You Say You Are a Market Maker? Great, Act Like One

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The drama of financial regulatory reform is, to a considerable degree, playing right into the industry’s hands.

I have several pet theories as to why this has happened. One is the fact that the drafting of new rules and the related horse-trading started before there had been any meaningful investigations, and more important, there did not seem to be much in the way of forensics in the offing. We had the FCIC, with a limited budget for this sort of exercise, tight timetable, and questionable structure, and SIGTARP, with real prosecutorial powers, but limited resources and a narrow mandate.

Attitudes shifted markedly with the disclosure of the Lehman bankruptcy report by Anton Valukas, and underwent a sea change with the SEC’s suit against Goldman over Abacus 2007 AC-1. But rather than
use the sudden change in public perceptions (and perhaps more important, media coverage) to reopen the scope of regulation, Team Obama is hell bent to get Something Done well before mid-term election, presumably to appease “populist anger”.

We seem to be missing a key lesson of the Great Depression, and that is likely by design, given the power of the financial services lobby. The abuses brought to light by the Pecora Commission helped secure the passage of securities reforms. And perhaps as important, it made clear to the banking industry that far-reaching changes were to be implemented. The 1933 and 1934 securities acts reflect a sophisticated understanding of market operations, precisely because some insiders were involved in the drafting of legislation. They recognized they were either going to be on the bus, or under the bus, and chose accordingly.

By contrast, the industry has done a very good job in maintaining a united front against reform. One example: a colleague, who has written a few articles that have appeared on the Internet related to credit derivatives. He has been asked to do expert witness testimony, both for plaintiffs (meaning against the big dealer banks) and for a big bank. Even though his work has been pretty technical in nature and does not implicate the bank in question, the bank and its attorneys are very uncomfortable with the fact that he has exposed tradecraft, and have made it clear that they do not want him publishing at all if he is to work with them. It is one thing to ask an expert witness to review articles pre-publication to make sure they do not compromise a client; quite another to put a gag order on someone who has a long-standing publishing history. Similarly, I have run across others who clearly believe abuses occurred, yet are unwilling to break ranks (and I don’t mean outing themselves, simply talking to an investigator or reporter on an deep background basis).

So the result is that we’ve had proposals come in late in the game that are crowd-pleasing but either ineffective or ill thought out, and that works to the industry’s benefit (they can beat them back, and the existence of a flawed proposal that is taking up legislative and press bandwidth makes it harder for other, better conceived measures to move forward).

One example of the ineffective sort is the so-called Volcker rule, to require depositaries to exit the proprietary trading business. On paper, this is a good idea, but the initial Volcker definition was to distinguish trades executed with end customer versus those that were not, which is not a helpful distinction (bond king Salomon Brothers did a tremendous amount of speculation in its regular trading books, long before there were separate prop desks). Although the language is still in play, banking expert Josh Rosner has said, via e-mail, “the Volker rule has holes large enough to drive 4 Mack Trucks through, side by side.”

By contrast, Blanche Lincoln’s proposal, to force banks to get out of the derivatives business (and the climbdown, to have those businesses separately capitalized), is misguided. The problem here is she and the media have fallen for a master stroke by the industry, that of lumping in credit default swaps with “derivatives”. CDS are highly problematic; they have almost no legitimate uses and come with considerable costs (hugely bad incentives). Moreover, the plans underway will not tame them much. They cannot be margined adequately on a contract by contract basis (any sufficient provision for jump to default risk would render the contract uneconomic and kill the product, which is an unacceptable outcome, so it will continue to be inadequately margined). The best remedy would be to regulate it like insurance (which is what it is) but no one is willing to change directions now.

Plain vanilla swaps, like simple interest rate and foreign exchange swaps are not problematic and customer pricing is pretty transparent. And the banks themselves use these products in large volumes to hedge their own exposures. The flaw in the Lincoln plan is that any derivative business running on an independently financed balance sheet would be unlikely to be large enough to handle the hedging needs of the banks themselves.

Via e-mail, Josh Rosner supplied a much better idea for how to handle banks’ derivatives books:

Instead of getting to the point where we talk of moving bank derivative activities into a new shadow system where end users begin to build insufficiently regulated dealer businesses (which the banks/i-banks would buy an unconsolidated interest in) why not require that the banks and the dealers no be allowed to speculate with derivatives. There is a precedent for this. In one of the few smart concepts in the former GSE oversight regime, the GSE’s were required to only use derivatives for hedging…in other words be as close, as realistic, to flat at the end of the day. They were required to put risk back into the market rather than aggregate it on their balance sheet.

In the case of the DEALERS, I would allow them to make markets but I would give them a time frame to get flat on the specific related exposures… a t+5-day type approach. While one could never be perfectly hedged on a delta basis, this is the right approach to minimize risk. That way their aggregate exposures, as market maker, would always be a function of the number of days of recent transactions and, if there was a crisis those number of days of recent transactions would likely be manageable. Moreover, knowing they had to get themselves flat they would be careful of the counterparty pricing and exposures they accepted.

From a former OFHEO official I have known for years:

Trading” of derivatives is not within the GSEs charter or mission. Dealers “make a market” in derivatives and can use derivatives to speculate. End-users use derivatives to control risk only. From a safety and soundness prospective, FHFA requires that the GSEs participate as end-users of derivatives for hedging purposes only and not as intermediary or dealer. Additionally, management assertions in the statement of financial condition (and in internal memoranda that documents the control process in risk management) are legally binding and those assertions (at the GSEs) include that derivatives are used only for hedging purposes.

Yves here. This is simple, elegant, effective….which means the odds of it happening are zilch. But we need to keep ideas like this front and center to remind us that there are some straightforward solutions to some of the complexity and opacity the financial services industry has created, particularly when they do shoot down other simple but misguided approaches.

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  1. student

    Yves, is there a single page of the regulations that you approve of and are “simple, elegant and effective”? would be great to hear your opinion on the rest of them.

  2. attempter

    The record is clear that Obama and the Dems do not want to reform the FIRE sector in any way at all. On the contrary, they’ve helped the disaster capitalists use the crisis to intensify the monopoly power of finance, and indeed to extend the racketeer dictatorship. The insurance racket bailout was intended to get the health insurance rackets onto the same Wall Street type gravy train. Laundering the bailout through the GSEs is meant to continue the Bailout in such a way as to also prop up the real estate end of FIRE.

    So the goal everywhere is to continue and aggravate the stranglehold of gangster rackets over the entire economy and the country itself. It’s the Bailout America dictatorship. (So far a “soft” dictatorship in terms of actual police state repression, but the assault on civil liberties and militarization of “law” enforcement is one area where Obama has not only continued all Bush/Cheney policies but considerably accelerated them.)

    So that’s the Obama/Democratic program, intent and practice. The rush to push through a sham bill before the election only plays into this.

    As for derivatives, it’s simple common sense and simple fairness that speculative derivatives be banned, that only actual hedging by those who actually perform a real economic service which is hedgeable in the first place be recognizable as contracts.

    Unfortunately, as Yves says,

    This is simple, elegant, effective….which means the odds of it happening are zilch.

  3. RueTheDay

    Re: Derivatives regulation – If we re-instated an updated* version of Glass-Steagall, then we could easily limit banks to derivatives for hedging purposes that caused them to be “flat” by end of day. Dealers would be separate entities, and the need for regulation would be somewhat less**.

    * By “updated”, I mean one that recognizes the existence of shadow banking, declares it to be banking, and regulates it as such.

    ** Once we re-instate Glass-Steagall, I think the regulation of non-bank financial firms can be streamlined. It should focus on limiting leverage (including hidden leverage) so that to the extent firms want to engage in high risk gambling, they’re doing it solely with their owners’ capital.

  4. fiscalliberal

    Yves – we spend a lot of time regarding legislation etc. Yet it seems that we are not doing anything regarding the fraud that took place at the loan origination level. It would seem that that would be low hanging fruit where legislation altready shouod exist. In other words, to to all the defaulting loans and find out where the loan officers (regulated or not) are that let this stuff get through. With 90% default rates being reported, it would seem that some jr prosecuters could handle this. The servicers should be able to provide the data.

    Do you have any idea of where the hang up is?

  5. Siggy

    The trade in derivatives is all about contracts. Difficulty arises when one of the counterparties is incapable, or unwilling to perform. If the incapicity to perform is occassioned by illiquidity and/or insolvency the difficulty is resolved by way of bankruptcy proceedings.

    What needs to be considered is the incentive inherent in criminal liability where contracts have been entered into by a defaulting party that knew it would be incapable of honoring the contract.

    The Naked CDS contract is a pure speculation on the part of both parties. Criminal liability would demand that the long and short sides of that contract post guaranteed performance collateral. That would make most CDS offerings uneconomic.

    Proprietary trading can be conducted by an institution from a principal position when the trading activity is undertaken as a market maker. A market maker can have no clients, it only has customers. For example, it appears that all of the parties to the Abacus/ACA/Paulson deal where customers and not clients. Therein lies the point of view held by Goldman, they had no liability for complete disclosure. There may have been, however, misrepresentation of material information that was tortious as opposed to being criminal.

    The point of this is that along with the repeal of Glass-Steagell there has been this naive belief that it is unnecessary to prosecute financial fraud. The SEC vs Goldman Sachs is as much political theater as it is enforcement of SEC rules and regulations. I see it as a good thing. I expect GS to seek a settlement without discovery and a trial. I also expect GS to make some major changes in its business model.

  6. Jon Claerbout

    I’m reading the book “Jimmy Stewart is Dead: Ending the world’s ongoing financial plague with Limited Purpose Banking (LPB)” by L. Kotlikoff. It appeals to me as an engineer because he presents a clear vision of where we should like to end up. Do you, Yves, agree with that vision? It seems to be based on the idea that transparency eliminates fraud.

    The title he should have chosen for his book: “Transparency Eliminates Fraud: Ending the world’s ongoing financial plague with Limited Purpose Banking (LPB)”

  7. Jon Claerbout

    Contracts greater than $10 million should not be valid until a copy exists in a government computer. The sharks will complain about their privacy, but the privacy of all us minnows is routinely invaded by the IRS.

  8. MichaelC

    One can still argue that the Volcker rule is the simple elegant rule you seek.

    Prop trading limits can be defined under the rule to provide the solution Josh Rosner and your Ofheo contact describe. Review Volcker’s definition of prop trading, he’s pretty clear.

    Licoln’s proposal calls to mind the AAA derivative subs that some banks, like Credit Lyonnais, were forced to establish, at great cost,in the 90s to stay in the game. They were prohibitively expensive, which is prety much what I think most opponents of CDS trading would favor. Her proposal is a blunt ax but I’d settle for that as a starting point.

    Is there a great problem if the plain vanilla derivatives transactions are transactacted between end users and derivatives dealers through separately capitalized subs? Hardly, since by their nature they are low risk, low margin businesses. In the separate units the crap will float to the top and can be skimmed much more easily than if they are buried in consolidated bank BSs.

    If leaving the derivatives dealing at the banks ensures their continued govt backstopping, and the alternative proposals to ringfence them in separate entities also result in de facto backstopping, then there is little reason to oppose a ringfence solution.

    It still provides some benefit, namely sunlight. Surely that’s a worthy objective. A more elegant solution is not going to emerge in this round of financial reform.

  9. tz

    What is likely to happen is that things will blow up again (early as this summer to fall, maybe in 2011), and the banks will come back to the public trough – but with whatever original “reform” in place being exposed to be just more industry writing its own rules. Then either they will not be bailed out (Congressmen suggesting this course would not just be expelled, but tarred and feathered or lynched), or there will be far worse command-and-control rules attached if not outright receivership, which would be overbearing and repressive, but at least effective. Or both.

    This is like another overused Wile E Coyote cartoon where the edge of the cliff breaks off, but he jumps to the still connected portion. While he is expressing relief, a rock falls on his head and a much bigger piece breaks off taking the rock, him, and the cliff edge into the abyss.

    Most of these articles sound like we are talking a patient at home resting instead of still in the ER or in the ICU.

    We are lucky enough that the financial system is still alive, but it isn’t exactly healthy even now.

  10. im moe green


    Great work and insights.

    I admire your having a comments section. Its fascinating to read the comments. Very strong status quo bias and a particularly U.S. centric approach is evident in so many comments here and in other sections. Also, a clear anti-european schadenfreud like approach.

    As a former Econ/Public policy professor and consultant, what is so puzzling so as to be astonishing is the lack of openness in the U.S. to good ideas that come from elsewhere.

    Canada: Great banking regulation. Harper and his minions have more sense in a pinky than the entire U.S. treasury Department.

    France: LaGuard. What can I say, some misssteps but well the structure of the banking industry is conducive to probity. the regulators are top notch.

    Australia: Good on all counts to date and favorable context. Lets see what RBA does….

    An Elephant in the room—Parliamentary systems. EU/OZ/NZ Finance ministers in most cases are members of parliament and a.) have been elected politicos and b.) have to stand for elections. I suspect Geitner would be more circumspect if he had to stand for election…..

  11. Andrew Foland

    Re: Blanche Lincoln

    The problem with cynicism is its amazing predictive power. Blanche Lincoln is facing a reals challenge from the left in her Democractic primary, and this amendment is a big departure from her historical record on matters financial. Expect to see it voted on before the primary and gutted immediately thereafter.

  12. Tim

    The failure lies with blogs like this.

    What could I possibly mean?

    REAL financial reform will onlybe achieved if the masses understand what is needed and how to achieve it and then demand it.

    What is needed:
    1. A clear explanation for non-econ geeks what fin-reform is needed at the bare minimum. Simple. No loopholes.
    2. Promoting people to “follow” the FCIC, SIGTARP, etc so “the people” implicitly and explicitly demand thorough forensics.

    How to achieve it:
    1. Promote the website that is created to explain the above.
    2. Use as inspiration and a model to have the masses contact their elected official.

    Rinse. Repeat.

  13. Tim

    I am curious as to whether the Lincoln amendment effects the foreign branches of US banks. I know most of the Volcker rule provisions for example in the Dodd bill did not apply to foreign branches of foreign subsidiares of US banks although US subsidiaries and branches of foreign banks would seem to have to comply. In this day and age Citibank for example could easily book all of its derivatives transactions through its branches in Toronto, Sydney, and Zurich lets say without creating any conflict with US law. A US corporate could execute a swap agreement with Citibank NA Toronto Branch through its Canadian treasury operation or quite possibly directly from US HQ without any timezone differential.

    Accreditated investors in the US have been allowed for decades to engage foreign securities dealers even lets say a US owned foreign dealer like Goldman Sachs Canada Inc without the foreign dealer becoming subject to SEC regulation or registration. One of the most well known electronic brokerages, Bloomberg Tradebook is actually a Bermuda licensed securities dealer that uses a Singaporean licensed broker SetClear PTE to clear its trades. Neither of the aforementioned entities are registered with the SEC or Finra.

  14. Amit Chokshi

    Yves said: CDS are highly problematic; they have almost no legitimate uses and come with considerable costs (hugely bad incentives)

    So being ignorant of CDS, my understanding is that CDS can be used to hedge against credit risk on the underlying bond. Don’t some firms also use like IG CDS to sort of protect/hedge the entire bond book too? Is there any data on the number of CDS used for hedging vs speculation or is that still not covering the real issue (ie CDS for hedging is still bad)?

    The costs being hugely bad incentives as in a CDS holder for the purpose of spec wants the company to all out fail, no incentive to do a workout/restructuring? This is different from shorting stocks because the second and third order impacts are greater (what specifically are those?)?

    Is there a post you have that better explains this? I am curious because I still don’t get how CDS can be this bad if regulated properly.

  15. Doug Terpstra

    “We seem to be missing a key lesson of the Great Depression…likely by design, given the power of the financial services lobby … the industry has done a very good job in maintaining a united front against reform.”

    And so unenlightened self interest continues “to undermine democracy and corrupt capitalism.” (ECONNED) But such short term manuevering to continue parasitism is ultimately suicidal, as there are certain to be more cliffs ahead…for the financial looters and the Obama administration.

    In an article on AlterNet, , James K. Galbraith echoes Yves Smith in “ECONNED”:

    “Why the ‘Experts’ Failed to See How Financial Fraud Collapsed the Economy” (to senators): “I write to you from a disgraced profession. Economic theory … failed miserably to understand the forces behind the financial crisis.”

    “…If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.”

    “Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.”

    So where are the prosecutions???

    “…Some [Obama] appear to believe that “confidence in the banks” can be rebuilt by a new round of good economic news, by rising stock prices, by the reassurances of high officials – and by not looking too closely at the underlying evidence of fraud, abuse, deception and deceit. As you pursue your investigations, you will undermine, and I believe you may destroy, that illusion…”

    “…In this situation…the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you.”

  16. EM

    Part of the UK financial sector is already regulated in such a way–UK building socities can use derivatives but only for appropriate risk management purposes and not to speculate.

  17. najdorf

    Yves said: “The flaw in the Lincoln plan is that any derivative business running on an independently financed balance sheet would be unlikely to be large enough to handle the hedging needs of the banks themselves.”

    Isn’t this a flaw in the current system too? That is, banks “hedge” risks with one another using capital and leveraged balance sheets created by depositors, government backing, relatively risk-averse bond holders, and stockholders, all of whom (wrongly, in the current system) don’t perceive themselves as being in the business of capitalizing and funding large derivative trading books?

    If no one would capitalize the guys who run derivatives at AIG to run an independent derivatives business of equal size (and it’s pretty clear that no one would), and the risks of that derivatives business overlap pretty well with AIG’s other risks, how does it benefit anyone to hide that business inside AIG until it blows up, then create an ad-hoc bailout? Why wouldn’t it be preferable to admit that credit risk can’t be hedged other than by finding someone to take the losses, and in most cases the most appropriate person to take the losses is the person who chose to buy the bond that went bad?

    If you think our current large bank holding companies won’t run circles around our current set of regulators with respect to characterization of derivatives as “for hedging purposes”, you’re demented. Not to mention that they will continue to play games with offshore subsidiaries, as mentioned above. Why even let them play the derivatives game if the theoretical goal of your regulation is to prevent them from taking any positive exposures? Who are they going to hedge with? The imaginary guy who wants $2 billion of credit risk that Bank of America wrote but has now realized it would rather not have?

    The whole concept of a flexible, multi-national bank holding company with any degree of home-government backing is rotten and ought to be discarded. The FDIC is quite capable of regulating and resolving actual U.S. banks that take deposits and write mortgages and should continue to do so, with even stronger restrictions on transfers between the bank and the holding company, as in insurance regulation. Bank holding companies that have international operations, derivatives trading divisions, etc. should continue to exist, but they should be required to fund themselves in equity and long-term debt markets at a true risk-based cost, not with FDIC-backed debt, TARP capital, Fed loans, dividends from despository subsidiaries that leave them undercapitalized, etc. Savers should be steered to the low-risk system with strong government backing. Risk-takers will gravitate to the higher-return options. It’s absolutely insane that in September of 2008 we had savers funding an institution as risk-laden and complex as Lehman Brothers in the overnight market, but we did – they had loans from well-regarded money market funds (Reserve, Columbia, etc.) and FDIC/Fed-backed holding companies thought of primarily as depository institutions. We have done NOTHING to change this system. It’s not acceptable and you’re not going to fix it without either harsh regulation or harsh government disengagement to remove moral hazard and bring back genuine risk-taking.

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