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The Securities and Exchange Commission (SEC) under Mary Shapiro is trying to escape a difficult legacy. Over the past two decades, the once proud agency was effectively captured by the very Wall Street firms it was supposed to regulate.
The SEC's case against Goldman Sachs may mark a return to a more effective role; certainly bringing a case against Goldman took some guts. But it is entirely possible that the Goldman matter is a one-off that lacks broader implications. And in this context the SEC's handling of concerns about "high frequency trading" (HFT)—following the May 6 "flash crash," when the stock market essentially shut down or rebooted for 20 minutes—is most disconcerting. (See the speech by Senator Ted Kaufman on this exact issue ; short summary.)
Regulatory capture begins when the regulator starts to see the world only through the eyes of the regulated. Rather than taking on board views that are critical of existing arrangements, tame regulators talk only to proponents of the status quo (or people who want even more deregulation). This seems to be what is happening with regard to HFT.
HFT is a big deal—perhaps as much as 70 percent of all stock trades are now done by "black box" computer algorithms (i.e., no one really knows how these work), and there are major open questions whether this operates in a way that is fair for small investors. (Disclosure: in 2000–2001, I was on the SEC's Advisory Committee on Market Information; I was concerned about closely related issues, although market structure has changed a great deal over the past 10 years.)
The technical, "fact-gathering" activities of bodies like the SEC are of critical importance in both building an overall consensus—do we have a problem, what should we do about it—and also in creating the basis for regulatory action (e.g., the SEC does not even collect the data needed to understand how HFT contributed to the May 6 disaster). And anyone who has ever put together a relatively complicated discussion of this nature can attest that how you frame the issues is typically decisive, i.e., what is presented as the range of reasonable alternative views?
On Wednesday (June 2), the SEC will hold a "market structure roundtable" to discuss "high frequency trading, undisplayed liquidity, and the appropriate metrics for evaluating market structure performance." But who exactly will be at this discussion?
The names of panelists for this discussion are not yet public and probably not yet final—but the preliminary list is far too much slanted towards proponents of HFT (6 out of 7 seats at the table; see Senator Kaufman's speech for details), with hardly any representation of people in the markets (e.g., "buy side" mutual funds) who think HFT is potentially out of control or unfair. It looks very much like someone is setting up a love fest for HFT—and a boxing match with 6 tough guys against one lonely critic.
To be fair, after coming under heavy pressure from a leading member of the Senate Banking Committee over the past 48 hours, the SEC is backpedaling quickly and indicating that the panel invitations can be broadened. This is encouraging—perhaps the agency is finally overcoming its tin ear problem.
But nothing other than a balanced panel on June 2 would be acceptable. At the very least, the SEC needs to increase the panel to 10 people—5 for and 5 against. And all the issues need to be on the table—including exactly who benefits from HFT, how much money they make in this fashion, and whether or not long-term investors (and the broader economy) really gain from such arrangements.
The SEC must understand that it has a long way to go to restore its credibility. Wednesday's quasi-hearing is an important test and many people will be watching carefully.
The Last Hold Out: Senator Blanche Lincoln Against 13 Bankers
May 26
By now you have probably realized—correctly—that "financial reform" has turned into a victory lap for Wall Street.
When they saved the big banks, with massive unconditional support (both explicit and implicit) over a year ago, top administration officials promised they would be back later to fix the underlying problems. This they—and Congress—manifestly have failed to do.
Our banking structure remains unchanged, the rules will be tweaked at the margins, and the incentive and belief system that lies behind reckless risk-taking has only become more dangerous. (The back story, if you can still stomach it, is in 13 Bankers).
There is only one small chance for any sensible progress remaining—and you are about to see this crushed in conference by the supporters of unfettered big banks.
Senator Blanche Lincoln's proposal with regard to derivatives has much to commend it. A fiduciary duty for swaps dealers vis-à-vis customers would be entirely appropriate—in fact long overdue.
Real time price reporting should also help regulators at least begin to understand what is driving market dynamics, for example around the May 6 "flash crash"—a point that Senator Ted Kaufman has also been making most forcefully.
Legal authority against market manipulation would be greatly strengthened, and there would be more protection for whistleblowers. And the kind of transaction that Goldman entered into with Greece—a swap transaction with the goal of reducing measured debt levels, effectively deceiving current and future investors, would become more clearly illegal. All of this is entirely reasonable and responsible—and completely opposed by the most powerful people on Wall Street.
Of course, most of the anti-Lincoln fire has been directed against the idea that "swaps desks" would be "pushed out" to subsidiaries—i.e., the big broker-dealers could still engage in these transactions, but they would need to hold a great deal more capital against their exposures, thus making the activities significantly less profitable.
It is striking that while Treasury argues that increasing capital is the way to go with regard to financial reform, they are adamantly opposed to what would amount to more reasonable capital levels at the heart of the derivatives business.
This is beyond disappointing.
No doubt the administration feels good about what it has "achieved" on financial reform. The public aura of mutual congratulation will last for about three weeks.
But outside of the inner White House–Capitol Hill bubble, it is very hard to find anyone well-informed about the financial system who thinks that anything substantial has changed or that risks will be better managed as we head into the next cycle.
"Business as usual" is the abiding legacy of the Obama administration with regard to the systemic risks posed by this financial system. Treasury and White House have let us down repeatedly and completely in the last 18 months on financial sector issues—just as they did (as decision-making bodies and as some of the same individuals) at the end of the 1990s.
At one point in early 1998, Larry Summers called Brooksley Born—the last person who really tried to rein in the dangers posed by derivatives (and it was a much lower level of danger then compared with now). Summers reportedly said, "I have thirteen bankers in my office, and they say if you go forward with this, you will cause the worst financial crisis since World War II."
We now seem to have come full circle to exactly the same people saying exactly the same things—no doubt top people in the administration are now calling Senator Lincoln and impressing upon her a version of the same point made by Summers to Born.
The 13 bankers have won, completely. Here we go again.
The Road To Economic Serfdom
May 23 with Peter Boone
According to Friedrich von Hayek, the development of welfare socialism after World War II undermined freedom and would lead western democracies inexorably to some form of state-run serfdom.
Hayek had the sign and the destination right but was entirely wrong about the mechanism. Unregulated finance, the ideology of unfettered free markets, and state capture by corporate interests are what ended up undermining democracy both in North America and in Europe. All industrialized countries are at risk, but it's the eurozone—with its vulnerable structures—that points most clearly to our potentially unpleasant collective futures.
As a result of the continuing euro crisis, the European Central Bank (ECB) now finds itself buying up the debt of all the weaker eurozone governments, making it the—perhaps unwittingly—feudal boss of Europe. In the coming years, it will be the ECB and the European Union who will dictate policy. The policy elite who run these structures—along with their allies in the private sector—are the new overlords.
We can argue about who exactly the peasants, the vassals, and the lords under this model are —and what services exactly will end up being exchanged. But there is no question we are seeing a sea change in the post-war system of property, power, and prosperity across Western Europe, just as Hayek feared. An overwhelming debt burden will bring down even the proudest people.
The ECB-EU approach will not of course return countries to reasonable levels of growth—the debt overhang is simply too large. The southern and western periphery of the eurozone cannot grow out of their debts under these arrangements, and so will stumble from stabilization program to stabilization program—just like Latin America did during the 1980s. This is bound to be acrimonious, leading to hostile politics, social unrest, and more economic crises.
The International Monetary Fund (IMF) will do just what the European Union and ECB ask to keep the charade in place. The old days when all member countries got nice presents from the eurozone are long gone; now it is all instructions and austere requirements. But enough resources will be provided to keep rolling everything over.
The top three French players—President Nicolas Sarkozy, Jean-Claude Trichet (ECB), and Dominique Strauss-Kahn (IMF)—seem to be enjoying themselves; presumably they think they will end up running things. More surprising is the reaction of other European leaders, who genuinely seem able to convince themselves that what they are doing makes sense—as opposed to being a series of crazed improvisations.
The market is telling them that their euro rescue schemes make no sense, and the market is probably right. Faced with the ugly reality of the loss of confidence in European finance and institutions, the Germans and even the normally sensible Swedish government are increasingly blaming "irrational" markets and speculators for homegrown problems.
The currently preferred messy solution of the European Union leaves the world at risk of shocks like we observed this week. This particular iteration may blow over, but another will arise when there is backlash in Athens, Dublin, Lisbon, or—heaven forbid—Madrid.
Meanwhile, rational market participants are selling debt of risky nations, and getting out of the euro. The whole fiasco is now leading to a messy shift away from risky assets all around the world, and the cost to the world of such volatility is not small. Debt peonage looms for a wide range of countries that were recently thought immune to serious fiscal crisis, including the United States and United Kingdom.
It is inappropriate for the Europeans to subject the rest of the world to these large, chronic risks. Europe should also recognize how disorderly insolvencies end—it is never pretty. The 1970s crisis in Britain is the model for what may go wrong. Ongoing large strikes, populations disenchanted with all authority, and great economic disruption are inevitably the outcome. When the assets are very cheap, deep-pocketed investors from the United States, China, India, and of course Russia will swoop in for the crown jewels.
What should be done? It is time to look in the mirror and recognize the problem. Several nations in Europe are bordering on insolvency, and it is now pretty clear that we shouldn't just "bandage" that over for a few years with large aid packages.
To deal with this insolvency we need to restructure the debts of those nations. But this has to be done in a way that does not destabilize Europe's fragile banking system. And it needs to be credible enough so that once restructured, the troubled nations will be able to finance themselves easily.
Europe now has the 750 billion euro package of assistance in place, and they should use it to fix the problem once and for all. The ingredients for a solution include:
- Announcing an orderly restructuring of the periphery countries' debt (Greece, Portugal, Ireland, and possibly others also). This should start with a standstill and a program of fiscal financing while budget cuts are put in place.
- Regulatory forbearance should be explicitly provided to all European banks, with a backstop of ECB liquidity, and a 500 billion euro support program to provide capital injections—as was done in the United States, 2008–09.
- The nations that are not restructured need to be supported via ECB liquidity lines that guarantee the rollover of their government debt.
- The G-20 needs to provide support to prevent chaotic foreign exchange markets but also accept a large further devaluation of the euro. At some point the G-20 will need to intervene to support the euro via central banks.
Such a comprehensive package of measures would be painful, but it is the only realistic solution to this chaos. It would also restore some credibility to Mr. Trichet and the ECB, who, at this stage, appear captives of the fiscal crises in the eurozone.
Unfortunately, there is no leadership today in Europe that could take such decisive actions, so Europe will only reform itself dragged through successive crises kicking and screaming until the current, and many ensuing, problems are resolved.
The United Kingdom and the United States need to prepare themselves for more storms. The United States will be in the more pleasant position as the world's safe haven, but this will only encourage America's profligate politicians to spend more and build more debt.
The United Kingdom will bear much more pain from euro devaluation and financial dislocation, all exacerbated by its own large deficit and debts. We might well see one more invasion across the channel, this time by bond vigilantes who question Britain's ability to rein in inflation as it builds too large debts.
At the end of this great tumult, Europe and the United Kingdom will have sound fiscal regimes. Debt will be defaulted on or inflated away, and nations will have dramatically cut spending.
Hayek's predicted demise of western society will prove correct, but welfare systems will prove the victim, rather than the mechanism, erased by a political and financial elite gone awry.
An edited version of this article appeared in the Sunday Telegraph (UK).
Focus On This: Merkley-Levin Did Not Get A Vote
May 21
After nine months of hard fighting, financial reform came down to this: an amendment, proposed by Senators Jeff Merkley and Carl Levin that would have forced big banks to get rid of their speculative proprietary trading activities (i.e., a relatively strong version of the Volcker Rule).
The amendment had picked up a great deal of support in recent weeks, partly because of unflagging support from Paul Volcker and partly because of the broader debate around the Brown-Kaufman amendment (which would have forced the biggest six banks to become smaller). Brown-Kaufman failed, 33–61, but it demonstrated that a growing number of senators were willing to confront the power of our biggest and worst banks.
Yet, at the end of the day, the Merkley-Levin amendment did not even get a vote. Why?
Partly this was because of procedural maneuvers. Merkley-Levin could only get a vote if another amendment, proposed by Senator Brownback (on exempting auto dealers from new consumer protection rules) got a vote. Late yesterday afternoon, Senator Brownback was persuaded, presumably by his Republican colleagues and by financial lobbyists, to withdraw his amendment.
Of course, Merkley-Levin was only in this awkward position because of an earlier lack of wholehearted support from the Democratic leadership—and from the White House. Again, the long reach of Wall Street was at work.
But the important point here is quite different. If Merkley-Levin did not have the votes, it was in the interest of the megabanks to have it come to the floor and be defeated. That would have been a clear victory for the status quo.
But Merkley-Levin had momentum and could potentially have passed—reflecting a big change of opinion within the Senate (and more broadly around the country). The big banks were forced into overdrive to stop it.
The Volcker Rule, in its weaker Dodd bill form ("do a study and think about implementing"), perhaps will survive the upcoming House-Senate conference—although, because this process likely will not be televised, all kinds of bad things may happen behind closed doors. Regulators may also take the Volcker Rule more seriously—but the most probable outcome is that the Fed and other officials will get a great deal of discretion regarding how to implement the principles, and they will completely fudge the issue.
Most importantly, everyone who wants to rein in the largest banks now has a much clearer idea of what to push for, what to campaign on, and for what purpose to raise money. These are the completely reasonable and responsible tasks:
- The Volcker Rule, as specifically proposed in the Merkley-Levin amendment
- Constraints on the size and leverage of our largest banks, as proposed by the Brown-Kaufman amendment
When the mainstream consensus shifts in favor of these measures, or their functional equivalents, we will have finally begun the long process of reining in the dangerous economic and political power of our largest banks.
