Trader explains why dishonesty rewarded on Wall Street and only transparency can end bad behavior

In his must read Guardian column, Joris Luyendijk interviews a Trader from London's City who explains why dishonesty is rewarded on Wall Street and how only transparency can end misbehavior.

Regular readers know that sunlight is the best disinfectant.  The trader describes what happens when Wall Street and the City are left to operate behind a veil of opacity.

The trader presents petty theft as an every day occurrence.

"Where I worked people seemed obsessed with power structures and keeping on top. For instance when someone was made redundant a remaining trader would do a deal between his book and that person's, creating a profit in his book and a loss in that of the person leaving...."

Left unsaid is that the trader creating a profit in his own book has his compensation based on the profitability of his book.  From the bank's perspective, the position hasn't changed, just the payout.  So effectively, the trader has stolen money from the bank.

The trader explains how they use opacity to take risks knowing that if the bet pays off they are well compensated and if the bet loses they will just move on to the next bank.

"In the end the bank is like a shell. You need a place to trade from, this is how we saw our bank. Sometimes an entire team can be poached and go from one bank to another. There's no loyalty either way. And the top at your bank has no idea what's going on, how could they? Why would anyone tell them what's going on?

The trader explains Wall Street and the City's ethics.

"Of course traders are constantly inquiring across the bank: what's happening? What are our big clients like institutional investors doing? Then they 'front run' those investors; buying ahead of them so when the price rises due the subsequent buying, they pocket the difference. 

"Chinese walls [between deal making, asset managing and trading bankers]? Bullshit. We could simply log on to our system and see what was happening and what they were doing all the time. 

"If there is a lot of money at stake then people will not adhere outside rules and they will evade Chinese walls....

Next, the trader explains who Wall Street and the City use the complexity and resulting opacity of the financial products they sell to benefit at the expense of their customers.

"My advice to people dealing with the financial sector is: never buy anything that's complex. Because the more complexity the more opportunities there are to screw you over. 

Finally, the trader highlights how important the role of caveat emptor (buyer beware) is when dealing with Wall Street and the City.

Traders see the capital markets as a zero-sum game.  If they win, you must lose.

Individuals and small companies see their relationship with the bank as a partnership with the goal of both parties winning.  This makes individuals and small companies susceptible to being mistreated and sold products like interest rate swaps.

I just can't get my mind around how banks can still call clients in the corporate world and say, look we've got this great idea that's going to make you a lot of money. I mean, what are they thinking? 

Nobody in the City can be trusted because they don't work for you, they work for themselves. 

"I do wonder why there seem to be so many somewhat dishonest people in the bank, and why the most dishonest are often the ones to walk away with the most money."

Wall Street and the potential to manipulate commodity markets

Bloomberg's Bob Ivry looked at the potential for Wall Street to manipulate commodity markets and highlighted the key issue: opacity.

Because of opacity, market participants cannot see and help the financial regulators assess the extent to which Wall Street is manipulating commodity markets through its participation in the physical markets.

“When Wall Street banks control the supply of both commodities and financial products, there’s a potential for anti-competitive behavior and manipulation,” [US Senator Sherrod] Brown said in an e-mailed statement. Goldman Sachs, Morgan Stanley and JPMorgan are the biggest Wall Street players in physical commodities.... 

Now, “it is virtually impossible to glean even a broad overall picture of Goldman Sachs’s, Morgan Stanley’s, or JPMorgan’s physical commodities and energy activities from their public filings with the Securities and Exchange Commission and federal bank regulators,” Saule T. Omarova, a University of North Carolina-Chapel Hill law professor, wrote in a November 2012 academic paper, “Merchants of Wall Street: Banking, Commerce and Commodities.” 

The added complexity makes the financial system less stable and more difficult to supervise, she said in an interview. 

“It stretches regulatory capacity beyond its limits,” said Omarova, who is slated to be a witness at the Senate hearing. “No regulator in the financial world can realistically, effectively manage all the risks of an enterprise of financial activities, but also the marketing of gas, oil, electricity and metals. How can one banking regulator develop the expertise to know what’s going on?”

An example of "Trying to pierce a Wall Street fog"

In her NY Times column, Gretchen Morgenson looks at the credit default swap market and finds that because of opacity the market is not acting in a competitive manner and Wall Street's informational advantage enables it to extract a much higher profit margin.

Regular readers are not surprised by this finding.  As Yves Smith said, nobody on Wall Street is compensated for developing low margin, transparent products.  Credit default swaps are an example of a high margin, opaque product.

BACK in 2009, the Justice Department said it was investigating the large Wall Street banks for possible collusion in the huge and opaque credit default swaps market. The question was whether the big financial institutions had worked to keep transactions in these insurance-like instruments closed to competitors and more profitable for themselves....

On July 1, the antitrust division of the European Commission announced that its investigators had come to a “preliminary conclusion” that the banks and two entities controlled by them had infringed European antitrust rules. These entities colluded, the commission said, “to prevent exchanges from entering the credit derivatives business between 2006 and 2009.” 

Credit default swaps were at the center of the financial crisis. These instruments allow holders of bonds or other debt to hedge their risks in those positions. But the swaps also let speculators bet on a debt issuer’s default. ... 

But the market for these swaps has been conducted in the shadows. Trades were made over-the-counter — between private parties and not on an exchange. This meant that participants’ positions were not disclosed to regulators. 

Wall Street likes the fog of over-the-counter markets because the profits generated by executing customers’ trades in them are far greater than in more transparent arenas. 

Think of the way you might shop for a mortgage: if mortgage rates were not publicly available, it would be hard to know whether the rate one banker offered was competitive. Customers that dealt with only one banker on their credit default swaps almost certainly did not get the best prices. 

The 13 banks under the microscope on credit default swaps include Bank of America Merrill Lynch, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS. Two associated entities controlled by the big banks are also being scrutinized — the International Swaps and Derivatives Association, a lobbying organization, and Markit, a data service provider....

“There was no question the banks did not want the C.M.E. to make the market more liquid and transparent,” said one person briefed on the banks’ internal discussions who asked for anonymity because he was not authorized to speak publicly. “This was their cash cow, and they didn’t want to give it up.”...

The banks have pushed to keep the market for credit default swaps in the dark. 

Three years ago, the Dodd-Frank legislation aimed to bring more competition by pushing trading onto exchanges and swap execution facilities. Wall Street tried to beat back regulators’ efforts to write tough rules after the legislation’s lead. They won some and they lost some. For instance, dealers now have to report swap transactions to regulators. 

There was a reason for the banks’ pushback: money. The Deloitte study cited a 2010 analysis by Citigroup showing that the big banks’ trading in over-the-counter derivatives generated revenue of $55 billion, or 37 percent of the total at these institutions. Such profits will fall as more swaps trade on swap execution facilities under the new rules.... 

“When you have markets that are .... opaque and where market players don’t have access to the same information, the markets are not functioning in a competitive fashion. Those that have the information can take advantage of that fact and extract anticompetitive leverage over those that lack the information.”

Please re-read the highlighted text as it nicely summarizes why transparency needs to be brought back to all the opaque corners of the financial system.

Being a universal banking means participating in all of bankings misdeeds

In his Rolling Stone column, Matt Taibbi catalogs all the fines and legal fees that JP Morgan has paid as a result of its involvement in all types of misbehavior.

It is not surprising the breath or depth of JP Morgan's involvement in all the sordid aspects of banking, it is simply a reflection of the current universal bank business model.

As you read through the list, please note how many of these activities would not have occurred if JP Morgan had been required to report on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

On the other hand, most of these activities would not have been prevented by either the complex regulations spelled out by the Dodd-Frank Act or the need for banks to hold more capital.

It really is true that sunlight is the best disinfectant.

For sheer curiosity's sake, I thought I'd list, in capsule form, some of the capers Chase has been caught up in in recent years: 

They were fined $153 million for the infamous "Magnetar" fund case, another scam in which a bank allowed a hedge fund to create a "born-to-lose" mortgage portfolio to bet against. Very similar to the Abacus case that's at the heart of the ongoing "Fabulous Fab" trial; 

Chase paid $228 million for its role in the egregious municipal bond bid-rigging case we wrote about in Rolling Stone in 2011; 

Chase paid $297 million to the SEC last November for fraud involving mortgage-backed securities; 

Chase paid $75 million in cash and generously agreed to forego $647 million in fines in the Jefferson County, Alabama mess, in which a small-town pol was bribed into green-lighting a series of deadly swap deals; 

In two separate orders this spring, Chase was reprimanded by the OCC and the Fed for money-laundering behaviors similar to the infamous HSBC case, and also for regulatory failures and fraud in the London Whale episode. There was a separate FBI investigation into the London Whale probe in which they allegedly lied to customers and investors about the loss; 

They're under investigation for allegedly failing to disclose Bernie Madoff's trading activities to authorities; 

They were one of 13 banks asked to pay up in this year's $9.3 billion robosigning settlement; 

They were one of four banks last year to settle for a total of $394 million with the OCC for improper mortgage servicing practices; 

They were ordered by the CFTC to pay $20 million last year for improper segregation of customer funds (this was part of the Lehman investigation). The CFTC also fined Chase $600,000 last year for violating position limits in the cotton markets; 

Last year, Chase paid a $45 million settlement to the federal government for improperly racking up fees for veterans in mortgage refinancings. Hey, if you're going to steal from everyone, you can't leave out those veterans overseas! 

In 2010, Chase paid $25 million to the state of Florida for selling unregistered bonds to a state-run municipal money-market fund; 

The bank last year was convicted in Europe along with several other banks for fraudulent sales of derivatives to the city of Milan. A total of about $120 million was seized from Chase and three other banks. 

There have been so many settlements with so many agencies around the world (I'm in a hurry and can't get to Chase's messes in Britain, Japan and elsewhere) that they're almost impossible to count. Some papers are reporting that Chase is being investigated by as many as eight different agencies in the U.S. alone. 

There are some other civil actions left out, too, like the $110 million class-action settlement for improper charging of overdraft fees, or their part in the gigantic $6 billion settlement completed last year involving Visa, MasterCard and other credit card providers for manipulating card service rates. And states like California have only just begun crawling up Chase's backside for its role in the lunatic filing of erroneous credit card collection lawsuits, a scam outed by whistleblower Linda Almonte. 

Chase is turning into the Zelig of the corruption era. In virtually every corruption scandal, the bank is in the background somewhere. The HSBC money-laundering mess? Chase was reprimanded for similar abuses. The Madoff story? They're under investigation there. MF Global? As banker to Jon Corzine's notorious firm, they were part of a $546 million settlement to return money to MF Global's outraged customers. Jefferson County? That was them. And again, you might have heard of Abacus, but Magnetar was just as bad. Not that anyone's counting or anything.

Not on the list yet of course is manipulating Libor.

Yet another bank hides behind opacity to mislead investors

A recurring theme since the beginning of the financial crisis has been how banks have hid their true financial condition behind a veil of opacity and used this to take advantage of other market participants.

These participants include, but are not limited to, taxpayers and central bankers through bailouts (see Anglo Irish), depositors who were mis-sold investments (see Bankia and the other Spanish cajas) and investors.

The Telegraph reports how the Co-op bank mis-led pensioners about its true financial condition.

In emails seen by The Sunday Telegraph, a manager at the Co-op Bank told a worried pensioner that “there is no need to be concerned” about a £50,000 investment. The email was sent on May 13, just three days after the ratings agency Moody’s downgraded the bank to “junk” . 

The following month, the Co-op suspended interest payments to pensioners and told savers they faced losses of at least 40pc on their investments. The bank also said it had a £1.5bn capital shortfall. 

The pensioner wrote: “I am a member of the Co-operative Group and my wife and I ... are extremely fearful that we are about to lose all of this very important retirement savings nest-egg, the income from which we rely upon. We are very, very worried.” 

The manager replied: “There is no need for you to be concerned. We do acknowledge the need to strengthen our capital position ... and we have a clear plan to drive this forward. I hope this provides some reassurance.” 

At that point, the bank was in discussions with the regulator about the size of its capital shortfall. A month later it revealed it needed £1.5bn, £500m of which was to come from enforcing losses on bondholders. 

Including large investors, the bondholders have £1.3bn of debt, £65m of which is with 15,000 pensioners and small savers. 

One of the primary reasons for requiring the banks to provide transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is to end bankers mis-leading anyone about their current financial condition.

Derivative alchemy used to transform short to long term capital gains for tax purposes

Bloomberg ran an interesting article on how a major hedge fund used bank sponsored derivatives to transform short-term capital gains to long-term capital gains for tax purposes.

Regular readers know that a substantial portion of the activities that banks conduct behind the veil of opacity provided by derivatives is to arbitrage some form of regulation (tax is a form of regulation).

The veil of opacity is important, because if the bank were required to disclose to all market participants the derivative and its terms, nobody would buy the derivative.

In this case, the primary purpose of the derivative was to arbitrage the tax code.

As described in the memo and by people with knowledge of the matter, the transaction worked as follows: Barclays bought a portfolio of stocks and other instruments that fund managers at Renaissance wanted to trade. The bank hired the fund managers to oversee the portfolio, paying them a nominal fee. 

Then Medallion bought an option with a term of two years, whose value was linked to the worth of the portfolio. Renaissance had full discretion to trade the securities in the portfolio. 

Medallion could claim it owned just one asset -- the option -- which it held for more than a year, allowing any gain to be treated as “long-term” when its investors reported the income on their personal tax returns. 

“The profits are just being transmuted, through the alchemy of derivatives, to a preferenced return,” said Urban Institute’s Rosenthal.

One of best indicators of genuine reform in financial sector shows no reform

In his Guardian banking blog, Joris Luyendijk interviews an equity sales director who explains how Wall Street profits from both valuation and pricing opacity when it buys or sells derivatives and why it is fighting so hard to retain opacity.

The equity sales director compares his product, which represent an investment in the real economy, with derivatives, which represent a zero-sum bet on the direction of, for example, interest rates.

Which brings me to complex derivatives. The culture of equity is so different from derivatives. We try to build relationships with clients who invest money in real companies, for the long term. Complex derivatives traders work with a far larger and diffuse pool of clients, who could decide at any point to switch from one product to the next.... 

With complex derivatives it's very much about here and now, as you can make money in a market that's going down as well as up. There's no direct relationship with the economic cycle. 

My clients choose to deal with me for the quality of advice, the execution of their trades and the value of our research. With complex derivatives it's mostly driven by price. 

Often complex derivatives are not traded on an open exchange but over the counter [OTC] – in other words, it's an agreement directly between bank and client. One reason is that OTC derivatives are usually custom-made for the client, so there's only of them in the world. 

To illustrate how transparency in equity works, suppose a client places an order to buy a particular stock at careful discretion which is trading at 25. My trader goes into the market and executes it for 25.12. At the end of the day my client sees on his information terminal that the day's average price was 25.10. Did he overpay? He calls me and I go over to our trader. If it's really the trader's fault we might take the loss and give the client a better price. Otherwise we could lose our reputation and he will go elsewhere. 

Now, with OTC derivatives, how does a client find out he was disadvantaged? There's no exchange. Traders and clients base prices for OTC derivatives on a number of 'Greeks' – parameters indicating levels of volatility and other derivative characteristics of the product. 

It all comes down to client's ability to understand these Greeks' their sophistication. There is a huge difference between genuinely sophisticated clients and those eager to be seen as professional who actually don't grasp [all of] it. 

I have heard OTC derivatives traders use the term 'rape and pillage'. That means selling a less sophisticated client a financial product carrying a high likelihood of blowing up and causing that client never to deal with you again. 

"Rape and pillage" was not confined to large investors or corporations.  Regular readers might recall that UK banks were involved in the mis-selling of interest rate derivatives to small companies and individuals.

A lot of regulation has come in to prevent this, but in some non-EU jurisdictions these can still be sold. Again, note the difference with equity. A client can lose money on my recommendations, but it is almost impossible to bring down the client. 

"You could argue that OTC derivatives are among the best indicators of the degree of genuine reform in the financial sector. 

If reform of OTC derivatives is one of the best indicators of genuine reform in the financial sector, what  does reform in this area show?

One reason the crisis of 2008 got so bad was that banks had these totally opaque derivatives on their books, so nobody knew who had what.

Nobody knew which banks were solvent and which were not.  So it is very clear that the reform that is needed is to bring transparency to bank derivatives books.

Since then there's been a fight to improve transparency but banks resist with all their means.  Transparency correlates inversely with profitability; it has always been like that. 

Given that transparency will reduce the profitability of the banks, the banks are fighting to retain opacity in the derivatives and about their exposure details (their books).

So have the banks been successful in retaining their profitability and fending off transparency in derivatives and their exposure details?

Yes.

Since OTC derivatives are one of the best indicators of genuine reform in the financial sector, the lack of transparency shows there has not been genuine reform in the financial sector.

Despite Lord Turner's claim, it was not impossible to spot Libor manipulation

Reuters reports that in his testimony before the Parliament Commission on Banking Standards, Lord Turner, the head of the UK's Financial Services Authority, asserted that it was impossible to have had a police force big enough to spot the manipulation of Libor.

This statement is false and underscores why bank regulators by themselves will never be up to the task of policing the financial system.

Had the banks been required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, there would have been a police force big enough and motivated enough to spot manipulation of Libor and other benchmark interest rates.

Even if Libor and the other benchmark interest rates had been compiled in an opaque manner, market participants could still have double checked what the interest rates against the actual transactions entered into by the banks.

A discrepancy between the benchmark interest rates and what was actually occurring would have been noticed.

Why would market participants have been looking to see if there was a discrepancy between the benchmark interest rates and the transactions the banks actually engaged in?

Because the market participants who had an exposure to Libor and the other benchmark interest rates had a financial incentive to do so.

Regular readers know that the global financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This framework provides a much bigger police force than just the financial regulators as every market participant has an incentive to look out for themselves.

One of the causes of our current ongoing financial crisis is the regulators' information monopoly when it comes to financial institution.  It was and still is only the financial regulators who have access to all the useful, relevant information for assessing the banks.

What the manipulation of the benchmark interest rates and the financial crisis have shown is that the financial regulators are not up to the task of replacing the market and all of its participants when it comes to policing the banks.

Since the beginning of the financial crisis, I have repeatedly said that the financial regulators should give up their information monopoly, require the banks to provide ultra transparency and then piggyback off of the market's ability to both analyze the banks and to enforce discipline on the banks.

There is a role for financial regulators.  It is just not as a replacement for the market.  It is as a second line of defense should market participants fall prey to some popular delusion.

Regulators could not have spotted the "lowballing" of Libor interest rates during the financial crisis even if they had looked, Britain's Financial Services Authority said.

But financial market participants could and more importantly would have if they had access to each bank's exposure details.

The watchdog's chairman, Adair Turner, told a parliamentary commission on banking standards on Wednesday it was much easier to see abuses in share trading by using computers.

Same computers could have spotted Libor manipulation.  What is required is that the computers have the actual transaction data.

Manipulation of the London interbank offered rate (Libor) during the 2008 crisis, for which three banks - Barclays BARC.L, Royal Bank of Scotland and UBS - have been fined so far was far harder to see, he said. 

"There was no information on the trader manipulation," Turner told the commission....

There was no information disclosed to the market that would allow it to discover that traders were manipulating the benchmark interest rates.

The regulators had and still have a monopoly on the information that would have shown that the rates were being manipulated.  It is only the regulators who have access to each bank's current global asset, liability and off-balance sheet exposure details.

The fact that the regulators were not up to the task of discovering the interest rate manipulation even after they had been told about it (see NY Fed and Tim Geithner), does not mean that the market would not have discovered it.

Neither the FSA, the CFTC - two of the regulators that have fined the three banks - or other regulators had ways to see the trader manipulation, Turner said. "We could not have got at it by intensive supervision. You just cannot have a police force big enough to spot all these problems."

When the banks are required to provide ultra transparency, there is a plenty big enough police force as every participant in the market has an incentive to police the banks.

While whistleblowing was one of the few ways to report illegal activity, Turner said trading room mentality was detached from the real economy as some traders see their job in front of a screen as being like playing a computer game, asking "Why shouldn't I cheat?".

With banks being required to provide ultra transparency, the answer to why shouldn't I cheat is because I will be caught! 

There is a reason that sunlight is the best disinfectant!

SEC's Jesse Litvak case shows the value of opacity to Wall Street

In a must read post, ZeroHedge looks at the SEC's case against Jesse Litvak and his conduct in selling mortgage-backed securities.  What ZeroHedge reveals is just how much money Wall Street makes from  opacity.  Specifically, opacity as it applies to both the securities and trading in the Over the Counter (OTC) market.

Regular readers know that since before the financial crisis even began, your humble blogger has been trying to bring transparency to the opaque structured finance market.

My focus has been on bringing 'valuation' transparency as oppose to 'price' transparency as price transparency without valuation transparency is worthless.

The reason that valuation transparency is critically important is that it is valuation transparency that makes it possible for an investor to go through the three step investment process:

1. Independently assess all the useful, relevant information to assess the risk and value the security.  This independent assessment can be done by the investor or an expert third party (think fund manager or an expert hired by the fund manager) hired by the investor.
2. Find out what price Wall Street will buy or sell the security at.
3. Make a decision to buy, hold or sell the security based on the difference between the price shown by Wall Street and the independent valuation.  If a decision is made to buy, limit the purchase to what the investor can afford to lose given the assessment of the risk of the security.

It is under valuation transparency that an investor is provided with access to all the useful, relevant information in an appropriate, timely manner so that the independent assessment of this information can take place.

Without valuation transparency, it is impossible to complete step one of the investment process.

If a buyer or seller of a security cannot complete step one of the investment process, they are reduced to gambling when they buy, hold or sell a security.  Specifically, the buyer or seller is gambling that the price shown by Wall Street reflects the fair value of the investment.

What the Jesse Litvak case shows is how Wall Street uses the simple fact that the buyer or seller is gambling and doesn't know what the fair value of the investment is to profit.  This profit goes away if there is valuation transparency as the buyer or seller knows what the fair value of the investment is and won't transact if the price doesn't reflect this value.

For many years one of the best jobs on Wall Street in terms of a mix of job safety and compensation, was to be a fixed income trader-cum-salesman working for a major bank with a deep balance sheet, which could hold illiquid securities on its prop account, to dispose of as the "flow" (or clients) required, and on unsupervised and unregulated terms that were simply a verbal arrangement between the bank trader and the end client, usually a counterparty trader working for a major institutional buyside shop, including mutual or hedge funds. 

Since for the most part, the buyside traders operated with other people's money, they were largely indiscriminate on the fine pricing nuances of the acquisition (or disposition) of the securities at hand, and while to the "other people's money" under management whether a given bond was bought for 55 or 55.75, or a given MBS was sold for 72-6 or 72-16 meant little (after all the trade was driven by a big picture view that the security would go up or down much more and certainly enough to cover the bid/ask spread, resulting in much larger profits upon unwind), the transaction price had a huge impact for the bank traders-cum-salesmen arranging said deals. 

Because when one is selling a $40 million MBS block, a 1 point price swing equals a difference of $400,000. Make 15 such deals per year, and one's $1,000,000 bonus (assuming a ~15% cut on the profits) is in the bag....

Bottom line:  the lack of valuation transparency allows Wall Street to extract a significant amount of profits as the buy-side is only gambling when it buys opaque structured finance securities ('trade was driven by the big picture view that the security would go up or down ... resulting in much larger profits upon unwind').

When there is valuation transparency, buy-side firms have a fiduciary duty to use this information.  This immediately ends Wall Street's ability to skim the bid/ask spread.

In short: the highly lucrative and extremely profitable bid/ask skimming that every bond trader engaged in for years has been impossible in equities for the simple reason that the bid/ask spread on most equity-related securities is minute and the market is far deeper and (at least used to be) far more liquid.

And the reason that the equity markets are far more liquid has to do with the ready availability of valuation transparency for most firms ('black box' banks are the exception).

It also explains why 4 years after the Great Financial Crisis, there is still no centralized, computerized trading portal for OTC trades, including corps, CDS, loans, etc. 

Doing so would mean that the banks would give up billions in additional commissions that they could charge if all such trades were facilitiated by the kind of sales coverage middlemen described above. 

Because while a salesman was incentivized to peel as much as they could of a given trade, they would at best pocket some 10-15% of the total spread. The rest went to the bank, and thus to management in the form a massive bonuses: comp at banks is not 40% of revenue for nothing, with some money left over for "retained earnings."

Please note, ZeroHedge has laid out why Wall Street is fighting to protect opacity.

But there is no reason to worry about Wall Street's profitability as it has shown itself to being equally adept at making money where there is valuation transparency (see the end of fixed commissions on stock trades for example).

With opacity, Wall Street makes a lot of money on each transaction, but there are very few transactions.  With valuation transparency, Wall Street makes a little money on each transaction, but the volume of trades is significantly higher.  As a result, Wall Street firms actually ends up making more money when there is valuation transparency.  They just have to work harder to make their money.

Banks convicted of fraud in Italian derivatives case

The Wall Street Journal reports that four banks including Deutsche Bank, JP Morgan and UBS were found guilty of fraud in selling derivative contracts to the city of Milan.

This case is interesting because it highlights the difference between a customer and a counter-party.

• A bank customer relies on the bank to make recommendations that are in the customer's best interests.

• A counter-party relies on the bank to disclose all the useful, relevant information and knows that it is responsible for assessing this information as it is entering into a trade with the bank where the counter-party is responsible for all gains and losses.

Please note, that a bank customer can be large enough to be considered a sophisticated investor, but might not understand that it is being treated as a counter-party.

An Italian judge convicted four big banks of fraud in the sale of derivatives contracts to the city of Milan in the mid 2000s, a criminal-case ruling that legal experts said could set a precedent for related civil cases across the country. 

Judge Oscar Magi fined UBS AG, UBSN.VX -1.11% Deutsche Bank AG,DBK.XE -0.50% J.P. Morgan Chase JPM -0.78% & Co. and Depfa Bank PLC, part of Germany's Hypo Real Estate Holding, €1 million ($1.32 million) each and gave nine of their employees suspended jail sentences of up to eight months. Mr. Magi also ordered that a combined €90 million be seized from the banks. 

During the trial, prosecutor Alfredo Robledo had argued that the banks defrauded Milan by tricking officials into believing the city would save money on its debt repayments by entering interest-rate swaps that affected payments on €1.68 billion of bonds it had sold in 2005. Mr. Robledo also said the city was defrauded because the banks didn't disclose that they made an aggregate total of around €90 million in profits from the deals. 

The four banks denied the charges during the trial. On Wednesday, the banks reiterated that neither they nor their employees had engaged in wrongdoing and said they would appeal their verdict. Italian law allows up to two appeals in criminal trials; during the appeals process, the financial penalties are likely to be suspended. 

"In JPMorgan's view, the evidence at trial demonstrated conclusively that the individuals behaved entirely honestly and appropriately throughout and that the transactions complied with Italian and English law," the bank said in a statement. The other banks issued similar statements....

In Italy, the ruling could prompt prosecutors in other cities to seek to press criminal charges against banks that entered into derivatives contracts in other municipalities. For much of the 2000s, a number of Italian cities entered into swaps linked to interest rates, seeking to hedge risk they had taken on by borrowing at a time when Italian and international banks were granting credit easily. 

Municipalities often got locked into deals—and future payments—that they scarcely understood or expected. In 2008, the government banned the use of derivatives by Italian municipalities. 

Municipalities have taken action in civil court against banks, alleging that they didn't properly disclose the risks of derivatives deals. In March, the four banks in Wednesday's verdict had settled with the city of Milan, agreeing to unwind the interest-rate swaps ahead of their maturity in 2032. 

"The sentence poses for the first time the issue of the need of transparency when dealing with public entities," Mr. Robledo said after the verdict was delivered. "There are tens of local authorities in this situation and they have never been assisted by adequate professional advice," 

Tommaso Iaquinta, a Milan-based lawyer who has worked on a number of cases involving local authorities, but not the Milan one, said the decision sets "a very dangerous precedent for the banking world." The decision could lead to more criminal cases, as well as additional civil action, Mr. Iaquinta said.

WSJ's Francesco Guerrera calls for Simpler Remedies for Banks

The Wall Street Journal's Francesco Guerrera became the latest to call for ending regulatory complexity and instead implementing simpler solutions that improve the safety and soundness of the financial system.

The reason for ending the race towards ever greater levels of regulatory complexity is the current financial crisis showed that the combination of complex rules/regulations and regulatory oversight fails as a substitute for transparency and market discipline.

Since transparency and market discipline are superior, the focus should be on bringing transparency to all the opaque corners of the financial system so that market discipline can works its magic.

For example, by bringing transparency to banks, we get a culture change as sunlight is the best disinfectant for bad banker behavior.

Or, as another senior watchdog told me, "We have enabled banks to get bigger in the crisis but we haven't devised a way not to bail them out in case of failure." If the statement sounds scary, that is because it is. 

Part of the reason for these shortcomings is that regulators and banks are drowning in complexity. As lenders have become more and more complicated, the authorities have responded in kind.

A response that protects the regulators' information monopoly and market participants' dependence on the regulators.

Remember, if banks have to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants can independently assess the risk of each bank themselves.

This dramatically decreases the influence of the regulators in the financial system.

The seminal Glass-Steagall Act of 1933, which forced banks to split their securities businesses from consumer units, was 37 pages long. Dodd-Frank is more than 20 times that, with some 30,000 pages of associated regulations expected on top. 

"Dodd-Frank makes Glass-Steagall look like throat-clearing," quipped Andrew Haldane, a top Bank of England regulator, at the Federal Reserve's Jackson Hole symposium in August. 

The arms race of complexity between banks and their guardians is having the same result as its Cold War equivalent: stalemate.

Stalemate that benefits the banks.  The banks continue to extract money from the real economy that they would not otherwise receive if there were transparency.

Regulators are struggling to catch up with banks' increasingly arcane businesses, while lenders and investors bemoan the paralysis created by the proliferation of rules. 

If the final goal is to make banks smaller and less risky, one solution would be for regulators to take a step back, limiting themselves to rules that are broad and easy to understand, as Glass-Steagall was. Mr. Haldane, among others, has made a strong case for simplicity.

Banks have increasingly arcane businesses as they are focusing on the opaque areas of the financial system where they can engage in bad behavior behind the veil of opacity.

Both the behavior and these businesses would effectively go away if there were transparency.

But broad-brush regulation can succeed only if two conditions exist. 

First, banks would have to shed unprofitable businesses much faster than they have.
And second, regulators would need to rely less on the rule book and more on their knowledge of individual institutions. 

Rules that are constantly fine-tuned in a vain attempt to keep up with the industry would be replaced by more general rules policed by watchdogs with their ears to the ground.

Knowledge of individual institutions that regulators can obtain by harnessing the market's ability to assess each institution.

UK financial chicanery creates unenviable reputation

An editorial by the Guardian concludes that the UK has earned its unenviable reputation because it has permitted financial chicanery and that something needs to be done to restore its reputation.

Regular readers know that the way for the UK and the City of London to restore its reputation is by ending its love affair with opacity and setting itself up as the global standard for transparency.

Opacity encourages bad behavior as it hides the activities of the participants.  When opacity is combined with 'light-touch' regulation, the result is a hot bed for financial chicanery and a bad reputation.

Transparency encourages good behavior as sunshine is the best disinfectant.  Transparency is the basis for the best reputation as it permits the strictest form of regulation:  market discipline.

Your humble blogger has advocated bringing transparency to all the opaque corners of the financial system.

For banks, this means providing ultra transparency and disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

For structured finance securities, this means providing observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the beginning of the next business day.

Recently, the BoE Financial Policy Committee highlighted why banks should provide ultra transparency.  It wants banks to clean up their on and off-balance sheet exposures and to provide the data so that market participants can independently confirm that all the losses have been realized.

Britain is at the extremes of the business of financial chicanery.

This is a conclusion growing in acceptance among economists and policymakers. In 2007, a working paper from the International Monetary Fund drew up a list of offshore financial centres that included the Caymans, Switzerland and the UK. The IMF's definition of an offshore centre was "a … jurisdiction that provides financial services to non-residents on a scale that is incommensurate with the size and the financing of its domestic economy" – and thus acknowledged London's position as one of the most advanced places in the world for ingenious tax planning and financial services. 

The other side of this coin is a relaxed attitude to regulation and risk, from officials and some businesses. Think of the financial scandals that have emerged in just the past few months: the Libor-fixing affair; JP Morgan's $9bn (£5.6bn) loss in derivatives trading; the downfall of the rogue trader Kweku Adoboli. These debacles all have one thing in common: they happened in London's financial centre. Other cases come up elsewhere, of course – think Jérôme Kerviel in Paris or Bernie Madoff's Ponzi scheme in Manhattan – but the Square Mile is too often the location for the greatest fiascos. 

As US congresswoman Carolyn Maloney observed this summer: "It seems to be that every big trading disaster happens in London." 

In other words, the offshore, light-touch regime that many have argued gives London a competitive edge is now earning it the kind of black reputation that might make it unviable. Allowing financiers too much freedom may now be doing them more harm than good. The same surely goes for our offshore industry....

And the secretive behaviour of some organisations and individuals risks doing immense harm to the reputations of others – and to the public supervisors. 

It is surely in the interest of advisers and participants and regulators to have a thorough clean-up of the system. Yet the offshore industry is marked by the same combination of sleepy watchdogs who have rings run around them by those gaming the system.... 

It is no good officials and advisers arguing that all such behaviour is perfectly legal; that merely implies the law needs changing.

Bank scandal settlements: another opportunity to behave badly towards customers

In her Guardian column, Jill Treanor looks at the handling of claims for mis-sold payment insurance.  What she finds is scandalous by itself.

On paper, the handling of claims seems sensible.  Customers who paid for payment insurance file a claim showing why the insurance was unnecessary in their case (for example, the customer had a job with an employer that provided sick pay).  The bank confirms this and sends the customer a check.

In reality, this handling of the claim is entirely for the banks' benefit.

First, customers have to take the initiative to file a claim.  The banks know that even with companies that will process the claim for the customer a substantial portion of customers will never file a claim.

If the customer doesn't file a claim, the bank gets away with its mis-selling.

Two, once the claim is made, the banks can reject the claim if it cannot confirm the reason insurance was unnecessary.  The banks know that there is some complexity in confirming or denying the claim and that errors will most likely result in denial of the claim.

If the customer's claim is denied, the banks profits from mis-selling are reduced by cost of processing the denied claim.

Third, once the claims has been denied, the customer has to take the initiative to refile it through an ombudsman.  The ombudsman has found that 25% of these claims should not have been denied and should have been paid instead.

If the customer doesn't refile their claim through the ombudsman, the bank gets away with its mis-selling.

The reason I went through the claim handling in detail is to show how banks continue to engage in predatory behavior even when it comes to settling up for conduct that they engaged in that was detrimental to their customers.

The banks' handling of mis-sold payment insurance is not unique.  Banks set up a similar process for handling claims under the representation and warranties section of residential mortgage-backed securities.

The ombudsman service, led by Natalie Ceeney, has little sympathy for the banks. She told MPs last month: "Banks not investigating cases properly played into PPI firms' hands. In a quarter of cases where banks said customers didn't have PPI, they did – the banks were not doing their job properly."....

Many people have never heard of the financial ombudsman service until they start a PPI complaint, yet the service can be invaluable. The ombudsman is now receiving up to 400 PPI complaints an hour, and upholding seven in 10 cases in the consumer's favour, with compensation averaging £2,750.  

In a quarter of cases where banks tell a consumer no PPI policy ever existed, the ombudsman later finds the bank was wrong. 

"We often find rudimentary searches have not taken place. For example, postcode searches, previous addresses, maiden names and checking both people on a joint policy," said a spokesman for the ombudsman. 

"Alternatively, we've noticed a reliance on some banks to dismiss complaints on the basis of what's showing on the computer, rather than actively searching for the documents that might establish what actually happened with each complaint."

What the ombudsman service shows is just how rigged the process of settling mis-sold payment protect is in the banks' favor.

It would not be surprising if the same statistics did not occur for mortgages that the banks refused to buy back under the representation and warranties claims by investors or guarantors of mortgage-backed securities.

Current examples of bankers behaving badly behind veil of opacity

The Guardian published an article that lists the current examples of bad bank behavior.

Linking these examples is the simple fact that in each one bankers used opacity to take advantage of customers and other market participants.

Manipulating energy pricesThreat of a £290m fine from the Federal Energy Regulatory Commission for allegedly attempting to manipulate the price of electricity in California between 2006 and 2008. Barclays and four former employees – Daniel Brin, Scott Connelly, Karen Levine and Ryan Smith – were said to be buying or selling enough electricity to make the bank's positions in the swaps markets more profitable through moving the price up and down on the Intercontinental Exchange (ICE). ...

Note: if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, this type of behavior would be immediately exposed.

Manipulating interest ratesBarclays was the first major bank to be fined for manipulating the benchmark Libor rate – initially to boost profits and later to protect its financial position – but it is unlikely to the be last. The Financial Services Authority has admitted it is looking at seven other financial firms and as many as 16 banks. Other firms are co-operating with regulators around the world. The bank has been named in class action lawsuits in the US and the Serious Fraud Office is investigating.

Note: ultra transparency would both reopen the interbank lending market and allow market participants to calculate Libor independently.  

Mis-selling interest rate swapsBarclays has set aside £450m to cover the cost of the latest mis-selling scandal. Small businesses, including fish and chip shops, were sold sophisticated interest rate swaps as a way to protect them against interest rate rises, often as a condition attached to a loan. The rate rises did not happen. Barclays is part of an industry-wide agreement to compensate customers. 

Libor/interest rate swap mis-sellingA high court judge this week concluded that Bob Diamond, the chief executive who quit over Libor, and other Barclays bankers should appear in court to explain what they knew about the manipulation of the key rate in a case brought by Guardian Care Homes about mis-selling of rate swaps. 

Mis-selling payment protection insuranceBarclays has just set aside a further £700m to cover the cost of PPI claims – taking its total bill to £2bn. Lloyds, which could make another provision when it reports on Thursday, has set aside £4.3bn. Royal Bank of Scotland's bill stands at £1.3bn, HSBC's at £1.1bn and Santander's at £500m. Customers were sold PPI alongside loans to cover sickness or unemployment but the insurance was not needed and did not pay out. 

Five years into financial crisis trust in banks hits new low

The Guardian reports that nearly three quarters of the individuals in a UK survey don't think that banks have changed their behavior for the better since the start of the financial crisis.

Regular readers are not surprised by this finding because UK policymakers and financial regulators, like their counterparts in the US and EU, chose to protect banker bonuses, no matter how they were 'earned', over protecting society.

Policymakers and financial regulators did this by adopting the Japanese model for handling a bank solvency led financial crisis and all of its related policies (think regulatory forbearance and 'zombie' loans, zero interest rate policies and quantitative easing, and lack of prosecution for financial crimes).

Given how the policymakers and financial regulators have bent over for the bankers, it would be surprising if the bankers had changed their behavior for the better.

Five years on from what is considered the start of the credit crunch –dubbed "the day the world changed" by the former boss of Northern Rock – the public are more disillusioned with the banking sector than ever, a consumer group has claimed. 

Nearly three-quarters – 71% – of people surveyed by Which? do not think banks have learnt their lesson from the financial crisis, up from 61% in September last year. 

Consumers have low expectations of a parliamentary inquiry into banking ethics, with only 26% confident that it will lead to positive change among the UK's lenders. ...

Which? chief executive, Peter Vicary-Smith, said: "Five years on from the beginning of the financial crisis, public confidence in the banking industry is at an all-time low, with a series of scandals exposing mismanagement and corruption at the very heart of the banking system that have cost UK consumers dear."

And yet the policymakers and financial regulators continue to protect the bankers.

Elizabeth Warren: Libor fraud shows Wall Street's rotten core

In her Washington Post column, Elizabeth Warren looks at the financial system and asks does Wall Street have so many friends in Washington and London that it cannot be fixed.

Everyone knows that all of the problems that have emerged in the financial system over the last few years have come from the opaque, corners of the financial system (structured finance securities, banks and now, Libor).

Opaque areas that exists because as Yves Smith at NakedCapitalism says, 'no one on Wall Street was ever compensated for creating low margin, transparent products'.  Opacity is the key to Wall Street current level of profitability and hence bonuses.

Opacity lets Wall Street engage in bad behavior in pursuit of their bonuses (think Libor manipulation and treating clients who think there is a fiduciary relationships as counter-parties for zero-sum trades).

Regular readers know that your humble blogger refers to Wall Street's friends in Washington and London as Wall Street's Opacity Protection Team. It is not just the banks, but the regulators and policymakers who are complicit in allowing Wall Street to create and maintain large opaque areas in the financial system.


Everyone knows that transparency and hence sunshine is the best disinfectant.  However, sunshine would make it harder for Wall Street to make money as everyone would have access to all the useful, relevant information in an appropriate, timely manner for making a fully informed investment decision.


Ms. Warren's question is really does Wall Street have so many friends in Washington and London that will help it protect the profits it makes from opacity that transparency, trust and integrity cannot be restored in the financial system?

The Libor scandal is more than just the latest financial deception to come to light. It exposes a fraud that runs to the heart of our financial system. 

The London interbank offered rate is a benchmark for a range of interest rates, and the misdeeds making headlines have to do with how those rates are set. If insiders can manipulate the basic measurement of a loan — the interest rate — there is rot at the core of the financial system. 

The British financial giant Barclays has admitted to manipulating the rate from 2005 to at least 2009. When the bank made a bet on the direction in which interest rates would turn, the Barclays employees who submit data for calculating interest rates would fake their numbers to help Barclays traders win the bet. Day after day, year after year, bet after bet, Barclays made money by fixing bets for its own traders.... 

It is also clear that many of those who didn’t have a fixer — including consumers, community banks and credit unions — lost money. 

Barclays padded its bottom line by taking money from everyone else. It won when it shouldn’t have won — and others lost when they shouldn’t have lost. 

The amount of money involved is staggering. On any given day, $800 trillion worth of credit-related transactions are linked to Libor rates. 

In most markets, consumers could simply take their business elsewhere once they learned that the scales were rigged. But interest rates are different. Everyone who borrows money on a mortgage, credit card, student loan, car loan or small-business loan — basically, everyone — is affected by a crooked market on Libor....  

Even those who didn’t borrow but saved for retirement or their children’s future got hit with interest rates that had been faked. 

It gets worse. During the financial crisis, Barclays and other banks also appear to have consistently manipulated Libor to show lower-than-real borrowing rates to convince the world — and their regulators — that the bank was stronger than it really was. In other words, they rigged the interest-rate reports so that no one would know exactly how much trouble they were in. 

With a rotten financial system once again laid bare to the world, the only question remaining is whether Wall Street has so many friends in Washington that meaningful reform is impossible....

Going forward, the rules would be changed so that Libor is calculated on actual borrowing costs, not estimated or claimed costs....

An idea your humble blogger presented to readers as part of requiring banks to provide ultra transparency.  Under ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This allows Libor to be calculated off of actual trades.

This allows market participants to assess the riskiness of each bank on an ongoing basis and adjust the amount and price of their exposures to each bank based on this assessment.  It is this ability to make ongoing risk assessments that unfreezes the interbank lending market and keeps it from freezing in the future.

But the heart of accountability lies deeper. It rests on acknowledging that we cannot trust Wall Street to regulate itself — not in New York, London or anywhere else. The club is corrupt.

When Mitt Romney says he will move to repeal all of the new financial regulations, he supports a corrupt system. When members of Congress grill regulators for being too tough on Wall Street and slash the budgets of the regulators charged with overseeing Wall Street, they prop up a corrupt system. 

Financial services are critical to the economy. That’s why everyone — every family and every business — has a stake in an honest system. The fantasy that reducing oversight of the biggest banks will make us safer is just that — a dangerous fantasy. The Libor fraud exposes rot at the core. Now, who will stand up to fix it?

Who will stand up for bringing transparency to all the opaque corners of the financial system.

BarCap trader explains how Barclays used derivatives to take advantage of clients

The Sunday Telegraph ran a must read article on how Wall Street, Barclays in particular, used its informational advantage and expertise in derivatives to benefit at their clients' expense.

A former Barclays Capital trader, who asked to remain anonymous, speaks about his job and the relentless pressure to achieve higher margins....

The problem with BarCap was that we were making so much money on FX products [hedges] we were constantly looking for structures to fling to clients. We were looking for higher margins. That’s where swaps came in. 

In 2008, we see crude go up and up and up. The hedges that we created left companies hugely exposed. There was really no insurance or hedge in there at all. Crude was over $110 and these clients found they had zero protection. 

With the hedges we created, the sales guys were making much more money. The margins were incredible. You were making $50,000 as opposed to $5,000 on the same quarter barrel. 

In 2008 we got a big lecture about leaving money on the table. The noise from the higher-ups was that we needed to be doing more – much more. 

BarCap was the Wild Wild West – that’s what we called it, that’s how it was. That year especially. 

Commodities was the big thing to be in. Barclays was this old great institution, but it had turned into a bucket shop. We hired a bunch of quants [quantitative traders] to just dream up these products. Layers of complexity in each hedging product. Each layer created a new angle to take a turn.

Regular readers know that complexity creates opacity and opacity was the foundation of profitability on Wall Street.

Suddenly at BarCap we were handed all the corporate clients to sell to. We all talked about it like it was lambs to the slaughter.... 

That's because corporate clients perceived the bank to be looking out for their interests and not as an adversary.

Before that, we were trading with people like BHP who knew everything about the market, the prices and the basis on which we set our prices. They knew all the reference points better than we did.

Suddenly our clients are people who know nothing about the business, nothing about trading, nothing about the products they should or shouldn’t buy.... 

People like BHP had transparency into the market and therefore couldn't be fooled by Wall Street.  The profit to be made off of people like BHP was much less because they had access to all the useful, relevant information in an appropriate, timely manner.

The BarCap mantra was that if at all you had a competitive advantage you ran all the way with it.

Please re-read the highlighted text as it nicely summarizes the culture on Wall Street.  Notice the emphasis on maximizing any competitive advantage and imagine the culture that surrounds this emphasis.

It is this type of culture that deliberately creates opaque products to take advantage of clients who see banks as business partners and not as counter-parties trying to maximize their profits at the client's expense.

It is this type of culture that deliberately creates opaque sub-prime mortgage backed securities to take advantage of investors who do not have access to current information and therefore don't know what they are buying.

It is this type of culture that sees the profitability in breaking the law to transfer cash for criminals and rogue states and doesn't think twice about do so.

It is this type of culture that manipulates Libor interest rates to take advantage of market participants on the other side of derivative contracts the bank has sold.

It is this type of culture that permeates all of the banks and is why each scandal is not the result of a few rogue traders, but is the personal responsibility of every employee of the banks.

Like Libor interest rates, were oil prices manipulated?

The Telegraph reported on how the same manipulation in self-reported prices that took place with Libor interest rates may have also taken place with oil prices.

Concerns are growing about the reliability of oil prices, after a report for the G20 found the market is wide open to “manipulation or distortion”. 

Traders from banks, oil companies or hedge funds have an “incentive” to distort the market and are likely to try to report false prices, it said..... 

Petrol retailers use oil price “benchmarks” to decide how much to pay for future supplies. 

The rate is calculated by data companies based on submissions from firms which trade oil on a daily basis – such as banks, hedge funds and energy companies. 

However, like Libor – the interest rate measure that Barclays was earlier this month found to have rigged – the market is unregulated and relies on the honesty of the firms to submit accurate data about all their trades.

Imagine that, an opaque pricing measure that relies on honesty of firms with a vested interest in acting as an oligopoly and manipulating the market.

This is another classic example of why benchmarks need to be based on actual trades.

This is one of the major concerns raised in the G20 report, published last month by the International Organisation of Securities Commissions (IOSCO). 

In the study for global finance ministers, including George Osborne, the regulator warns that traders have opportunities to influence oil prices for their own profit. 

It points out that the whole market is “voluntary”, meaning banks and energy companies can choose which trades to make public. 

IOSCO says this “creates opportunity for a trader to submit a partial picture in order to influence the [price] to the trader’s advantage”....

Is there a regulator who is responsible for this market?

The price reporting agencies, Platts and Argus, argue they employ journalists to weed out false data submitted by oil traders. 

IOSCO says reporters are “well-aware that traders have an incentive to push the market one way or another and do not generally believe everything they are told”. 

However it points out this system is heavily reliant on the “experience and training” of journalists to make a judgement about what the oil price should be....

Why rely on judgement when historical facts could be used instead?

Lord Oakeshott, the former Liberal Democrat Treasury spokesman, said the oil price system ought to be examined in the wake of the Libor scandal. 

“Clearly it’s right we must shine a light on how other crucial benchmark prices are reported, especially when they affect the cost of living for millions of motorists,” he said....

Shining the bright light of transparency into the opaque corners of the financial system.

Simon Lewis, chief executive of the Global Financial Markets Association, has raised concerns about the “opaque” way the oil price is worked out. 

In a letter to IOSCO, he said price reporting agencies may not be as impartial as they claim, because they take fees from banks and oil companies to provide information.... 

Platts added that there are four main differences between oil prices and Libor – the quality of its data, its independence, competition between reporting agencies and the transparency of its methodology.

And one similarity, neither oil prices or Libor is based off of actual trade data that is made readily available to all market participants.

Bank of England's Paul Tucker discovers opaque markets are not to be trusted

In his testimony before the Treasury Select Committee, Bank of England deputy governor Paul Tucker revealed that he was unaware that opaque markets are not to be trusted.

[Mr. Tucker] said, he had not been aware until recently that Barclays was a "cess pit" of rate manipulation. 

"What has been revealed has come as a deep shock, a deep shock," he added. 

"We thought it was a malfunctioning market not a dishonest market. 

With this explanation, Mr. Tucker explains why the economic profession did not see the financial crisis coming.  The issue of transparency/opacity was nowhere to be seen.

It took Barclays paying almost $500 million in fines to bring the attention of the economic profession to the simple fact that by design the calculation of the Libor interest rate is opaque.

It took Barclays confessing to manipulating the Libor interest rate to show that opacity hides bad behavior.

Why do I keep saying the entire economic profession missed seeing the financial crisis when there were  a couple of economists at the BIS who warned about the problems with subprime mortgage securities?

Because rather than adopt their warning, the economics profession dismissed it (I am missing the link to Bill White's speech in which he discusses being dismissed).  What was clear from this dismissal was that their prediction was not based on widely accepted economic theory, but rather their analysis of the situation.  If it had been driven by economic theory, it would have been far harder to dismiss by the economics profession.

As a result, it is highly unlikely that in the future they could repeat this success or that they necessarily had any insight into what steps needed to be taken to end the financial crisis.  The latter has been confirmed by what they have written and said since the crisis began as only recently has the BIS begun to support the idea that banks have to recognize the losses currently hidden on their balance sheets.

By way of comparison, I too also predicted the financial crisis.

Regular readers know that the prediction was based on the FDR Framework.  Specifically, that the failure of financial regulators to ensure transparency provided bankers with the opportunity to engage in bad behavior behind the cloak of opacity.

Please note, the FDR Framework happens to be based at the very heart of economic theory.  Specifically, it is based on the one necessary condition for the invisible hand to operate properly.

The necessary condition is that there is transparency so the buyers knows what they are buying.  This means that the buyer has to have access to all useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.  

I say it is the one necessary condition because everything else is a market inefficiency.  Included in inefficiencies for example is the seller is a monopolist.

Unlike the BIS prediction, my prediction had very explicit steps that need to be taken to fix the financial system and avoid future crises.

For example, due to the Nobel prize winning work of Joseph Stiglitz, we know that opaque markets are not to be trusted.  As he pointed out, opacity hides information asymmetry and the party with better information has an incentive to take advantage of the party with worse information.

Once the party with worse information realizes they have been taken advantage of, they exit the market until there is transparency that eliminates the information asymmetry.

The FDR Framework captures this by making it the responsibility of the government to ensure that market participants always have transparency.

Now that the Bank of England has found that markets like Libor and structured finance are not malfunctioning, but dishonest, it is time we take the first step and address the underlying opacity in the market.

I look forward to hearing from the Bank of England and advising them on how to remove opacity from every corner of the UK financial system.

MF Global bond offerings make case for requiring ultra transparency

In his Bloomberg column, William Cohan looks at the reasons that investors in MF Global bonds felt duped.

Had MF Global been required to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, each of the ways that investors might have been duped would have gone away.

On July 28 and again on Aug. 3, MF Global raised $325 million by selling bonds -- the first a 3.375 percent convertible-note offering, due 2018; the other a 6.25 percent senior note offering, due 2016.... 

Not surprisingly, in addition to all the other lawsuits that MF Global executives and board of directors are facing, one brought by the buyers of these notes is wending its way through federal court in the Southern District of New York. 

The plaintiffs make a compelling argument that they were duped by the public statements of Jon Corzine, MF Global’s former chief executive officer, and the company’s Securities and Exchange Commission filings.

Had their been ultra transparency, the investors would not have had to rely on MF Global's representations.  They would have had the information they needed to verify the facts for themselves.

The class-action complaint claims that MF Global’s collapse was caused by management’s “wholesale disregard for its purported risk management and internal controls as MF Global sought to transform itself from broker-dealer to a full service investment bank at all costs.”... 

the plaintiffs cite the statements MF Global made in its 2011 Form 10-K about its abundant liquidity as evidence that the company was intentionally misleading investors. 

“Our policy requires us to have sufficient liquidity to satisfy all of our expected cash needs for at least one year without access to the capital markets,” reads the form. “To manage our liquidity risk, we have established a liquidity policy designed to ensure that we maintain access to sufficient, readily available liquid assets and committed liquidity facilities.” 

The plaintiffs argue these statements were false. “MF Global was suffering from severe liquidity pressures” -- as quickly became evident -- “based on its exposure to the European debt crisis through its enormous holdings of European sovereign debt,” according to the complaint. “MF Global was materially undercapitalized.”

With ultra transparency, it would have been easy for the investors to see if MF Global was experiencing severe liquidity pressures.

Further, the plaintiffs claim, whereas the offering documents for the bonds claimed that the use of proceeds would be partly for “general corporate purposes” -- a typical catch- all -- MF Global management knew that large chunks of the $650 million were “desperately needed to provide required liquidity and working capital given the then-deterioration in value of MF Global’s $6.4 billion holdings of European sovereign debt.”...

Again, with ultra transparency, investors could have determined with the market value of MF Global's $6.4 billion holdings of European sovereign debt was and seen that most of the proceeds would be used to plug the hole between the cost of these securities and the then current market value.

And few tears should be shed for sophisticated investors who miscalculate the risks of owning securities in companies that are highly leveraged and have new management intent on changing business plans. (By last summer, it was certainly no secret that Corzine intended to change the way MF Global conducted its business by making big bets with other people’s money. He said as much publicly on several occasions.)

It is one thing for investors to miscalculate risk when they have access to all the useful, relevant information in an appropriate, timely manner under ultra transparency and quite another when the true condition of the firm is hidden by opaque reporting practices.

Still, the level of deception by MF Global’s executives and board members demands that they be held personally accountable for the losses suffered by these bondholders -- just as they should be held personally liable for the losses suffered by MF’s customers. 

It seems to me, demanding this level of accountability -- which, of course, their lawyers will say is unjustified -- is the only way Wall Street executives will begin to take seriously their fiduciary duties to their customers, counterparties and creditors. 

At the moment, though, that is just a columnist’s fantasy. No MF Global executives have been held accountable for their actions, more than six months after the firm’s collapse and billions of dollars of other people’s money have been lost. 

Come to think of it, no one else on Wall Street has been held accountable for blowing up our economy, either. How can this still be the case?

Ultra transparency brings accountability to Wall Street.  With this information, market participants are able to exert discipline on Wall Street.  Particularly when their is a gap between what they represent as the condition of their firm and what is the actual condition.