Reform or Regret

Monday, September 12, 2011 7:00 PM

The equity (stock-oriented) and debt (bond-oriented) departments of investment banks have long, colorful histories that track the development of modern industries and economies, of entrepreneurialism, wealth creation and even social empowerment. Like the underlying financial instruments in which they deal, equity and debt businesses both complement one another and they compete, even intensely, as their respective fortunes rise and fall, often out of step.

Accustomed to operating under the same roof, debt and equity businesses now occupy more common ground: the structures of markets in which they operate, although almost polar opposites, each need urgent reform.

Debt markets are illiquid and opaque, dominated by highly customized “over the counter” products that change hands away from published price feeds and prying eyes. Lacking central clearing facilities, many debt trades entail counterparty risk that can lead to chain-reactions of default (a danger exacerbated by participants fraudulently misrepresenting deals).

In stark contrast, equity markets transact mostly in plain view with a kind of hyper-liquidity characterized by computer-driven trading models battling for nanoseconds. Whereas equity trading benefits from central clearing, the mismatch of trading (instantaneous) and settlement (days) leaves the market exposed to irresponsible participants, many of whom have no capital and nothing to lose.

Each of these market models poses significant risks for capital markets and, left to themselves, may well lead to serious economic problems if not a repeat of financial catastrophe.

In the case of credit products, the illiquidity of the market and its opacity were essential ingredients to the economic crisis (2008 - present). Misled or incompetent or both, professional investors proved easy prey for rapacious bankers until their ruse finally collapsed, wreaking havoc with the global economy. Witnesses to the destruction they had wrought and grateful for the subsequent generosity of taxpayers, chastened banks might have opted to prioritize structural reforms. But, no, they don’t think that way.

Addicted to the profitability inherent in opaque credit markets, the banks poured money (much of which had to be taxpayers’) into an unprecedented lobbying effort to maintain the status quo. It would take too long to institute reforms, they protested. It would be hard work to change markets, they asserted. It’s incredible to imagine that they were even allowed to comment on the situation, except to apologize and plead for light sentences, but they were, and their arguments have carried the day. Reform will wait until after the recovery (whenever that is).

For their part, equity trading chiefs have largely swept aside any lessons from the “Flash Crash” last year that wiped a trillion dollars from markets in the space of twenty minutes. In fact, equity markets today are even more susceptible to systemic risk as the proliferation of ETFs, leveraged and not, and of index swaps and options and futures all continues unchecked so that microscopic arbitrage opportunities can be exploited by innumerable automated trading desks whose computer code runs on remote machines, flirting millions of times a day with feedback loops that will trigger the next crash.

Meanwhile fear pervades equity markets as real investors experience breathtaking volatility on stock exchanges overrun by trading algorithms. The vested interests - banks and trading firms who love the volumes (if not always the volatility) - point to research that might vindicate them, but nobody believes that high frequency trading hasn’t increased market volatility. Investors are losing faith; more ominously, listed companies may well be next. Markets that resist reform may find themselves barren: think tumbleweed bouncing past computer racks in abandoned high-tech data centers.

Did equity and credit markets get this way because of some sort of intelligent design? Not at all. They each represent in different ways classic cases of what goes wrong when means become the end.

In credit, the business of securitizing loans began as a wholesome enterprise where banks packaged loan portfolios and sold pieces of them to willing investors. Willing buyers earned interest while banks cleaned up balance sheets and lowered risk. But as securitization became a business in its own right, it became a commercial justification for creating more loans in dizzying varieties and dubious quality. Inevitably, avarice got the better of them and bankers filled their structured products with toxic credit.

Similarly, in equity markets the trend to electronic trading was natural, an easy benefit of standardized financial instruments and new technology. Troves of data enticed statistical arbitrage hedge funds and high frequency trading firms, while investment banks deployed computer algorithms to reap efficiencies from mundane processes. And one thing led to another until the markets became about trading for trading’s sake and the primary function of stock markets took backseat to the need to satisfy machines whose investment horizons are determined by the speed of their microprocessors.

It will go horribly wrong - it has already, it might be even now, and it will certainly again.

Why would banks not act to stave off the next crisis? Well, banks don’t act; their managers do. Motivated by their own self-interest, and keenly aware that virtually nobody was held accountable for the last crisis, bank executives do what’s best for themselves. These market structures, flawed as they are, are intrinsic parts of fiefdoms. There are responsible grownups around, but they don’t always get the straight story from people below.

With major risks in the status quo, what should be done to reform debt and equity markets? Credit markets need to be made more transparent and liquid, which can only happen when basic debt instruments are standardized to look more like stocks. Stock markets need to take steps to responsibly govern the automation, either with tariffs or rules restricting orders. At a higher level, there needs to be a rationalization* - driven by regulation and policy - of the universe of tradable products and the way banks interact with traded markets.

Debt and equity businesses need to be recast along the lines of their original intent and their vital role in capital markets. Reconstituted with modern technology, rational design and effective oversight, equity and credit markets can again play their part in financing productive economies with real prospects for recovery and growth. It would go a long way in the rehabilitation of investment banks if they abandoned self-serving defense of the status quo and committed themselves to leading market reforms.

If they don’t, they’ll soon wish they had.

* The third article in this series will look at the social cost of failing to take substantive action to properly regulate markets and bank trading participants.