What the Heck Do We Do With Wall Street?

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.

5 thoughts on “What the Heck Do We Do With Wall Street?

  1. Paul

    2010/01/14 at 12:57pm
    Jeff, well said:

    “Dual trading is a conflict of interest. Payment for order flow and internalization codify the conflict and exacerbate the practice.”

  2. Paul

    2010/01/14 at 10:30am
    Goldman, Morgan Stanley and all the other proprietary trading groups need to be separated from their commercial banking duties and customers.

    Spin off Goldman’s prop trading house from the rest of the company and make it a stand-alone company.

  3. 2010/01/14 at 8:46am

    Simon, the government was the root cause of all the problems. What they need to do is regulate by function rather than by institution. Institutions change and evolve. Functions remain similar.

    Dual trading is a conflict of interest. Payment for order flow and internalization codify the conflict and exacerbate the practice.

    If we want to assign blame, start with the Federal Reserve. Then go to the Congressional Committees that allowed Fannie and Freddie to accumulate loans, along with refusal to tighten lending standards allowing for a proliferation of alt-a and sub prime loans. Then the ratings agencies rated the crap AAA, when it was bbb or worse. The banks winked at their own customers, sold them a boat without and oar and shorted the trade against them-and also “insured” the trade at AIG.

    Taxpayers got left holding the bag-Banks got 100% of their money back plus access to cheap government capital and being able to put up new forms of collateral. The whole house of cards is being built again

  4. outrade

    2010/01/13 at 9:56pm
    What happened to the global economy and what we can do about it

    “I Do Not Blame The Regulators”

    Jamie Dimon has all the best lines. In May 2009, he told JPMorgan Chase shareholders that 2008 was probably “our finest year ever.” That was before he thought about profits for 2009.

    And today he told to the Financial Crisis Inquiry Commission, “I want to be clear that I do not blame the regulators. The responsibility for a company’s actions rests with the company’s management” (p. 9).

    This is true enough – and something to reflect on during bonus season. But at a deeper level, the crisis of 2008-09 and our continued dangerous financial system are very much the fault of our regulators.

    Bank executives are supposed to make money; Jamie Dimon has a fiduciary responsibility to his shareholders. It is not his responsibility to prevent bankers from taking over the state or to ensure system stability. He pursues profits – and rent extraction from the government.

    It is the government’s responsibility to prevent people like Jamie Dimon – who is very good at his job – from creating massive social costs. The failures here – and they were colossal – were on the part of the people who ran the Federal Reserve, the Treasury, and associated agencies over the past 20 or so years.

    Hopefully, these people will soon appear before the Commission.

    By Simon Johnson

    Written by Simon Johnson
    January 13, 2010 at 9:25 pm
    Posted in Commentary

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