. Leaks can omit key nuances and facts. Leaks can — and often do — provide biased perspectives of the information in question expressly for the purpose of influencing the reaction function.
The challenge expands exponentially in advance of major meetings. Leaking activity peaks before major meetings and decisions as more policymakers start communicating with each other and the public through leaks. Those leaks often contradict each other. At best, they provide perspective on the scope of the policy discussion. But they are not dispositive of the outcome. Automated processes that track headlines or leaks in order to fuel high -frequency or other trading will thus generate additional volatility, increasing the misperception that the policy process is random.
Consider the leaks regarding trade policy captured by our patented technology on April 24, 2019:
Do leaks regarding tariffs and trade wars signal that trade tensions are intensifying? Not really. For example, the trade war reference occurs in an FT story regarding a chip manufacturer. The leaks in question on that day had nothing to do with the breakdown in bilateral negotiations between the United States and China in May over intellectual property and regulatory policy issues.
Or consider the relationship between leaks, action and rhetoric regarding Brexit in the month leading up to the end-March deadline for the UK and the EU to reach a deal:
The leaks operated at a substantially lower level of volume compared with action near significant meetings and summits. As we noted in February, concrete technical actions by policymakers on both sides of the Atlantic were a far more reliable indicator of a no-deal outcome than any leak, and they had the benefit of being real decisions.
Moreover, not all policy processes are driven by leaks. Compare activity levels during March 2019 for Brexit (above) and for FinTech policy (below).
An alpha generation strategy premised on leaks would generate little to no actionable data for FinTech policy issues globally. Not only is the aggregate level of activity low (despite all the hype regarding cryptocurrencies), but there was only one leak from the official sector for the entire month.
In other words, leaks are important but they are unreliable drivers of any investment strategy.
Managing The Risk
Context matters greatly. In order to generate alpha responsibly and reliably from the news cycle, it is crucial to place leaks into their proper context.
Sophisticated technology to monitor, track, and analyze leaks is a necessary, but not sufficient, component of a serious alpha generation strategy with respect to the news cycle.
Identifying that a leak occurred without identifying the context and content of the leak is a recipe for making mistakes when executing trading strategies.
We expect that our patented data will enable machine learning and artificial intelligence to identify inflection points and policy trajectories in real time, but only after we have gathered statistically significant observations to use as training data. In the meantime, there is no substitute for doing things the old fashioned way by having a human being (preferably a policy expert) read the content of the stories containing leaks.
The good news is that advanced technology makes it possible to find those leaks faster, which means the human can make smarter strategic decisions regarding relevance more efficiently than in the past.
When evaluating the context and content of leaks, the handy infographic in this post will go a long way towards helping you remember to retain a healthy skepticism about the completeness and reliability of the leaked information.
Leaks are an important component of the policy process but not necessarily as a reliable predictor of policy outcomes. Advanced technology can help accelerate the analytical process placing leaks into context.
BCMstrategy, Inc. provides strategic investors seeking to maximize alpha from the news cycle with daily, automated, objective, and patented policy risk momentum data and a time series of policy activity in the following areas: Brexit, Global Trade, FinTech, and Banking. Data analysis is also available through specialized publications starting June 1, 2019. An earlier version of this post first appeared on Traders’ Insight, a blog hosted by Interactive Brokers.