Capital Markets Vortex Calling: Anyone Home?

I use the term legisgulator as proxy for “legislator and regulator”, but also perhaps because it has a nice guttural ring to it. Legisgulators are modern-day emperors unable to appreciate their nakedness or, in other words, unable to see that their well-meaning rulemaking is, to put it bluntly, worthless.   

If my attention grabber intro has not been too intense for your sense of convention, you might yet extract value out of this irreverent article.

Legisgulators on both sides of the Atlantic are busy dotting the Is and crossing the Ts on derivatives regulations, oblivious to a vortex of collapsing capital markets headed their (our) way. This peculiar crowd firmly believes in creating its own climate, and historically this has an element of truth – just not today.

Maybe they can only see the tree, not the jungle. Or maybe their inaction highlights another systemic shortcoming, i.e., that the legislative process also needs serious fixing.

MONKEY BUSINESS

Pushing the envelope of the jungle concept I just referred to, I will compare problems in capital markets

today to a jungle with a case of large mammal infestation, namely monkeys, gorillas, and elephants. The limited peripheral vision of legisgulators is known to identify at least smaller primates:

Monkey #1. The self-interest of certain corporate leaders tends to push the short-term profitability envelope as far as possible and, when possible, help their firms gain the status as too-big to fail. Over-the-counter (OTC) derivatives trading activities, like just about anything under the sun, can be a source of systemic risk.

Cage #1: Legisgulators will hold firms of systemic importance at a higher regulatory/capitalization standard, will mandate higher bank capital ratios every few months, will force banks to jettison proprietary trading desks (Volcker rule), and will concentrate much more trading activity around new entities – like swap exchange facilities, SEFs – that in theory will reduce counterparty and clearing risk.

Monkey #2. Abuse in capital markets has taken various forms: ponzi schemes a-la-Madoff, pseudo investments like CDOs (collateralized debt obligations), and financial firm agents posing as fiduciaries to investors but in reality siding with firms they represent – not clients.

Cage #2: Legisgulators will pass investor protection laws (the only redeemable goal) and frown upon exorbitant executive pay. 

GORILLAS IN OUR MIDST

With the monkey infestation somewhat neutralized, I wonder if at some point legisgulators will turn their attention to the 800-pound gorillas still running wild:

Gorilla #1. The interconnection of our global capital markets is broken and beyond repair. 

The globalization of capital markets is a phenomenon of the last 20 years. It was not of a well-conceived plan, but rather the indirect result of trade openness efforts among regional blocks in North/South America, Europe, and parts of Asia.

The great challenge lies in rolling back/restructuring global capital markets without disrupting the more than US$19+ trillion that change hands every day under the old, inefficient rules AND skirting the menacing vortex.  

The still unfolding impact of the MF Global collapse signals that time has almost ran out for the current version of capital markets. It, along with the May 6 2010 flash crash, parade the nakedness of legisgulators in areas they thought were under control..

MF Global was an umbrella company to more than 3,000 legal entities, regulated in many jurisdictions, across hundreds of financial instruments, and engaged in several hundred counterparty relations. It is no surprise that the legal complexity of MF Global was daunting (impossible?) for its regulators to handle.

Gorilla #2. Financial innovation has become unhinged and runs rampant in much of the clumsily interconnected world.

This is the era of wrapping half-cooked, derivatives concepts around boring banking or mortgage products, and raising their complexity and risk to the nth degree - i.e., cases where product S derives its price from product H, and product H gets its price from product I, and so forth.

As the financial product becomes detached from its intrinsic value or collateral, the task of managing risk for such an asset inexorably falls short in four key areas:

-         Credit evaluation: the financial product may seem more credit worthy than what it really is

-         Risk management: the risk that is not quantified cannot be managed

-         Margining: by the same token, market forces and generalized acceptance of risky assets during good times has led to low levels of margining and difficulty raising those levels in times where the risk of loss on those assets is more apparent (i.e., euro-related instruments)

-         Clearing. The technical aspects of clearing products (even if they are of questionable value) are rather straight forward. But exchanges and OTC clearing firms are legally bound to honor the delivery of cleared transactions – the buck stops with them. To use an extreme scenario, many US$ trillions worth of derivatives contracts trading today are based on the euro. Should the euro cease to exist abruptly, clearing firms could not possibly meet their obligations.

Gorilla #3. There are disruptive domestic policies of consequence (such as the arbitrary Chinese yuan peg to the U.S. dollar and the anachronistic over-dependence on the U.S. dollar and Treasuries) that cause massive capital dislocations at the supranational level, such that:

-         The United States experiences arbitrarily low interest rates which, among other things, prevents the efficient pricing of private U.S. assets

-         The invisible hand of markets can NEVER weaken the USD relative to its Asian trading partners enough to correct trade deficits – a situation that morphs into high-stakes, structural trade deficits

-         Exporting U.S. monetary policy decisions wholesale to helpless countries which are forced by market forces to mimic the U.S., even at the detriment of their country's economic growth

Continuing to tolerate distortions of basic capital supply/demand may be the road of least resistance for legisgulators, but it will only foster more asset bubble episodes and their inevitable, painful burst.  

HUNGRY ELEPHANTS

Alas, there are also hungry elephants threatening to destroy trees in the pristine jungle protected by legisgulators. I draw a distinction between gorillas and elephants to differentiate (respectively) long dated systemic problems and problems caused by the touted ‘solutions’ of legisgulators since 2007.      

Elephant #1. Weak liquidity is not conducive to healthy capital markets.

Weak liquidity refers to situations where the low bid/offer levels for a particular security weaken the efficiency of capital markets. Price discovery for an asset happens best and more cheaply when there is an abundance of bids and offers.

Following the massive write downs in the value of real estate and investment holdings since 2007, liquidity in general decreased sharply but also reallocated to favor certain asset classes more than others. 

Certain policies announced since 2007 suggest that at least some legisgulators believe that capital markets are flush with liquidity, so much so that this liquidity is taking the form of abusive speculation they feel compelled to contain/eliminate:

-         Volcker rule

-         Short-sell bans

-         Mandating banks to take huge sovereign debt losses and then forcing them to raise capital for reasons beyond their control (sovereign debt and currency policy problems)

-         Demeaning the price-discovery and market-making value of high-frequency traders, and setting anachronistic obstacles to slow the speed of trading

-         Imposing unproven new trading venues and higher margining/regulatory costs that are disincentives for trading

-         Assessing taxes on financial transactions

Levels of liquidity are definitely elastic to measures such as these and it is reasonable to expect that liquidity will continue to suffer and reallocate to geographies and asset types with most favorable regulations. But capital reallocations of this kind, although efficient on the surface, lead to more capital markets distortions – case in point: look at the behavior of the Swiss frank in July 2011 and the dramatic Legisgulator response.   

Elephant #2. Derivatives regulations today miss the risk-reduction target, are looking economically unviable, and will lead to more problems unless synchronized at the global level.

There seems to be a silly rivalry for regulatory preeminence in transatlantic relations. The far reaching measures being enacted in the United States following the Dodd-Frank Act lead raise troubling issues of extraterritoriality, something that means that non-U.S. firms/individuals wanting to trade derivatives with U.S. counterparties need to know about and abide by U.S. laws. It is as annoying as having your bags X-rayed in Paris only to have them X-rayed again when the plane arrives to New York City.

Policy proposals by ESMA (the European Securities Markets Authority) suggest that Europeans will respond in kind. Who knows what Asians and Latin American regulators will say on this topic. Interoperability agreements across jurisdictions, and multi-venue/multi-jurisdiction compliance requirements will certainly help a robust crop of lawyers make school loan payments, but will not do much good for market participants.

WHAT’S NEXT

Compared to 20 or even 10 years ago, legisgulators today are much more aware of systemic issues and capable to set up sustainable capital markets. Many of the errors in policy solutions that I highlighted here originate from legisgulators keeping alive a brain dead patient instead of developing (jointly with the financial industry and tech firms) smarter, robust capital markets.

Having said that, I have seriously doubt legisgulators will join hands to proclaim their nakedness, let alone come forth with true systemic fixes.

More likely, I believe that the “new-‘new normal’” for capital markets is decoupling, geographic and asset class decoupling. We will see a painful period of transition rolling back exposure to global capital markets, followed by up to 10 or so national/regional capital markets emerging from the ashes.