September 24, 2009
More Regulation Not the Answer for Wall StreetBy Jeffrey R. Carter
Washington DC talks a good game about re-regulating Wall Street. Will we get meaningful regulatory reform that will help the market function more efficiently? It's highly doubtful. Wall Street banks have dumped billions of dollars into lobbying. Senator Richard Durbin said banks, "Frankly own the place." The industry was an oligopoly before the financial crisis. Post crisis, we have an even more concentrated industry. Any new regulatory structure needs to break up banks, change market structures, and recognize that different markets have different uses.
Mega banks wear too many hats in the marketplace. Wearing all these hats cause huge conflicts of interest, and hurts competition in the marketplace. A mega bank like Goldman Sachs can borrow at the Federal Reserve window, had access to TARP funds, is a broker, an investment bank and also trades for its own account just like a hedge fund. We must end these conflicts with a new regulatory structure that limits how many hats an entity can wear.
Banks should not be a broker and a proprietary trader at the same time. They need to make a choice: be a broker or a trader. Suppose you want to buy 1000 shares of XYZ company stock at any price. This is called a market order. Since you are a buyer, you are only concerned with the offer price. Currently XYZ shows 100 shares offered at $5.52, 300 at $5.53, 200 at $5.54 300 at $5.55, 1000 at $5.56. Your broker might buy all the shares offered at $5.52-$5.54, and fill your entire order at $5.55-profiting slightly more than $.02 per share on the whole transaction, plus the brokerage charge you incur for executing the order. Or, the broker might buy up everything, and fill your order at $5.56. They act knowing your order.
It doesn't seem like a lot of money, but it's actually exponential when you think about all the different investment vehicles to trade. A ban on dual trading in all marketplaces will make capital markets more competitive. This means that mega banks will have to spin off some segments of their companies.
Wall Street mega banks legal structure should be regulated too. We should permit a simple broker/investment bank to be a publicly traded entity. Before 1970, such enterprises were prohibited from becoming public companies. Any bank that desires to engage in proprietary trading should be prohibited from being structured as a publicly traded company. These entities would organize as partnerships or LLC's.
Salaries and appetite for risk increased on Wall Street after banks became public companies at the end of the last century. Instead of partners having their capital at risk, the public's capital became the risk capital for the bank. This change in psychology produced a far different style of trading. Forcing banks that want to proprietary trade back to a private structure will do a lot to restrict the type of trading those banks engage in. Mega banks trading psychology will change when all the partners' money is on the line.
Currently, not all markets are structured to be fair and openly competitive. Mega banks reap huge profits off of their own customers. Instead of executing your order on a public market like the NYSE, banks use their own proprietary trading desks to trade against your order. They send your order to the market when they can't make money off the order. They also pay other brokers a small fee and the broker sends the mega bank retail business to internalize.
Prohibiting internalization of orders and payment for order flow will force more orders into an open public market. These two unseemly practices give customers a worse price. Customers pay less in commission, but the price they would have received had their order been competitively placed in a public market would have been better, given the other changes to structure I have proposed. The banks use riskless arbitrage to lay off the transaction instantaneously and make tremendous profit. They use your order to establish a position in a market, and immediately offset it in another market. The mega banks derive over one third of their revenue from proprietary trading. This percentage grows year after year. Trading is a very risky business where profitability is variable. Not so at the mega banks.
Changes can be made in market rules to enhance competition. Currently, the equity markets trade with a penny wide bid/ask spread. Enlarging the bid/ask spread to a nickel increment will be better for the overall market. A slightly larger spread will attract more volume at each price because there will be a better chance to make money. When spreads are narrow, volumes at each price are lighter because it benefits the trader to wait and see if the market will move directionally. Narrower spreads cause more volatility within a trading range-or what the street calls "noise."
Widening these spreads by a little will encourage all entities to put more volume on the line for fear of missing a trade. A five-cent spread rather than a one-cent spread could be interpreted by some as increasing transaction costs. However, the spread is still tight enough to give customers a fair price, and the bid/ask spread will be more stable. This allows more customers to get orders filled at less volatile prices.
The old standard Wall Street spread until 1999 was twelve and a half cents. Using a one-cent spread was an arbitrary choice not based on any rigor. Lately, some market participants use sophisticated computer programming to try and rig the market in their favor using flash orders. The one-cent spread makes this technique effective. A wider spread would dampen the effectiveness of any flash order strategy because the volume on each side of the spread would be larger.
Selling a stock without owning it is a common, but sometime controversial trading practice. Shorting stocks would still be allowed. However, re-enacting the uptick rule, along with a rule limiting the amount of shares one can short to the amount of the companies available float. The float equals the outstanding shares minus the restricted shares. Uptick rules mean you can only short when stock it goes up in price. Traders would assume more risk to be short. These types of changes would end capricious attacks on a helpless company. Changing the rules slightly will make the market more efficient, competitive and fairer for everyone.
Some principles are imperative to adhere to in every single market. All markets need to be very transparent. People need to be able to look at a market and be able to instantaneously interpret the price and volume being traded. Price reporting should be done when all trades happen because we have the computer sophistication to do it. Immediate price reporting also give necessary information and feedback to the entire market, making it more efficient and competitive.
Sometimes, pension funds or other entities need to trade large lots of shares or contracts at one time. Often, mega banks internalize these trades and make money off them because the rest of the market participants don't know the trade happened. Block trades need to be reported immediately, not within five minutes, or at the end of the day.
Mega banks have established electronic communication networks that are unregulated, called "dark pools." Dark pools of liquidity need to be closed down and brought into the open. We should do as much trading on open regulated public exchanges as possible because they allow everyone access to the price and volume information in the most democratic way. Any regulations that are proposed should be in the spirit of generating more trading, and more transparent trading. Lack of transparency is one of the inefficiencies that caused last years' breakdown.
Lastly, capital markets are global. Firms and businesses compete globally. Companies make decisions on where to trade, deposit money, and base certain parts of their organization because of a countries' regulations. They engage in regulatory arbitrage and will try to put their capital in the least restrictive countries that are easiest to do business with. This doesn't mean we have a regulatory race to the bottom. There are many advantages to keeping capital and trading within America, too many to list here. Certainly, regulators from each country should communicate clearly with each other. But, a change to a far stricter regulatory attitude and climate will not endear companies to the US capital markets. We will lose business if the Obama administration is too heavy handed and bureaucratic.
Over the last years, the alphabet soup of agencies that already exist didn't have enough knowledge or firepower to regulate the financial industry from disaster. There is not a need to consolidate all federal agencies that regulate, but they do need better communication. From Bernie Madoff to the bank collapse, our system fell down. The crash didn't happen because we didn't have enough regulation or government intervention. It happened because we don't have the correct regulation or structure to enable free market checks and balances to work for us.
Jeffrey R. Carter is an independent trader, televison commentator, Former member of the Chicago Mercantile Exchange board, co-founder of Hyde Park Angels.