Who Can You Trust?

There have been a series of issues in the financial community that has caused the public not to trust the institutions that administer it. The three latest involve the futures industry. MF Global stole $1.2 Billion in customer money, and customers are fighting tooth and nail to get it back. PFG Best (Peregrine) stole $200 million, and today it was revealed the CEO simply spent it. Then we find out the regulators(British Banking Assoc, Federal Reserve, US Treasury) knew that the big banks were lying about the LIBOR rate when they reported it. Not only that, but traders were marking their own positions, and making it look like things were better than they really were. That happened in the middle of the financial melt down, when LIBOR rates should have been skyrocketing-and didn’t.

Independent traders in the midst of it knew something was wrong. But, because we don’t have a high dollar constituency behind us, the word never got out.

However, $CME tried. From Barron’s: “In memos exchanged over the summer of 2008 — some of which we report for the first time — the futures exchange revealed clear concern that Libor’s bank contributors might conspire to rig the benchmark. To the dismay of both groups, one of the sixteen bankers caught up in the Libor price-fixing scandal, Barclays (BARC), late last month paid fines and civil penalties totaling $450 million to the Commodity Futures Trading Commission and Department of Justice in the United States and the Financial Services Authority in Great Britain.”

So, we know there have been crimes committed. What should we do about them? Currently, there is nothing on the books that will stop banks from cheating again. Dodd-Frank doesn’t do it. Sarbanes-Oxley doesn’t do it.

The only thing that will prevent fraud from happening again is a transparent free market. Transparent markets are the great truth detectors in modern society. The price and quantity information that is easily seen and historically available can tell you so much about the forces driving the market it is impossible to cheat.

Currently, the most liquid place in the world for a transparent market is the Eurodollar contract ($GE_F) at the CME. Millions of contracts worth trillions of dollars change hands there everyday. More notional value is traded in the Eurodollars in one day than the New York Stock Exchange ($NYX) does in a year.

The LIBOR problem stems from the cash market. The banks under reported the rates they were paying. The other problem with the cash market is the bankers all compete with each other. Many times when they trade they are trying to put one over on their competitor. That seeps into the way they mark up their cash trades for settlement, and ultimately into the way they report them to the BBA.

The solution to this is transparency. Report cash price and volume anonymously. There are computers that can collate and spit out cash data. When a trade is made, it automatically ought to be routed to a central computer. No human reporting. No cheating. Each day at an appropriate time, an average of the trades should be published, weighted by volume. Each and every market participant can trade the futures to hedge. Both sides of the market will be transparent.

It should be no surprise to anyone that bankers are deliberately making a market less transparent. In the stock industry, corporate bond industry, and munibond industry they have been doing that for eternity. They have institutionalized opaqueness, and codified it in regulations. When someone complains, bankers simply state, “You don’t understand.”. The fact is most people don’t understand. But they are getting ripped off each and every day and everyone pays a higher cost for capital because of it.

If the rules of the game are changed in the cash market, confidence in the marketplace will return. Humans will be taken out of it, and the actual transactions in the market will rule. The playing field will be flatter, and the market a better indicator of what is going on in the world’s short term money markets. The cost of short term money influences everything behind it.

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thanks for the link Instapundit.

thanks for the link Eddy at Crossing Wall Street