It's the Banks Stupid

Jeff  Carter
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Posted: Aug 24, 2011 12:01 AM

Much is being made of Goldman Sachs ($GS) CEO Lloyd Blankfein lawyering up. It’s unprecedented. Matt Taibbi’s article finds him guilty before having a trial. If you are a regular reader of this blog, you know that there is no love lost between me and the investment bank traders of Wall Street($MS, $BAC, $BX, $BLK, $C). Taibbi’s article brings up some great points, and shows how standard operating procedure on Wall Street leads to some really crummy business practices when it comes to dealing with Main Street. The unfortunate part of Taibbi’s analysis is his conclusion that the banks were under regulated. I don’t think that is the case-but I do think the way they were regulated was incorrect.

Solutions to the problem are a lot more difficult than just bringing back Glass-Steagall. They are more comprehensive than just bringing back the uptick rule, which needs to be done.

99% of people’s eyes glaze over when you bring up regulation of the banks and trading. It doesn’t seem important. It’s not glamorous. But the way they are regulated sets the wheels in motion for the discrepancies that occur when your orders are executed in the marketplace. Conflicts of interest are codified. Unethical business practices are whitewashed. By the way, Dodd-Frank didn’t contemplate any of it. The banks are actually probably better off under D-F than before, since D-F will get rid of most of their competitors.

First, accept that the roots of the financial crisis were in the way Washington administers financial markets. If agencies like Fannie Mae and Freddie Mac didn’t exist, the mountain of home mortgage debt the banks traded against wouldn’t have existed. I want to be clear, I don’t give Wall Street a pass but Washington shouldn’t get a pass either. All the programs designed to get people into homes, subsidize mortgages, and backstop the mortgage market were designed in the oak paneled committee rooms of Washington. Not the walnut encrusted board rooms of New York. New York reacted to the policy of Washington.

Did Goldman knowingly trade against their customers and make huge amounts of money? There is no doubt that they did. However, virtually every big bank and big hedge fund does the same thing. When a bank or hedge fund buys order flow from a discount broker they aren’t doing it for market efficiency. They buy it to trade against and make money on.

Trading against the customer has been standard for over a century on Wall Street. At the NYSE, the old specialist system was a license to print money. Once electronic trade began siphoning off volume and the SEC passed Regulation NMS, the license to print money left the specialists and went directly to the prop trading desks of the banks. It not only happens in the mortgage market. It’s de rigeur in equities, currencies, cash bonds, muni bonds, corporate bonds and virtually anything Wall Street trades. The customer always finishes last.

Taibbi starts to get to the issues in the financial industry with this paragraph,

“This issue is bigger than what Goldman executives did or did not say under oath. The Levin report catalogs dozens of instances of business practices that are objectively shocking, no matter how any high-priced lawyer chooses to interpret them: gambling billions on the misfortune of your own clients, gouging customers on prices millions of dollars at a time, keeping customers trapped in bad investments even as they begged the bank to sell, plus myriad deceptions of the “failure to disclose” variety, in which customers were pitched investment deals without ever being told they were designed to help Goldman “clean” its bad inventory. For years, the soundness of America’s financial system has been based on the proposition that it’s a crime to lie in a prospectus or a sales brochure. But the Levin report reveals a bank gone way beyond such pathetic little boundaries; the collective picture resembles a financial version of The Jungle, a portrait of corporate sociopathy that makes you never want to go near a sausage again.”

The structure of Wall Street is a relic of the past. With electronic markets, with increasing access to information, and with destruction of distribution systems in virtually every industry caused by the internet, Wall Street has been able to cling to its outdated structure simply by virtue of controlling the regulators. It’s time to change it and put the customer next to the order flow.

Most of Wall Street is against it because they all profit in some way from the current system. They will scare you by saying commissions will go up, or markets won’t be as liquid because they won’t make markets. This is no different than a politician scaring senior citizens when one party wants to change Medicare or Social Security.

The market as currently structured has built in favoritism to one class and Main Street gets the back of the bus.

What would I do?

1. End payment for order flow. Have orders hit a central limit order book.
2. End dual trading. Entities handling customer business should not be able to trade against their customers.
3. Bring back the uptick rule. Not having it invites bear raids on stocks. The uptick rule also recognizes that shorts assume slightly more risk in a marketplace that is designed to raise and grow capital
4. Have a real futures market for single stocks and ETF’s. Margin and tax them like futures.
5. Ban Dark Pools. Force everything out into the light of day. Report price and volume traded instantly. Current regulations and all proposed regs under Dodd-Frank make markets less transparent, not more.
6. End the penny spread, which has just made it easier for Wall Street to front run and steal. Make it a .05 spread. The book will be thicker and the market will function better. Volatility will decrease.

These changes will also impact high frequency trading. They will have to adjust their algorithms and compete. With current market structure they are able to utilize technological practices that would have been banned in the past to manipulate markets.

The problem isn’t that we don’t have enough regulation on the books. The problem is that we have some gerrymandered regulation on the books. The current rules slant the playing field. The average Joe is getting ripped off and doesn’t have a chance.