There are two bills pending in each house of Congress that are re-regulating the financial industry. The premise is that we can’t let Wall Street do this to us again.
Some Senators, and Thomas Frank in Tuesdays Wall St. Journal have called for a reinstatement of Glass-Steagall. This shows how desperate, and inept the two bodies of Congress are. Frank is a PhD in History, not Finance or Economics, so he simply wants to go back in time. The simple answer is we can’t.
In 1999, I was part of a group that was meeting with the then Chairman of the Senate Banking Committee, Senator Phil Gramm. Yra Harris, a CME Board member at the time asked Senator Gramm, “Are you creating institutions that are too big to fail?”. Gramm smartly replied, “No, we don’t think we are.” This was after the Long Term Capital Debacle in 1998, and before the Y2K scare of December of 1999. (Yra Harris blogs at Notes From Underground)
Flash forward through all the turmoil of the NASDAQ bubble bursting, Y2K, 9/11, and the crash of 2008. What to do now? We have seen that the TARP, TALF, and all the other methods put forth by Treasury and the Federal Reserve have been ineffective. The actions of government over the past year have simply rebuilt the house of cards that existed pre-crash. Economist John Taylor even wonders if we are headed for another boom/bust cycle like we had in the 1950’s-70’s.
Why not take a novel approach to re-regulation? Why not take an approach that recognizes the role and risk that an entity plays in the market and prohibit activities that detract from transparency and competition? If we did that, Wall Street would be very different, markets would be different, and Wall Street would be more self regulating than it is today.
First, we need to separate functions. For example, you could ban any dual trading at any entity. This would mean a business like Goldman would have to choose, be a broker or a risk taking trader. They would not be able to have investment advice, market making, hedge fund, lending, brokering all under one roof. However, they could be an insurance company, bank, investment advisor. They would just have to end/spin off all trading for profit. There is a massive conflict of interest within entities like Goldman. They even sent a letter to their customers apologizing for that conflict. Why have it at all? In the early 1990’s, the CME took steps to ban dual trading in all financial products traded at the exchange. It didn’t hurt markets one bit.
Second, there are several industry practices that detract from transparency and competition. One is payment for order flow. It’s legal under the SEC, illegal under the CFTC. It creates market distortions. Part of the profit stream of newly controversial high frequency traders is harvesting the payment for order flow. Ending it ends that game. High Freq. Traders would have to adopt different strategies to make a buck.
Third, we need to end the practice of internalization. The big boys on Wall Street take huge orders from places like pension funds and “internalize” them. This means they take the opposite side of the order, or a part of the order and then arbitrage them against the market for profit. Do it enough, and you can generate massive profits. Look at the top line revenue of the largest investment banks on Wall Street. At least 30% of their revenue comes from proprietary trading. It grows every year. No trader makes money year after year after year. Sometimes you have a loser. The big investment banks never have a loser.
The other change I would advocate is to prohibit hedge funds or trading groups from accessing the public markets for their risk capital. When you are trading your own money, or your investors’ money, you use a far different trading strategy than you do with public money. If I have to look my partner or investor in the eye and explain a risky trading strategy, it’s a lot different than just selling some stock to a schmuck and using the money to put on the same strategy. If a bank didn’t trade, they could be a public company. Simple.
The other thing that will make markets work better is transparent clearing. Wall Street banks have resisted it. Why? They want to internalize as many orders as they can and make money for themselves off them. The OTC market is a perfect example. It’s okay to have the Wild West, but their customers are showing up to a gunfight with a pistol. The big banks have tanks and an army. Clearing allows counter parties to manage their risk effectively. Clearing also requires parties to put up real money to hold positions. With adequate clearing, the crash of 2008 theoretically could never have started. A good clearing house would have liquidated positions at whatever the prevailing market price was.
Instead of focusing on these kinds of things, Congress is focusing on executive pay, creating more agencies and writing the rules to benefit whoever gives them the most cash. They feign concern for the American public. In reality, they are scared and don’t know what to do.