We’ve pointed out from time to time that the financial services industry has lost sight of its role. While helping companies borrow and raise money, providing investment and saving vehicles and payment services are all useful activities, the cost of financial intermediation is ultimately a tax on commerce. Perversely, some businessmen complain bitterly about how big a role lawyers play in the economy (their real beef is usually tort lawyers), when bankers simultaneously extract much more, yet have also been much more successful in co-opting their customers than lawyers have been. Analysts and financiers not only tell businessmen how to run their affairs, the now-notorious short-termism of American companies says they listen and comply.
But most important, Wall Street no longer serves the interests of broader society.
Now before you say, “Well that is just how markets are,” the markets in which major capital markets firms operate are hardly natural constructs. The modern securities industry grew out of the heavily regulated US equity markets; all the leading firms today either were long-established players or bank aspirants who drew on securities industry know-how. Firms are regulated and subject to licensing requirements. Even the rating agency business has restricted entry and capital requirements. So these were always regulated businesses precisely because financial services was understood to serve public ends. Yet the industry managed to persuade government officials and the public that it could be trusted to operate its businesses responsibly and everyone would benefit from more “innovation”. As we noted in ECONNED:
Institution after institution was bled dry. Yet economists and central bankers applauded the wondrous innovations, seeing increased liquidity and more efficient loan intermedation, ignoring the unhealthy condition of the industry.
The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.
The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
Nearly two years after the worst phase of the crisis the bogus premise of what passes for innovation in banking is largely unchallenged. Entire swathes of the industry that were once thought to live and die on their merits are now government backstopped (“living wills” and resolution authorities are public-placating headfakes, even though some members of the officialdom may be so naive as to believe they will work on globe-spanning megafirms). So both the scale of damage done and the recognition that capital markets activities and payment functions are now government supported means the case for regulating major financial players like utilities is even strong than ever, but instead, we are more or less back to status quo ante.
In the UK, some members of the media are questioning this sorry state of affairs. John Plender notes in the Financial Times:
First, Lord Turner, head of the UK’s Financial Services Authority, put the cat among the pigeons by questioning the social utility of much financial innovation. Then Paul Volcker declared that the only financial innovation that had impressed him over the past 20 years was the automated teller machine. Yet, despite these reservations the world remains remarkably tolerant of anti-social behaviour in the markets and in the wider business environment.
Exhibit A is high-frequency trading. This type of computerised dealing exploits the millisecond gaps between news events and their impact on the markets. With the regulators sitting on their hands, such trading has expanded rapidly to the point where, on some estimates, it accounts for 60-70 per cent of the trading volume in US equities. Much of this volume is conducted by a very small number of companies.
A big reason for concern is that exchanges appear to have joined in an unholy alliance with this small group, which is allowed to see orders before the public. In effect, these people are privileged insiders who are profiting at the expense of those who are innocently saving for retirement and what have you.
Worse, the exchanges, which have a business interest in high volume, encourage co-location whereby traders can route their orders to servers in the same location as the exchanges’ computer matching systems. Reducing geographical distance in this way cuts milliseconds off the time it takes for buy or sell messages to be sent into or back from an exchange.
This is all a form of front-running, even if the trading is not taking place in front of a client order. Proponents argue that anyone can co-locate, but genuine private investors cannot engage in this with an entry price measured in thousands of dollars. The supposed benefit is greater market liquidity. But the resulting market liquidity is far more than is needed for genuine investment. Why should a difference in the milliseconds be relevant to meeting pension liabilities with a 20-, 30- or 40-year duration? And, as the “flash crash” of May 6 showed, the activity can be highly disruptive.
Now that the regulators are taking an interest, they will probably focus on making the playing field more level. Far better would be to recognise that this competitive technological battle reduces social welfare in a similar way to an arms race. The fact that a handful of traders are creaming off big profits at the expense of genuine investors undermines the integrity of the market. A more draconian regulatory response would be appropriate.
Yves here. We haven’t said much about HFT because, in all honesty, as offensive as it is from a fairness and integrity of markets perspective, the damage done by it pales in comparison to the devastation wrought by abuses in the credit markets, where we normally focus. And truth be told, equity investors are a vocal lot, and many commentators had taken up the attack on HFT.
So it is remarkable that a highly visible abuse, one that unlike the bad practices in the credit markets, can be addressed readily, in isolation, without widespread ramifications, still persists. And as Plender points out, the planned remedies look certain to be inadequate.
This says that critics need to keep hammering on the observation that financial services is only a support function to commerce, that when it is too big and profitable, that means it has become parasitic and extractive. The public understands that intuitively; it’s time the media and government officials have the nerve to state the obvious.