Disruptive Change Caused by Credit Crisis akin to War

Two Speed World, by Gerald Ashley and Terry Lloyd. My friends and ex-Dow Jones colleagues have written a fantastic book about change, how fast it happens (or doesn't) and its impact on the world.
We live in a bewildering world of change, which splits naturally into steady progress punctuated by sudden disruptions - the two speed world.  Disruptive change occurs at high speed, according to the new book Two Speed World, while incremental change happens more slowly.
Two years ago, a world that was mainlining credit like cocaine was stunned when its habit was abruptly curtailed. A few economists and bankers had been predicting that the credit binge could not last, that it was dangerous, that credit derivatives were out of control - but no one was listening. So when the credit crisis exploded it set the world on its ear and forced change; far-reaching, disruptive change with concomitant, painful withdrawal symptoms.
Incremental change, or life in the comfort zone, is a "dull advance over a long period of time that can add up to a great deal of progress," according to Gerald Ashley, co-author of Two Speed World.  Disruptive change comes from exceptional events such as wars, new inventions or financial markets meltdowns.
 Ashley noted that disruptive change is not to be considered as an extreme example of incremental change. "Many decision makers tend to see most issues in incremental terms and on occasion, for example a financial crisis, they fail to understand that it is disruptive change underway that demands different analyses and approaches to those that they employ in normal times."
Disruptive change is the most feared and the least understood type of change and "may receive more attention than their importance warrants relative to the incremental changes of everyday life," said Ashley.
The financial crisis, given its severity and danger to the world economy, probably deserved the attention which has led to draconian changes in regulation and processes in many countries. Though not always welcomed, new regulations are necessary to rebuild the health of financial markets and to prevent another such disruptive change. 
"Disruptive change should be treated with respect, not feared, because it is disruptive change that drives progress," said Ashley, who once worked for Baring Brothers in London and Hong Kong and the Bank of International Settlements in Basel, Switzerland.
Incremental change arises from routine, doing what you have done on many occasions before. Many people may strive for more excitement and variety in their lives but in practice most of their lives and experiences tend to be within a narrow compass, said the book. In the case of financial markets, too many firms relied on mathematical models that used historical data and scenarios that were based upon short windows of time and the incremental changes that took place therein.
"Mathematical models were based on economic events in a very narrow window of time, as short as ten years. Bankers did not incorporate cross-correlations where the effect of adverse events in, say, the mortgage market, might trigger a move in others," said Ashley.
Most people live from day to day in a world of incremental change and do not expect to be much affected by disruptive changes. The financial crisis and resultant global recession proved that disruptive change can be right around the corner. "Every person and business should regularly review their situation and not assume that the future will continue as a simple extension of the present state. Even disruptions that eventually are a benefit to all, produce some short-term pain."
The book explores the development of the classical techniques for handling change that were developed in the second half of the twentieth century.  Ashley and co-author Terry Lloyd worked together in the 1990s in the financial information industry, but came from different backgrounds. Llloyd, with an engineering and financial software background, has worked for Rolls Royce Aero Engines and Digital Equipment Corporation (DEC) among others. Ashley's background was international finance.  The combination of technology and wholesale banking expertise gives the co-authors unique insight into changes in modern financial markets, as well as the world in general.

API Finds it's Not Easy Being Green

I am working on an article about the Dodd-Frank Act and stumbled on a great piece in the LA Times about armies of lobbyists marching into Washington to try and water it down. One paragraph caught my eye and made me laugh: "The American Petroleum Institute met with Securities and Exchange Commission officials Sept. 27 to argue that new rules forcing oil and mining firms to report payments made to foreign governments "raises significant practicality and cost-benefit concerns by vastly increasing the amount of data that must be reported.""
LOL. Is that the best they could come up with? Too much paperwork? Is the API suddenly going green? Doubtful.The reason it is using the weak excuse of 'practicality and cost-benefit concerns' is because it cannot say to the SEC: "Gee whiz, how do you expect us to get drilling or supply contracts in dodgy countries without greasing a few palms?"
The practice of bribery is ingrained in the oil business. Officials in Russia, Middle East, Africa, and Latin America have been supplementing their income with bribes since oil was discovered under their feet. Oil firms have always been creative in disguising the payments, but now - in the US at least - they will have to report them. It won't matter, they can open an office somewhere else and send some poor schmuck out with a brown bag (it used to be schmucks in London, but the UK is cracking down too). As long as there is no paperwork to file.

The Fading of Old Glory

As I write predictions for 2011 in the capital markets for various clients, I am seeing a picture that I don't particularly care for. The United States' star is losing its ascendancy as hungrier, less regulated nations begin to encroach on our traditional territories. In just the past two weeks I have seen my kids - educated and trained graphic artists - lose freelance work to equally educated young (or old, who knows?) people in India, China and Korea - for a tenth of the going U.S. rate. I have seen a relative's MRI results read by a doctor in India. I read that many hospitals in the U.S. are outsourcing basic medical services, such as reading CT scans, to doctors in India and China who are doing remote diagnosis. I have heard of lawyers in India training to be able to help companies deal with new U.S. financial regulation. Indian tax accountants are taking away jobs here in the U.S. as domestic consultants outsource the production of tax returns.
The United States is all about commerce and profits. The constant emigration of jobs, manufacturing, innovation and trade to emerging countries where the talent is plentiful and cheap saves U.S. corporations billions. But what does it leave for this country? Manufacturing is all but dead apart from cars. Financial services firms propped up the economy for a while - albeit with smoke and mirrors - and are now heading for the exit as fast as possible, fearing new financial regulation will harm profit margins. Brazil, Australia, and other countries are embracing high speed and algorithmic trading and will soon not need our bulge bracket banks to help them out with it. The health care industry is top-heavy and inefficient with health insurance companies a complete rip-off which will someday be exposed. What is left? The generation that is attending and/or just graduated from university is going to pay dearly for American excesses. It is said half-jokingly that graduates today are most likely to land jobs where they will say "would you like fries with that?" It may be years before they can get into solid, growth area companies where they can make a career.
But what companies will they be? Technology? We have Apple and Microsoft and IBM and Intel, true. But they are on the downward edge of the razor blade that is the technology innovation curve. Innovation can also be outsourced, but it has been the exclusive domain of America for about 150 years. It has to remain so, otherwise what do we have left? A bit of oil, some corn and a lot of people.
New products need to be invented and fast-tracked to production before the Chinese can copy them. I remember in the 1960's when "Made in Japan" was a standard joke for crappy quality, a snide reference to how much better things made in America were. Now Japanese cars are  the ones U.S. car makers have to beat in terms of quality and service.
I think this country is in more trouble than we can foresee. If there is not a dedicated effort to increase innovation and support the opening and growth of new companies we could one day see our kids moving to India or Brazil to find work.

Throwing Jerome Kerviel Under the Bus

I feel sorry for Jerome Kerviel. His face was a picture of devastation. His life is in tatters, and the next three years will be spent in prison. I realize that Kerviel is not an innocent man. He lied and hid his losses using his knowledge of risk management systems gained in previous jobs. What he did was stupid and financially damaging to SocGen - he came close to ruining the bank. There is no excuse for what he did.
There is also no excuse for SocGen to have let it happen.The most cursory of glances into trading accounts would have flagged up issues. The most elementary of audits would have caught Kerviel before his mistakes were monumental. The bank repeatedly ignored warnings and red flags concerning Kerviel's positions, preferring instead to focus on the profits he appeared to be making. SocGen is guilty of extreme moral hazard, and should also be punished.
If there is a lesson to be learned from the trial of Jerome Kerviel, it is that the big banks almost always win. A big bank can gamble its clients' money, let traders take on huge positions with no risk or leverage controls, and cut corners on technology and common sense and still win the day. Government, and that includes judges, will continue to support them because they are 'systemically' important. The only answer is to force banks to take steps to prevent a Jerome Kerviel from happening again. Regulation in the form of forcing banks to employ real-time risk management, trade monitoring and surveillance might ward off another $4bn loss. And prevent what actually appears to be abject stupidity in the name of profits. 

Wall Street: Proof that Money DOES Sleep

All hyped up by the SEC's flash crash report, I trotted off to see Wall Street: Money Never Sleeps on Sunday. The movie was proof that, even if money itself doesn't sleep, movies about money can send you to sleep. Oliver Stone's take on the 2008 financial crisis was almost as bad as CNBC's original take. (And then we had to watch CNBC do it ALL OVER AGAIN in the movie.) Seeing non-financial types squirm over explaining credit default swaps and collateralized debt obligations does not amusing cinema make.I think whoever wrote the screenplay fell asleep trying to understand the nuances of a very complicated series of events and issues.
I loved the "A" story - Gordon Gekko gets out of prison, wants his money back so he can get back to raping and pillaging the idiots in this world. But somewhere along the line, the "B" story took over - mixed bunch of evil bankers (who the Hell was Josh Brolin supposed to be? He had John Thain's office, for sure) are....hmm. Doing what bankers do, which is not really movie material.
The "C" story - a love story between Gekko's daughter (the British Carey Mulligan was excellent as an American do-gooder) and the most-likely-to-be-killed-by-a-Disney-baddie Shia LeBeouf - took over and finished whatever promise the movie might have had. What is the point of Shia LeBeouf? He is not a great actor, his looks are odd (his nose could have been crafted for Mr. Potato Head dolls), and he is the least financial-looking type ever.
There were some good moments, however, most of which involved Michael Douglas. His Gordon Gekko character was intact, if weathered. Josh Brolin was all smooth looks and evil smiles, which could have gone a lot further. Maybe if Brolin had played hedge fund honcho John Paulson, squaring off against Gekko to see who could short the credit market the furthest without going bankrupt, we would have had more action. And I would have stayed awake.

On Regulation and Real Estate

Goldman Sachs is preparing another temper tantrum over regulation, this time it is threatening to quit Europe if the region comes down too heavily, according to today's FT. 
The bank has already thrown some toys out of the pram in the U.S., leaking that it wants to spin off its prop trading arm well in advance of any Volcker Rule taking effect. (Although why anyone would pay GS for the privilege is beyond me, just hire the traders away!) Now CEO Lloyd Blankfein is predicting gloomily that mismatched regulation between the U.S., EU and other regions will cause banks to move. GS already booked some extra space in Zurich, but perhaps that is too close to Basel. The last thing GS wants is to have to responsibly manage its leverage.
Zurich is the next stop for many banks on the regulation underground. Escaping to Switzerland for tax purposes started a few years back and the trend has grown exponentially in the past two years as regulation in the EU looms. The U.K. is losing hedge funds and bank trading arms in droves. Geneva, arguably the most civilized and pleasant of Swiss banking centers, is overflowing with foreigners. The International School apparently has a long waiting list for entrants. Good rental accommodation is like gold dust, my sources tell me. Many bankers are leaving their families back home while they stay in hotels and try to find reasonable houses or flats to rent. And the rental rates are going through the roof.
If real estate speculation is your game (it is mine, although not on this scale), then Zurich and perhaps Zug and Basel might be good places to buy rental property. Singapore might be next.
However, it is my opinion that no one can escape the long arm of the regulators. Having a base in a lightly regulated country may help to avoid excessive taxation and perhaps even some capital requirement constraints for now. But when you go to do business in the U.S. and the U.K. or Europe, which you will, you might have your hand bitten off. I'd stick to real estate.

SEC Tries to CONTROL High Frequency Trading KAOS

In the 1960's American sitcom Get Smart there were two opposing agencies - CONTROL and KAOS. At CONTROL you had The Chief, Maxwell Smart (Agent 86) and Agent 99 as the good guys. KAOS was the bad guys of course.
In today's seemingly perplexing world of electronic trading The Chief appears to be played by U.S. Senator Charles Schumer. The well-meaning but hapless Maxwell Smart is played by U.S. Securities and Exchange Commission Chairman Mary Schapiro. (The SEC staff can take turns as Agent 99.) KAOS is represented by high frequency and algorithmic trading.
The Chief (Schumer) made a strong suggestion (order) to regulators to get a grip on KAOS, by looking into slowing down some high-speed trading at times of market stress and investigating manipulative strategies including quote stuffing.
Agent 86 (Schapiro) got on the case and the investigation is underway (http://tinyurl.com/3yk6aou). One telling statement by Schapiro this week alluded to the algos that automate execution when she said that regulators need to decide whether they "are subject to appropriate rules and controls."
"An out-of-control algorithm not only can cause serious losses to the firm that uses it, it can also cause severe trading disruptions that harm market stability and shake investor confidence," Schapiro said in the statement. She added that the SEC will review market fragmentation and the role of dark pools of liquidity that fall outside the traditional market structure.
“High-frequency trading firms are subject to very little in the way of obligations,” Schapiro said at an event held by the Security Traders Association in Washington. “We will consider carefully whether these firms should be subject to an appropriate regulatory structure governing key aspects of their market behavior, including quoting and trading strategies.”
The SEC may also need to peer a little more closely into the market structure that preceded all of these issues. A third of TabbFORUM readers polled said that the Securities and Exchange Commission had something to do with the May 6 flash crash: 31% of respondents to the poll blamed the crash on Reg NMS. (Still, 29% said it was “something else." Cue Siegfried - the Vice President in charge of Public Relations and Terror at KAOS).
All of this investigating is good news, as long as moderation is the byword for resolution. If indeed your opinion is that HFT and algos are run by a shady KAOS-style cartel on Wall Street then the more controls the better. It is my opinion that KAOS-as-HFT is a figment of non-financial industry scaremongers, and that a lighter touch is needed.
CONTROL can best come out on top if it deploys the proper tools: pre-trade risk management and controls, real-time risk management, real-time market monitoring and surveillance. All of these will help to stop KAOS in its tracks before it has the chance to throw another bomb into the room (flash crash...get it?).

Right Conspiracy Theory, Wrong Conspiracy

So I was right that the timing of the SEC's announcement that it was investigating Goldman Sachs for fraud in April was too convenient. I said at the time that the case was politically motivated due to the impending financial regulation bill vote. And it seems I was right about the timing, but wrong as to the real reason. Reuters reported that an SEC inspector called the timing of the SEC's case against Goldman Sachs suspicious, suggesting that the SEC used it to divert attention from some bad PR. A report that sharply criticized its probe into accused Ponzi schemer Allen Stanford was about to be released, and the SEC seemingly hastened to get the Goldman Sachs news out. According to Reuters: "The SEC filed civil fraud charges against Goldman in mid-April, the same day it released a watchdog report accusing the agency of mishandling an investigation into Stanford's alleged $7 billion Ponzi scheme."
We all know that the SEC has been late to the market monitoring game, and that many innocent investors have suffered as a consequence. Maybe the agency really did not have the power to stop fraudulent behavior in the past. So when I read today that Chairman Mary Schapiro is taking a hard look at high frequency trading, algorithmic order execution and dark pools I have to wonder why we keep hearing that litany. And why nothing has yet been achieved.
From Bloomberg today: "Robert Khuzami, the U.S. Securities and Exchange Commission’s top enforcement official, said the agency is gearing up to use new powers from recent legislation to crack down on Wall Street after being faulted for not pursuing executives’ misconduct." Let me know how that works out for 'ya Bob?

Time to Stop the Market Structure Madness

According to some increasingly loud voices, the US equities market structure is a runaway train destined for an accident that will make the May 6th flash crash look like a fender bender. High frequency trading is getting unwanted attention ranging from bloggers and mainstream press to investment firms' newsletters. All are concerned that HFT is dangerous (might cause another flash crash) and unfair to retail investors.
A quarterly newsletter sent out by Baron Funds draws attention to Reg NMS and says shareholders have been harmed by its unintended consequences. In the newsletter Ronald Baron, CEO and CIO of Baron Funds, calls for HFT firms to adhere to "affirmative obligations" such as specialists have always had to do, and to eliminate co-location of servers at exchanges and other venues. He also wants HFT to be disallowed in the first and last 30 minutes of a trading day.
Last week Themis Trading went to the extreme and called for a ban on new market venues. “Most industry professionals generally agree that something in our current market structure caused May 6th and unless we get to the bottom of it, May 6th is more than likely to happen again,” said Themis co-founders Sal Arnuk and Joseph Saluzzi.
HFT supporters keep dragging out the increasingly impotent "adds liquidity" argument, even as revealing graphics from trade database development firm Nanex show that there are some not-quite-cricket practices such quote stuffing going on. (Quote stuffing is the practice of firing so many orders into the order book - in particular ticker symbols - that the market cannot possibly respond.) This is not liquidity, just the opposite.
The SEC's recommendation to form a consolidated audit trail to - at the very least - help do forensic investigations after a flash crash event is attracting a lot of wannabe technology vendors, but little other enthusiasm. Inside Market Data reported that the estimated $4 billion industry-wide costs required to build a consolidated audit trail ( with ongoing annual costs of around $2.1 billion) are too high and the 32-month implementation period far too long.
In the meantime, another new venue - this one for futures- is popping its head above the parapet. ELX says it is time for CME Group to let go of its virtual monopoly on US futures markets and the courts agreed, signalling the next explosion in new trading destinations. In Europe new MiFID rules may not help to bring that fragmented market time-bomb together, nor will they necessarily encourage liquidity. Worries about a flash crash there surface almost daily in the press.
Maybe it is time to say 'enough already! Stop the madness!' Themis thinks so: “In our US equity market place alone, we have in excess of 12 exchanges, as well as over 40 dark pools and ATS's. These market centers all operate by their own rules and have their own fee schedules.  Given that the US equity market is more fragmented than ever, which is a direct and unintended consequence of Reg NMS, we question the wisdom of allowing even further fragmentation until our regulatory bodies have a firm understanding of precisely what went wrong on May 6th, as well as their having a firm understanding of all the newer nuances of our modern market structure, including the effects of various order types, co-location, and data feeds.”
In Europe the venues are also proliferating - exchanges include Bolsa de Madrid, Deutsche Börse Eurex, the London Stock Exchange, NYSE Euronext, and SIX Swiss Exchange. MTFs include BATS Europe, Chi-X, NASDAQ OMX Europe, NYSE Arca Europe, and Turquoise. Yikes.  No one knows for sure what caused the flash crash, but fragmentation from new market structure is surely one of the culprits.
As blogger Steve Wunsch, of Wunsch Auction Associates, said in TABB Forum on August 10: "The flash crash is not difficult to explain, if one is willing to honestly look at it. But that wouldn’t suit the SEC, because the picture that emerges is one of the Commission having created an electronic Frankenstein that went berserk on May 6 with a suddenness and ferocity that only the SEC could have devised."
Reg NMS and MiFID and the resulting fragmentation of each marketplace are getting a bad rap, and it may be time for the SEC and European regulators to speed up their investigations. In the US, at least, the SEC continues to approve new equities trading destinations and more are entering the approval process regularly.
Inside Market Data asks how much an orderly market is worth: "Those who believe lightning never strikes the same place twice might say the benefits aren’t worth the cost. But lightning always strikes again somewhere, and—as the saying goes—those who don’t learn from the past are doomed to repeat it."
Until there is an audit trail, along with monitoring and surveillance technology, deployed to all destination venues and controlled by the regulators, HFT and algorithmic trading will remain the skunks at the garden party. I wonder if more draconian measures are not imminent.

One Man's Meat is Another Man's Poison

As algorithms in US markets chug away - cheerfully gaming each other and quote stuffing - two men in Norway have been arrested for doing something very similar. According to Zerohedge, day traders Svend Egil Larsen and Peder Veiby face up to six years in jail, for reverse engineering a stock trading algorithm used by broker Timber Hill, which is Interactive Brokers' key market maker. They found a weakness in it and took advantage of it to (allegedly) artificially inflate the share price of three companies listed on the Oslo Stock Exchange.
That Norwegian regulators have taken a hard line on this sort of activity is interesting, especially as here in the US the regulators have not even begun to drill down into high frequency trading practices. While HFT and quote-stuffing algorithms are widely believed to have caused the market meltdown of May 6th, little has been done to try and rein in dodgy practices.
A global body of regulator, the International Organization of Securities Commissions (IOSCO), is also concerned. It proposes tougher guidelines to monitor high-speed traders - particularly those with direct market access to exchanges. Calling it "direct electronic access", IOSCO says that securities markets should be monitored for risky practices both before and after their trades are made.  This is not a novel idea, the SEC is also proposing that brokers deploy pre-trade risk controls for their DMA or naked access clients. Brokers, and their clients, are not impressed with this idea because it could add a latency "hop" of maybe milliseconds to their trades.
But given that almost 40$ of trades in US stock markets is via naked access, it is time someone took action. Another flash crash is lurking, and fat fingers or outright fraudulent trades can set it off far too easily. The SEC has to get off the pot.

Let's All go to the Lobby

Show's over folks. Financial regulation has passed and been signed by President Obama. Basel III has had its teeth removed and its testicles cut off by the usual lobbyist-armed suspects. The (seemingly stress-free) stress tests for European banks have been and gone, with anxiety over European sovereign debt on hold until the summer holidays are over.  And Tony Hayward has been banished to Siberia just as BP's gusher in the Gulf is about to be sealed. Time to head for the lobby for a snack and to wait for previews of things to come.
Summer is the silly season in Europe, when the Brits, French, Germans and Italians head for the beaches. Those who stay in the nearly-deserted cities think up fun things to do like sailing regattas, horse racing or polo matches to keep them occupied. Little gets accomplished in the business world in August, and everyone accepts that normalcy will resume in September.
But wait - in America the wheels keep on spinning. I was shocked when I moved here to see that major conferences, press briefings and cocktail parties were scheduled in August. A good PR in London knows that there if there is no one around to attend you don't throw a party. I, of course, do not attend anything in August. My mindset is stuck in summer mode and it would seem sacrilege to do 'real work' in August.
But, because the wheels of American commerce do keep spinning I have to keep up with the news. So it was that I found, buried within thinly disguised political crap-stirring, an article from Fox Business News. It said that the SEC is now allowed to withhold information about its goofs - I mean investigations. This was a little clause hidden within the new financial regulation bill, apparently.  According to the New York Post: "A provision buried in the week-old law allows the Securities and Exchange Commission to deny any public request for information under the Freedom of Information Act, a time-honored tool that's exposed scores of scandals from Washington to Wall Street for the past 44 years."
Looking into it further the clause is said to strengthen an existing rule that enables the SEC to keep any information it receives from brokers and banks away from public access. Otherwise the brokers and banks wouldn't want to give the SEC anything. This makes sense. If your bank turns over confidential client trades to the regulator, Fox News (or I) should not be able to requisition those documents for a story. But we could, under the FOIA, so I wonder how many brokers and banks refused to turn over their records in the past.
After the May 6th flash crash it was obvious that the SEC and the CFTC were struggling to get the information necessary to investigate the causes. Was this because the industry participants were afraid of what would happen to them if they did? Clearly if a broker's client fat fingered a trade and the broker didn't catch it because it provides naked access then the broker would appear culpable. No broker wants the reputation of having loosey-goosey risk management practices. If a bank was 'making bets' against its clients' trading positions and it got caught by the SEC, then that bank would be very unhappy if it hit the press.
And now, with the inevitable deployment of some version of the Volcker Rule, if a broker dealer was running a book bigger than its client business required, it would be considered proprietary trading. Again, not something it wants anyone to know about.
If the SEC were staffed with highly experienced ex-traders, trading managers, risk managers and securities business lawyers I might have faith that they could sensitively handle these issues. To date, that has not been the case. Which leads me to believe that journalists probably should have the right to requisition relevant documents. I hate to agree with Fox News or the New York Post, but....

Hands Off my Mental Health

The Economist Magazine reports this week that companies are no longer satisfied with coercing employees to get physically fit (mainly to save on insurance bills, not for any philanthropic reason) and are venturing into managing their mental health. Apparently this arises from "management gurus" who are discovering the "joys" of psychology.  I have never held much stock in management gurus, and the idea that they might be dabbling in psychobabble scares me. Especially here in America, where you are measured by the size of your smile and the eagerness of your greeting.
Personally, I do not want to be surrounded by a bunch of perky cheerleader types at work (or at all). In my experience, they waste time with gossip and meetings and rarely achieve very much of note. In fact, the Economist's article states that "history shows that misfits have contributed far more to creativity than perky optimists". I agree. Some of the most productive sales people and traders I have worked with were also the grumpiest. They barked and growled and got on with the job, leaving the cheerful (and often overly sensitive) wannabes in the dust. On the other hand, when you got the grumpy ones on their own for a drink or a meeting they were civil, informative and good fun.
Some of the worst time wasters I have known were the friendliest, chattiest people who wanted nothing more than to bend everyone's ears at meeting after meeting. Even now as a freelancer working from home I am often interrupted by bored fellow home-workers who want to wane away hours at the local coffee house gabbing. They can never understand why I am "always working".
So next time you see a grouchy curmudgeon at work, leave them alone to do their jobs. Do not bring in a psychologist or a management guru with a 'certificate' in pop psychology to examine their mental health. Instead be grateful that they are productive, hard-working employees.

Wall Street 1, Main Street nil

If ever there had been any question as to who runs the United States, it has been answered. Wall Street has once again run roughshod over Washington and Main Street by pulling the teeth out of the financial regulation bill, one by one.
The pressure from banks, hedge funds, lobbyists, CNBC, talk show hosts, and - it seems - the markets (which tend to puke conveniently whenever 'finreg' looms) wore Washington down. Although the bill made it through the House, the Senate now wants to sit on it and percolate (i.e. find a way to squirm out of more stuff) for a few extra days.
Standing up to Wall Street takes real guts. So it makes sense that the bill did not touch upon one of the biggest culprits in the financial crisis - bankers' compensation. That is a hornet's nest that even the bravest reformers dared not tackle. And it will be a miracle if the Volcker Rule makes it through unscathed.
The latest victory for the bulge bracket was to strong-arm Congress and the House to remove the $150bn bank levy, as well as the $19bn tax on large banks and hedge funds. The deciding voter, Massachusetts Senator Scott Brown, crumbled under pressure from his Republican leaders (presumably also from the not-insubstantial financial services constituency in Boston) causing him to flip-flop like a pro.
I am not saying that the levy or the tax, intended to help fund the next crisis, were great ideas. They were more of a sop to shut up protesters who didn't want another taxpayer-funded bailout. But these same protesters don't want banks to have to hold higher capital reserves to help cover their own losses, claiming this will stop them from lending to "Main Street".
Had anyone on Capitol Hill been reading the business press, they would have known ages ago that capital requirements are poised to become more stringent anyway due to Basel III. Capital reserves will be raised regardless of Wall Street's weeping and wailing and gnashing of teeth. (The Swiss are not known for bowing under pressure, especially from nosy Americans which want them to reveal their banking secrets.)
The time that passed since the crux of the crisis and the drafting of the bill dulled the urgency needed to propel the stiffer rules forward. The only fly in that ointment was the flash crash on May 6th, which threatened to derail the banks' anti-regulation rally. The violent moves brought Wall Street and high frequency trading back into the headlines and questions again arose about reckless trading practices.
Luckily for the banks the flash crash is now nearly forgotten by almost everyone except the SEC and CFTC, who are still scratching their heads as to how to do the forensics. The panacea of circuit breakers seems to have satisfied politicians enough that they can once again canoodle with their Wall Street lobbyists.
That circuit breakers were not mandated market-wide across ECNs and exchanges from the onset of Reg NMS is the mystery. Many blame the regulators for being asleep at the wheel, with the excuse that they have no money hence cannot hire the necessary expertise.
One contact at an exchange calls the new market structure "a monster created by Wall Street and Washington", who did not realize - or ignored - the repercussions. He believes that the regulators have no money and no teeth by design - to benefit a very influential constituency, i.e. Wall Street. Banks were behind the formulation of many ECNs, after all. And they pushed the exchanges to embrace automated trading and decimalization, so that their algorithms could do their work - making money and obfuscating regulators.
As Michael Lewis said in his column for Bloomberg: "The oath of the Financial Crisis Inquiry Commission, is: 'We pledge to find out, by the year 2050, what exactly happened on Wall Street in the early part of this century. We pledge to reform Wall Street. Or, failing that, to be taken seriously. Or, at a bare minimum, to attract a bit of media'." 
Media attention it got. Results, not so much.

The Words "Can" and "Worms" Come to Mind

The U.S. financial regulation reform bill (called 'finreg' for reasons I don't care to know) seems to be all over bar the shouting, which of course began immediately on CNBC on Friday morning. The crux of criticism appears to be that the banks will - GASP - have to retain enough capital to cover their own losses in future. (Have they not heard of Basel II or III?)
The more draconian rules that impact capital markets players - with regards to proprietary trading, hedge funds and swaps trading - were greatly watered down in order to get a deal through. The Volcker Rule was shaved to allow banks to continue to invest in private equity and hedge funds, albeit on a very limited basis. But it is far from its Glass-Steagall roots.
Vanilla over-the-counter derivatives will be required to trade on exchanges and to be cleared, with bespoke OTC having to report central repositories. There are new margin and capital requirements. And banks will only have to spin off some of their riskier derivatives into subsidiary companies, leaving interest-rate and FX swaps in-house. No major surprises.
Which begs the question, was it worth all the trouble? I think it was - and it wasn't.
I like the fact that the big banks, hedge funds and prop trading firms are now aware that they are being watched. The days of free market for all, and damn the torpedoes full speed ahead, are over. The regulators will pick up the ball once the bill is signed into law, and - in theory - will understand how to make the rules stick. (This of course depends upon whether they stop acting like government employees, i.e. not just surfing naughty websites while their pensions mature).
I don't like the fragmentation that spinning off affiliates for swaps and OTC trading will create. Risk managers will have a nightmare trying to gauge risk and maximize capital across not just asset class silos in-house, but across subsidiary companies that are taking large positions.
It could be that the new regulations open up many new cans of worms. I feel certain that the banks and big trading companies are already figuring out how to game the new rules, that is what they do after all. There are always new opportunities to be found with new regulations. At the SIFMA conference a group of analysts discussing the impact of financial regulation on technology mentioned one.
If derivatives are to be more widely traded on exchanges, they will be eligible for high frequency and algorithmic trading. This means the margins will shrink (it is already happening with energy futures, a major oil company tells me), as will profits. Transparency does not come without costs. This means players will have to create more complicated bilateral OTC deals in order to make money. Or move away from the U.S.. My bet is that both will happen.

SIFMA and the World Cup

I just returned from the Securities Industry and Futures Market Association's Financial Services Technology conference and exhibition in New York City. There were a record number of registrants, a SIFMA rep told me 9,000 people signed up, which was a very good sign (last year was dire - maybe 5,000 I'd guess). The stands were busy, if still more sparse than before the financial crisis, and the parties were packed with Europeans as well as Americans. That is the good news.
The bad news is that on Wednesday, when the U.S. was playing in the World Cup against Algeria and England was playing Slovenia, there were only two or three screens airing the matches. At the Bloomberg stand, one of the sales guys had tracked down a free streaming TV service and had the U.S. match in a tiny corner of the screen. Downstairs in a 'pub' set for a vendor there was an actual TV screen and probably 50 people crammed in around it. I mentioned it to some other vendors who all said that they didn't want to pay the Hilton for internet service at the conference, it was too expensive. And too slow. Therefore nearly everyone had canned demos at their stands.
Now I realize that the SIFMA technology exhibition is mainly attended by swotty geeks (I count myself as one, so please do not take offense). And the U.S. is only just beginning to take notice of football, i.e. soccer. So the fact that not many people were interested in the World Cup is fair enough.
But the fact that the foremost technology exhibition in the world, with big name vendors from IBM to Bank of America, cannot provide even the most basic technology to its exhibitors is not understandable. It is downright ridiculous. (And, by the way, Verizon was exhibiting - hellooo...)Vendors pay a lot of money to exhibit at this conference, and if they want to display the World Cup at their stands or show their clients something live online they should be able to.
So, vendors - take a stand. Tell the Hilton and SIFMA that you are mad as Hell and are not going to take it anymore. Demand connectivity for free (or at least cheap). If SIFMA wants the industry to crawl back to normalcy, it really ought to provide it with the necessary tools.

Crisis, Drama then Reform

In the 1980s, insurance company Commercial Union had a very catchy tagline: "We won't make a drama out of a crisis." This phrase could be turned around for the ongoing financial markets disaster, because much drama has been made from this crisis. And out of drama comes reform.
Change comes when big drivers - i.e. crises - force the industry to address its issues. The Enron debacle gave us the Sarbanes Oxley Act, global terrorism and 9/11 spawned Know Your Customer and anti-money laundering initiatives. Now the meltdown of 2008 is about to be rewarded with comprehensive financial regulatory reform. And BP's massive oil spill in the US Gulf is going to be the game-changer for oil drilling regulation (maybe even climate change).
As with most painful events, once the drama fades the will to punish the wrongdoers often weakens. In the run-up to the two financial regulation bills - one from the House and one from the Senate - resolve appeared to be wilting. Unrelenting pressure from an army of lobbyists for the financial services industry seemed to be making progress.
Fierce lobbying seemed to stiffen the resolve of politicians instead. Now as the bills go to a committee to find middle ground, much of what is irking Wall Street may come to pass. The Wall Street Journal reported on Tuesday that many lobbyists are now being turned away, with many being told their bank's views are already well known (imagine that!).
The Volcker Rule, once considered the most over-reaching solution possible by financial institutions, now looks certain to be included. The banks shrugged and turned their drama queen act toward Senator Blanch Lincoln's more draconian derivatives legislation. Although this one is losing momentum, with some softening indicated, it is still likely to be part of the overall package. Proposed regulation of ratings agencies (who practically minted the term 'conflict of interest') seems to be falling off the radar, however.
Whatever regulation gets through will have to be finessed and managed by the SEC and CFTC in the future. This is a task they were not up to previously. But again, perhaps lessons are being learned. According to the Washington Post, the SEC is hiring experts with specialized quantitative skills or have worked on Wall Street, thus will have a better insight of the  markets they regulate.
But as regulators learn, financial institutions learn faster. They gird their loins by hiring better lawyers or even SEC executives. The secretive high frequency trading company Getco hired Elizabeth King from the SEC, she was a key associate in charge of crafting rules for the equity and option markets. Last year Goldman Sachs hired Arthur Levitt Jr., the former chairman of the SEC, to advise the bank on public policy issues. (Although this year Goldman Sachs had to hire legal gun Gregory Craig, President Obama's former legal counsel, to help fight a civil suit brought by the SEC.)
Maybe now that the last financial crisis is on its slow, bumpy way to normalcy and the drama is fading, the regulators can get on with their work and prevent the next crisis. We can only hope that the regulators will have the wherewithal to hire the right experts, buy the right monitoring technology and the power to demand the transparency needed to make sure they know what is going on. Next stop - oil drilling regulation.

A Potted History of BP Trading

Joke: Why did the bumblebee fly with his legs crossed? He was looking for a bee pee station!
The first time I heard of BP was when it installed a gas station on the corner near my high school in Bath, Maine. BP was largely unknown in New England in the 1970's. Unlike today.
Fast forward from high school to my first real job in London in 1981, where I was reporting on oil prices for Platt's (a McGraw-Hill company, now under the Standard and Poor's umbrella). I would speak daily to the oil trading offshoot of BP, known as BP Amro. The traders were located in the Hague in Holland, for some reason. They soon moved to London, where the action was. (Albeit to the City - where only dusty financial types lingered. The real action was in the West End where Vitol, Vanol, Marc Rich, etc. worked and played.) From the beginning, I saw that BP traders were different from the rest.  For a start they all seemed to have northern or Scottish accents. (The accent norm in the oil business in London at that time was wide-boy Essex or Kent.) I'm told that is because BP recruited engineers, who were mainly educated at Sheffield University near Manchester. They were more like barroom brawlers than oil traders. In an industry where heavy drinking was practically a requirement, the BP boys put everyone else to shame. There was a pub under their City offices to which most of the trading desk (or bench as they insisted on calling it) would decamp for the afternoon. This was before cellphones, so there were dedicated phone lines behind the bar so that they wouldn't miss a deal. Because underneath the fug of smoke and beer, there were some pretty sharp traders. Maybe it was the northern stubborn streak, but once they had a mind to do a deal they did it. Corners were cut if necessary, and lies were told. But, hey - that was part of the business. My sources tell me that BP's trading desk was and still is the most successful of any oil company. It also had a reputation for being a skinflint. Salaries were pathetic and there were no real bonuses at the time. Then after losing trader upon trader to Phibro or Vitol, BP started to pay its traders properly, and to reward them with decent bonuses. It realized that training someone from college all the way to the trading desk, only to lose them a year later, was perhaps more expensive than rewarding them in relationship to industry standards.
Besides the skinflint reputation, there also a whiff of the bully about the company. The traders often turned violent after bouts of drinking. The BP Curry, a legendary 'lunch' party at the end of the annual Institute of Petroleum Week, would usually end in fisticuffs. Sometimes these even involved journalists, and one of my old reporters got pounded a few times. (He was a stickler for the truth, so perhaps it was not the industry for him.) BP's Chicago trading office still takes 2 hour pub breaks at lunchtime, my sources tell me, something that is rather unusual in the US - even for Brits living here. But the money was piling in, and no one at BP cared too much about what the outside world thought of them.
Then, in 1987 BP's Grangemouth refinery started showing some cracks. A fire was followed days later by a hydrocracker explosion. It was so powerful that, according to a friend who worked there, a farmer on his tractor a mile away was blown into the air - with his tractor. He survived, but two BP fitters did not. Grangemouth continued to deteriorate and in 2000 suffered several incidents including a major catalytic cracker fire, despite continued warnings about possible safety violations from the Health and Safety Executive. A fire at its US Texas City refinery in 2005 killed 15 people. BP was beginning to get a bad rep for safety. Many fines later, the deepwater oil rig in the Gulf blew.
I am not trying to pass judgment on BP. It was and is a fine oil company, and I have many friends who have passed through its doors. I do wonder, though, if in the pursuit of profits perhaps too many corners were cut.

Push-me Pull-you

Europe and the United States are locked in competition to see who can pass the strictest new financial regulations first. Each believes that if it is first, the other will have to harmonize their rules behind it. Both could be wrong about that, but it looks like Europe will win the blue ribbon for first place in the regulation race.    
Angela Merkel and Nicolas Sarkozy are throwing their weight behind the European Commission's hedge fund regulation known as the Alternative Investment Fund Managers directive. The AIFM is causing consternation from the US and other non-resident hedge funds which, if it passes, may not be allowed to do business in Europe. Many EU leaders actually believe that hedge funds are the reason their countries have become destabilized. And it looks like AIFM will pass on Tuesday, leaving US hedge funds to swing in the wind.
Meanwhile, the US Senate is debating the finer points of (read: pretending to understand) Chris Dodd's financial regulation bill. It rejected Ben Bernanke's and Wall Street's pleas to loosen derivatives trading rules, including keeping in there Sen. Blanche Lincoln's proposal to hive off swaps and derivatives from banks altogether.
And Paul Volcker is running around Europe touting the virtues of his prop trading rule, which he is absolutely convinced will pass. (I agree that the odds for the Volcker Rule passing are pretty good. The Volcker Rule makes its presence known in almost every discussion on how to regulate the TBTF banks. His reasoning is solid, saying that when commercial banks venture into capital markets functions their risks grow too high.)
So we have a regulatory first-mover stand-off, but the focus of these regulations makes me wonder if they are missing something. None of the immediately visible rules - regulating hedge funds, separating derivatives or prop trading from banking, clearing derivatives, smacking down credit ratings agencies - will do the first thing to prevent another market structure bump like the one on May 6th.
The US market has become so terribly fragmented that no one seems to know who is doing what and where, and under which rules. Regulators are running around like lunatics trying to figure out what happened on May 6th, while exchanges are tearing up their databases trying to see who did what and when. What is lacking is market-wide oversight, monitoring and - most importantly - transparency. I hope that some of the new rules and regulations we are about to have will help to pave the way toward this. The good news is that US exchanges, ECNs and regulators are experienced at cooperation.
These are still untested waters in Europe, which can barely deal with common currency issues. Fragmentation in European exchanges, ECNs, clearing houses, and regulators is becoming a major concern.  I fear a flash crash in European markets is the next shoe to drop, and it will be faster and more severe than anything we have seen in the US to date.

Tipping point for high frequency trading

Although a trading error may have been to blame for the domino effect that knocked the Dow Jones Industrial Average down by almost 1,000 points on Thursday, May 6 it highlighted the damage that high frequency trading can inflict in the blink of an eye. It also proved the fragility of the post-Reg NMS market framework, and proves the need for government mandated pre-trade risk management, market surveillance and monitoring.
'Greek Thursday' - as I have dubbed it - could be the tipping point for HFT. Regulators are poised to decide upon new controls for high speed markets, and Greek Thursday might just be the clarification they needed. Here are some of the lessons that could be learned from the experience.
1. Pre-trade risk management is a necessity. Fat fingered errors are absolutely avoidable. Using pre-trade risk management tools would prevent fat fingered errors and/or breaching trade limits. That trading firms do not use them is unbelievable.
2. Smart order routing can also be stupid order routing. Many algorithms are designed to 'find and nail' liquidity, no matter where it rests or what the price. You must monitor and manage your algorithms in real-time.
3. All exchanges and ECNs should have to take a break when markets are volatile.  If an exchange such as NYSE institutes a trading pause due to volatility, your order routing can go to a venue where liquidity is less than desirable, and prices are downright miserable.
4. Orders should be tagged. Whether an order comes through from an algorithm or a sales trader or broker, it should have an electronic tag so that when regulators/exchanges/ECNs see an error they know where it came from and can respond accordingly.
5. Real-time market monitoring is a necessity. Electronic trading means that crashes such as that on Greek Thursday can happen in an instant. If a trading anomaly is spotted in real-time, preventive measures could be taken.
Days like Greek Thursday could repel retail or institutional investment - the very money the industry has been trying to lure back into the stock markets.  When prices started to collapse on Thursday, it became all too clear that everyone was on the same side - bearish. Algorithmic players had their pants taken down and their positions exposed to the world yesterday. This hardly builds confidence.

Oil and Water

You would not think there was as much in common between the oil industry and the OTC derivatives markets; they look about as similar as oil and water. Oil is the substance upon which this country runs its cars (and trucks, SUVs, RVs, ATVs, speedboats....), heats its homes and runs its factories.  Derivatives are complex instruments that are (usually) derived from underlying trading instruments or exchange-traded contracts. Yet both have made the news lately for the same reason - they proved they can be dangerous weapons when in the wrong hands.
The oil leak offshore in the Gulf of Mexico is happening because the oil lobby is one of the most powerful in the US and has spent decades bribing politicians to allow more and more exploration. The mouthpiece of the oil industry, the American Petroleum Institute, is the official pooh-pooher when it comes to subjects such as over-consumption, pollution, global climate change. It spends millions every year saying how safe it is - how good for the economy - to drill, to refine, and to use oil.
The lobbyists for the financial services industry are also extremely powerful. There are reportedly four financial industry lobbyists for each politician in the house and the senate. The U.S. Chamber of Commerce, an anti-regulation group, reported spending $30.9 million on lobbying in the last three months, much of it on financial regulation, with major industrial and other corporations weighing in too, said the Global Association of Risk Professionals in an article. These lobbyists and the line that they feed the politicians ('regulation will kill this business') have helped to keep the lid on financial regulation since Glass-Steagall was abolished in 1999.
So, when you see the oil spill headed for the Gulf coast and wonder 'how can this happen?', picture a herd of lobbyists marshalled  to head for Washington, DC (beautiful image courtesy of Larry Tabb) armed with tens of millions of dollars. Picture the heads of these oil companies looking at their bottom line each year, trying to figure out how to make more for their shareholders. (There is really only one way - exploration and development, the rest is pocket change comparatively.) Remember hearing Sarah Palin screeching in her fingernails-on-a-blackboard voice that we need to 'drill, baby, drill.' Think of the pristine coastline of Norway and ask yourself whether that country would allow drilling if it did not have a disaster prevention/recovery plan in place. (It has an exhaustive plan.)
And when you hear anti-derivatives legislation voices raised from Washington (again with the 'regulation will kill this business', yeesh), remember where they are coming from. Wall Street's army of lawyers and lobbyists and even Warren Buffett. Yes, OTC derivatives regulation will cost them money. It will cost them capital. It will shrink profit margins. Boo hoo.
When you hear anti-regulation voices raised in the oil industry, much of the general public used to echo them. After all, who wants to pay $5.00 a gallon for gasoline? Why can't we drill and drill and drill until our oil is all-American, all the time (impossible, but hey why let the facts get in the way of a cause)? In the next couple of days you will see why we can't - when you turn on the TV. There will be birds and beaches and fish covered in oil, and livelihoods lost to the black gold.
Somehow in the pursuit of free markets, the interests of the few became paramount. The ones with the most lobbyists and the most money won, time and again. Because the politicians, who seemingly know nothing about anything, went along with it for their own self-interests (re-election). And now these same politicians are angry. They have been duped. They want blood. And both industries, oil and derivatives, will get their comeuppance in the form of draconian regulation. Free market proponents need to wake up and realize that free isn't always without cost.

Fiddling While America Burned?

Goldman Sachs is a trading company. It was set up to be a trading company and it remains a trading company. It goes long and short to make money, takes risks and mostly manages them pretty well. When the sub-prime damages began to be tallied in 2008, GS came out OK because it had shorted the market. Bravo, everyone said. Clever boys!
Then Washington finally got around to digging into the whole mess, and lit upon GS like a duck on a Junebug. Cries of "trading against The American People" rang throughout the country. Outrage ensued. Butts were hauled in front of a senate panel yesterday to explain why they were net short the mortgage market.
For several grueling hours in front of the panel, the poor mugs from Goldman Sachs' mortgage-backed market making desk tried in vain to explain how markets work. Although it was clear that Goldman Sachs' lawyers briefed their clients well, they were no match for the irate - if often ill informed - questioners. In the end, they had to answer some of the questions. (And Fabulous Fab, cool as 'le concombre', was the most forthright.)
But, as my Mum always told me, when someone criticizes you maybe they should take a look in the mirror. The senate is bashing a trading company (turned investment bank) for packaging, selling and buying instruments that the government itself allowed - even encouraged - to exist. There were no regulators screaming about sub-prime mortgages until it was too late. "Free markets" was the term bandied about with absolute certainty during the years after Glass-Steagall's demise. 
After the dot com bubble burst, the government was thrilled to have a new bubble to take people's mind off it. The housing market. The similarities are remarkable. When I started writing about dealing room technology in 1999, there were over 1,200 companies in London that were on my 'talk to' list. After the dot com bubble burst, there were about 12. Before the bubble burst, I remember hearing people say it would never end. That technology stocks would go up and up forever. They didn't, of course.
When I moved to the US in 2003, it was clear to me that the housing market was overheated. But everyone kept saying it would never go down. Look at all the Baby Boomers that have to buy retirement property or second homes, they said. Even the most sophisticated investors believed it, clearly. Five years later, the market collapsed. And the traders that were taking advantage of people's naiveté were both buying and selling instruments based on the very mortgages the government had encouraged.
GS happened to be net short at the time. Whether by design or by accident, GS was not fiddling while America burned. It was simply trading. Today Goldman Sachs must be wondering whatever possessed it to get into investment banking. And to go public with an IPO. I would be absolutely astonished if the powers-that-be at Goldman Sachs were not currently investigating the quickest path back to partnership.

Regulating OTC derivatives will take more than clearing

I tend to be a pro-regulation kind of person. I agreed with President Obama when he said last week that a free market was not supposed to mean free license to take whatever you can get, however you can get it. (Clearly he has not met many traders.)
But the recent hue and cry over OTC derivatives regulation is beginning to annoy me. It appears to be a battle between clearing houses, which stand to gain a LOT if the bulk of derivs have to be cleared, and derivatives traders, which stand to have to PAY a lot (and maybe stop inventing stuff that can't be cleared).
I do believe that OTC derivatives need regulating, and not just because they have attracted a lot of unwanted attention recently. Credit default swaps were one of the culprits often blamed for the credit crisis and for bringing Greece to its knees. And CDOs made the mainstream press (for probably the first time) after one of Goldman Sachs' CDOs was fingered by the SEC last week.
Warren Buffett was right to call them "financial weapons of mass destruction"  seven years ago. Not because of the instruments themselves, but because of their enormous growth rate and lack of transparency. CDS took off at light speed: when the International Swaps and Derivatives Association began surveying volumes in 2001, CDS volumes were $631.5 billion. At the end of 2007, 8 months before the credit crisis exploded, they had reached an unbelievable $62 trillion. (Can that really be 9,999% growth? Geeks, please help.)
Processing them was a tedious and mostly manual effort, and was falling so far behind that if anyone defaulted it sometimes took months to figure out who was owed what. But, while a heroic effort by ISDA and an industry working group automated the processing as best they could, the risk associated with CDS and other OTC derivatives was soaring.
Think about it. In the late 1990s/early 2000s traders were still using Black Scholes models and (mainly) individual spreadsheets to calculate their positions. Risk management was a back-of-the-envelope process for the most part, or was partially manual with clerks entering trades into one of the new-to-market risk solutions.
When the enterprise software boom took hold pre- Y2K, major investment banks had to migrate thousands upon thousands of these spreadsheets onto internal platforms. Risk management systems were asset class related therefore risk was managed in silo fashion, with little cross pollination. In the meantime, banks, traders and quants were breeding new instruments like flies. Risk was bubbling furiously under the surface and no one knew it.
Technology is catching up with OTC derivatives, but simply throwing clearing at them will not solve the problems. Complex instruments need to be automated and risk systems must make the downside more transparent, using strenuous stress testing under doomsday/Black Swan scenarios. Capital requirements should go hand-in-hand with the stress testing, i.e. if the worst should happen there is enough money in the bank to pay the bill.
Mandating that OTC derivatives go through the clearing process is a step toward transparency, true. But I worry that the clearing houses themselves are biting off more than they can chew. How many can handle trades that have the potential to double each year in volume?
Also, I know the beast (trading firms), and they will figure out ways to get around it.

Timing is Everything

As the storm clouds gathered over Washington, D.C. in the run up to the battle over financial regulatory reform, a little ray of sunshine peeked out and shone on President Obama and his band of reformers. The SEC nailed the Big Kahuna, the Vampire Squid, the biggest swinging Mickey of them all for fraud - Goldman Sachs.

The beauty in this is in the timing of the announcement - a ringing endorsement for regulation and oversight on the virtual eve of the battle to get the reform bill through Congress. It is difficult to tell your constituents that you are voting against financial reform when they can read in the papers that yet another bank was involved with fraud. It also dovetails nicely with the SEC's quest for additional funding.

The charge against Goldman is, of course, serious. A GS vice president (a Frenchman - perhaps channelling Jerome Kerviel?) structured a sub-prime portfolio on hedge fund giant Paulson & Co's advice, which Paulson then promptly shorted against. The bottom line is, however, not so serious. GS will get slapped with a fine and might have to make some of the investors whole, but that is chicken feed for the bank. (If it remains a civil crime that is. If the Department of Justice gets involved, it might open a different can of worms.)

Paulson comes out of it looking less like the genius that predicted (and cashed in on) the financial crisis and more like a criminal mastermind who found a willing patsy. The hedge fund shows the world exactly how far some of them will go to make the returns their wealthy clients demand. (Which reinforces the regulation of hedge funds too.)

Goldman's Fabrice Tourre (who called himself "Fab" in an email) comes out looking like a sap. I wonder how much Goldman could have been paying him if he was that motivated to break the law. I guess keeping up with the Joneses in Tribeca is a seriously expensive endeavor.

Nabbing Goldman Sachs is a shot across the bow to those Congressmen who thought the regulations we had worked "jus' fahhhn." They did not. But Congressmen are under almost unprecedented pressure from Wall Street lobbyists. There are reportedly four financial industry lobbyists for each politician in the house and the senate. Larry Summers said in an interview that the lobbyists were spending on average $1 million per Congressman.

The crux of the matter is capitalization. Capital requirements have to be raised in order for Wall Street to be able to bail itself out next time. The trouble is, Wall Street does not want to waste good trading money by keeping it in the bank (especially if they pay themselves the same crappy savings rates the banks pay us).

So those Congressmen on the Wall Street side might have to step into the middle of the road before the upcoming vote. Their constituents may be able to see the picture a little bit more clearly now. The government gave Wall Street a bucket load of money, which was spun into golden bonuses. For Wall Street. And all the while it was smiling and nodding and "Three Bags Full"-ing, and continuing to rip the faces off investors.

Critics of the financial reform bill are already screaming that you can't legislate against fraud. That may well be. But you CAN find the fraudsters and nail them as long as the regulators have the authority and the tools to do so.  The SEC is doing better all the time, but it remains seriously underfunded. It has a big hill to climb and one showcase conviction is not enough. 

It Was Like That When I Got Here

The headlines in the financial press lately sound like a litany of Homer Simpson's three little sentences that will get you through life:

Number 1: Cover for me. (Citigroup to - allegedly - Oliver Wyman for recommending it enter into structured finance).
Number 2: Oh, good idea, Boss! (Alan Greenspan on how Congress would not have let him put the brakes on the housing bubble.) 
Number 3: It was like that when I got here. (Robert Rubin testifying to Congress about his time at Citigroup. )
I'd like to add my own little sentence to Homer's:
Number 4: "Everyone does it." (Repo 105.)

Citi entered into collateralized debt obligations for the same reason every other bank did - because everyone was making money on them. So what if a consultancy produced a study that showed that CDOs were as harmless as fluffy clouds and could make a shed-load of money? Shouldn't the bank have done a little due diligence before jumping in? Blaming (allegedly) Oliver Wyman is shooting the messenger.

Alan Greenspan - had he read the foreign press - should have known full well that the US government was creating a housing bubble to replace the burst dot-com bubble. Money had to go out of consumers' pockets one way or another in order to support the economy. Buying and fixing up houses is one very efficient way to spend a lot of money. He is right not to allow Congress to throw him under the bus, but he should have been a lot tougher with them at the time. If indeed he suspected there was an issue.

Robert Rubin, became a 'senior advisor' at Citi after he had systematically dismantled Glass-Steagall, which gave Citi and others the chance to dabble in investment banking (read: trading). After receiving over $125 million in total over 8 years to 'advise' Citi, he told Congress that he was not responsible for looking at Citi's activities with any real 'granularity'.  Eek. What exactly was he looking at then? (He could also be compared to Sergeant Schultz in Hogan's Heroes: "I know nothing! Nothing!" )

The Wall Street Journal on April 8th reported that most of the major investment banks had masked their debt levels, hence risk exposure, by using repos. Shock, horror in the financial press. How could this have happened without us knowing? Hellooooo. End-of-year balancing is rife for trading companies, whether they use repos or stuff things off-balance-sheet or roll positions forward. One way or another they will boost the coffers for bonus calculation. (Haven't they ever met a trader?)

Whatever happened to accountability?

BTW, Goldman Sachs is channelling Lisa Simpson instead of Homer. Accused of 'betting against its own clients' it stood firm in its annual report by defending what it did as normal trading practices and hedging. Which is true. But a few clients might have stepped in the way when they shouldn't have and got burnt.
As Lisa said: "You can't create a monster, then whine when it stomps on a few buildings."

Parlez Vous la Regulation?

You know you are doing something very wrong in the global financial arena when the French have to tell you how to fix it.  France is not exactly a powerhouse in financial markets, despite its attempt to lure investment banks and funds from London to La Defense.  Yet the vertically-challenged Nicolas Sarkozy came to Washington this week and let it be known that the United States is not doing its part to reform regulation. Hinting strongly that Washington cannot run the world on its own, he urged the Obama administration to work closely with France and the G20 in regulation reform.

Meanwhile a senator from that Mecca of financial markets - Tennessee - has thrown his toys out of the pram and is threatening to jeopardize reform.  According to the Wall Street Journal, Republican Senator Bob Corker said Tuesday he "absolutely cannot support" a bill written by Senate Democrats to overhaul financial regulations unless changes are made. (He is clearly not a "corker" in the English slang sense - i.e. an excellent and outstanding thing or person.)

I wonder if Senator Corker ever reads the financial press. If so, he might have come across reports yesterday on the real cost of the financial crisis. Speaking at the Institute of Regulation & Risk, North Asia (IRRNA), in Hong Kong this week, Andrew Haldane - the succinctly titled executive director for financial stability at the Bank of England - called the banking industry a 'pollutant' where systemic risk is the byproduct.

Them's fightin' words to U.S Republicans, seemingly bent on supporting the banks in their quest to dominate the world - unfettered by rules and regulations. This shot across the bow was accompanied by a breakdown of the actual cost of the crisis, or "the $100 billion dollar question."  

According to Haldane, the approximate outright cost to the US government (and taxpayers) of the financial crisis was about $100 billion. So far, so what? This is less than 1% of GDP.  The kicker here is that, as a result of the crisis, world output in 2009 "is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis," said Haldane. To the tune of output losses of $4 trillion in the US alone. Moreover, he said that some of these GDP losses are expected to persist and may even be permanent. If this is the case then the $4 trillion will be an understatement.

Doing nothing is not an option - $4 trillion is not chicken feed and if it were to happen again I fear financial Armageddon..... Republican naysayers will have to pitch in with concrete ideas that support financial markets reform. Otherwise the French and the rest of the G20 will make the US government look weak. Like it is enslaved by its banking giants.

Using Technology to Detect Insider Trading

There is a very fine line between insider trading and informed trading. A trader is supposed to gather all of the information he or she can in order to make decisions that make money - either for the company or for the investors. Often times that information comes from a seemingly innocuous comment overheard at a cocktail party, or even from a speaker at a conference. For example, in the oil business it is not unusual for a trader to hear at the weekly booze-up (oops, I mean business lunch) that his colleague's oil company has a refinery problem. If the trader goes back to work and trades on that information before it is known to the press and the outside world, is that insider or informed trading?
I once went to a conference where a software company that provides solutions to a mobile phone company told us that the mobile phone was selling like hotcakes in Europe and Asia and that the company was going to have a very good year. I bought shares in that company (although, being the worst trader in the world, by the time I bought them it had already hit its all-time highs and I ended up getting slaughtered). Was I guilty of insider trading? What about others in that room, those who maybe did go back to their offices and buy the shares (in far greater numbers than my paltry 20 shares)? Were they guilty too?
The line begins to become clearer when the activities that can be construed as insider move markets. Once those markets are moved, and it becomes clear to regulators that something funny was going on, it is a question of careful forensics to sift through whatever evidence they can find.
The SEC and FSA have been very busy of late doing just that - sifting through evidence and nailing criminals. The SEC found a high-ranking UBS investment banker was tipping off his buddies about health-care mergers over 2005-2009 using emails with code words like 'frequent flier miles' and potatoes (or something). The FSA, with the help of the police, just dug up a ring of up to 11 bankers and hedge fund traders, including Deutsche Bank, Exane and Moore Capital Management, who had been reportedly front-running block trades.Also in London a whistle-blower chastised the CFTC for not following up on his tip (in November 2009) that JPMorgan was manipulating the gold market there.
The pattern that is emerging in all of these investigations (or lack thereof) is that the crimes are being detected well after they happen. There is a reason that insider trading and front-running and market manipulation still goes on today - because people can make money from these practices. And the likelihood of getting caught is very small indeed.
Hector Sants, the outgoing CEO of the FSA, said that the regulator would be implementing an intensive supervisory model, which should make people "very frightened" of the FSA, according to the Economist. I think he was alluding to tougher cell-phone and email monitoring, which is what caught the most recent scoundrels. What would really make the wannabe inside traders tremble in their boots would be if the FSA, SEC and CFTC installed market surveillance software. Surveillance software can detect market anomalies and abuses as they happen, not after the fact. Using this kind of software, inside trades and market manipulation can be tracked down by compliance managers before the traders get to finish the deals. Position limits, such as those that were manipulated by Jerome Kerviel at Socgen in 2008 and hiding losses of nearly 5bn euros, can also be monitored real-time and alerts sent to managers to tell them when something fishy is going on. Fat fingered trades can be spotted and caught (and hopefully unwound) before they are settled and cause a firm big losses.
So the question is - why don't the regulators use this kind of software? Maybe the US Congress should think about adding a mandate to do so to the financial regulation reform bill. Then rogue traders would be afraid, very afraid.

Give the SEC the teeth to stop fraud

That Lehman Brothers had hidden its dire financial situation with the aid of accounting tricks is no surprise. Banks, trading companies and even Big Oil and Big Car have been doing this for years. Lehman was special in this, however, as the size of the losses was of such a magnitude that they nearly wiped out several other banks and helped to take down the global economy. Enron looks pale in comparison (and its execs went to jail). That Merrill Lynch staffers had spotted Lehman's trickery and grassed them out to the SEC is a surprise. Most banks tend to collude, or at least ignore others' peccadilloes with a nod and a wink, when it comes to the little tricks that keep them cozy with their shareholders. That the SEC somehow failed to grasp the significance of the so-called Repo 105 accounting practice is the biggest surprise of all. After the Bernie Madoff scandal, the SEC had a lot of explaining to do to the American public, and to the government. It went hat in hand for a bigger budget in order to hire experts to help sniff out and nail financial fraudsters. And got it. The task at hand now is to figure out how to hire people who actually understand the very things the SEC is supposed to be nailing people for. One idea is to hire outside firms with the expertise.
Last year in an article for Financial News, I wrote about the possibility of regulators cracking down on hedge funds and making them more transparent. At the time I spoke to former Securities Exchange Commission chairman Harvey Pitt, who is now CEO of business consulting firm Kalorama Partners. Pitt said that what needs to be done about hedge funds had already been laid out in an SEC request for comment in 2003: Data about hedge funds' activities should be available to regulators, and the SEC's concept of examination and inspections needs to be changed. Pitt said: "It is not structured to succeed."
Further, Pitt believes that all portfolio managers should be required to allow (and to pay for) a regular independent examination by a company that it has no relationship with. These independent examiners would then give their report to the audited entity as well as the SEC.
This tactic would work well for the whole of the TBTF businesses in America. There are independent firms out there including one run by ex-FBI agent Ken Springer - Corporate Resolutions. (Inexplicably, Financial News cut this part of my story - and I think it was the most important angle.)
Springer said: "Investors need to re-claim confidence and more regulation alone will not necessarily do it. Often, things fall through the cracks and investors need to take more pro-active steps." He advises conducting independent onsite financial due diligence with comprehensive background checks, and implementing an ethics hotline where employees, accountants, prime brokers, fund administrators can anonymously report wrongdoing to an independent third party.
Springer said: "Managers can hide trades or have brokers eat fees to boost the fund's performance. Up to now fund managers have resisted this enhanced transparency. Now they may have to do this as a condition of investment. The bigger funds won't want to, but the smaller ones will jump through hoops to get investors. Investors bring us in as part of due diligence."
The answer to a Lehman- or Enron-like conspiracy to bury bad news is twofold. Give the regulators the power to hire outside experts, and the power to insist on their use. Having the staff, the money and the will to investigate and find fraud is one thing. The SEC needs to have the power and the authority to go into these companies and actually do it.

You Put Your Right Foot in, You Put Your Right foot Out....

The US Congress and Senate appear to be doing the Hokie Cokie with the law these days, particular in the case of Chris Dodd's financial reform package. Put in an independent consumer protection agency - then take it out and give it to the Fed. Take out the Volcker Rule, then put it back in. I guess this is US politics at it worst. Water down the original concept so much that neither party can object to it (except the most extreme right or left-wingers), add a whole barrel of pork for each representative, and presto - instant crap. What I don't understand is how anyone can object to the consumer protection agency at all. It seems that Republicans think most people are extremely intelligent beings that completely understand if they are a day late paying their credit card bills their interest rate will go up to 124%. Democrats, on the other hand, seem to think that most people are dimwitted idiots who will use a credit card until it is maxed out then complain that they can't afford to pay it back. The Democrats are actually closer to the truth. So why are Republican politicians working so hard to knock it out of the financial reform bill? It can only be because the credit card and mortgage companies are lobbying them so hard they cannot resist the pressure.
The Volcker Rule debate confirms that Democrats think people are stupid. At first Dodd, a Democrat, took it out because it was too hard for his colleagues to understand it. Now I believe he has put it back in again precisely for that reason. His colleagues in the Senate will not be able to grasp the whole concept of separating out prop trading, despite hard lobbying from the bulge bracket, and will probably pass the bill in its entirety. Good plan.

Moral Hazard for Dummies

When I read this morning that banks want to take some of their taxpayer-fueled cash piles and distribute this as dividends or share buybacks, I saw red. Luckily regulators did too and stopped them. For now. It is obvious that the same banks that led to the current recession, and the biggest financial crisis since the Wall Street Crash of 1929, are once again courting shareholders in order to line their own pockets. CEO's that took massive pay cuts (again to placate shareholders) have had enough of their $1.00 annual salaries. In order to get back on the gravy train they have to convince shareholders that all is well. And maybe this is true, but I think it would be wise to take the billions of dollars of losses and write-downs from the property market crash before distributing any cash.
It seems to me that despite all that has happened to the world's financial markets and economies, little has been done to address moral hazard. Moral hazard remains the biggest risk to stability and recovery, and continues to run unchecked. Call me a hopeless optimist, but I was hoping that the US Congress at least would grow some balls and push out sensible regulatory reform. And then I thought, maybe no one really understands just what moral hazard means. Maybe the powers-that-be believe that "the markets" can sort themselves out, and let the buyer beware. So I thought a little primer might be in order to try and educate our politicians about the beast known as "the financial markets". (As I shamelessly cadge the For Dummies style, I beg the brilliant and totally cool Wiley Publishing not to sue me.)

Moral Hazard for Dummies

Understanding Moral Hazard - Moral hazard is what happens when someone (let's say a trader) who is insulated from risk behaves differently than he would if he were fully exposed to the risk. In other words, he believes that his short-term bonus will be bigger if he takes on a larger long-term risk. He tells himself that he will probably be working for another bank  by the time he is rumbled anyway (i.e. when the longer-term risk fails to pay off). He has nothing to lose personally, and everything to gain.

Making Moral Hazard Simple 
Derivatives trader - I just sold an unbelievably complicated interest rate swap to some idiot in Umbria. She thinks it will save her town from having to shut down schools and turn off the power. What she doesn't understand is that in order to keep from having to pay me off when it goes wrong, she has to keep paying me off. Win/win! It looks fabo on my P&L. (Anyway, what does Umbria need with electricity? The hospitals probably have generators, right?)
Oil trader - Obama is really getting hot under the collar about Iran's nuclear program. The authorities are leaning on us to stop selling them gasoline. But the margins are terrific. John -you like the beach, right? Take the next flight to Dubai and open me a little shell office. We can use that to keep selling gasoline to Iran and no one will be the wiser! A little bizzo in the morning and the rest of the day to sun yourself!
Executive of a bank -  Our share price still sucks and the Board meeting is coming up next week. I can't live on a dollar a year for much longer, I need a new carriage house. George, what can we do to make people think we have recovered from the downturn? Never mind the mortgage write-downs, those are for next year! Have corp comms leak it to the press that we are sitting on a mountain of cash and that we might institute a share buyback program.

Do's of Moral Hazard

• Do regulate derivatives - beyond central clearing and making them trade on exchanges. They should NOT be a "buyer beware" product. 
• Do regulate banks the Volcker way - take away prop trading, hedge funds and private equity.An instant reduction in temptation and moral hazard.
• Do monitor oil markets - they are getting away with murder because you can't be arsed to upset the oil lobby. 

Don'ts of Moral Hazard

• Don't leave the banks to make their own rules.

A Leopard and His Spots

Saturday's Financial Times had an article about London's cab drivers, saying that they need to go to 'customer relationship' courses as well as learning The Knowledge. It suggests that the cab drivers are too talkative and insensitive to those passengers that prefer not to chat. Now I am as antisocial as they come, being a good New England Yankee, but I beg to differ. Even a perma-grump like me (when I lived in London that is - I blame the severe lack of Vitamin D due to almost no sunshine) likes to chat to a London cabbie. They are funny, knowledgeable about all that is London, and mostly harmless. Many a late night they would pour me out of the cab and wait on the curb while I let myself into the house. One kindly driver, when learning that I was moving to New York City, helpfully advised me never to use the "C" word when swearing in America. Most cabs today have a speaker system anyway, and you can switch it off if you don't want to chit chat. But what would London be without chatty cabbies? They should not change - nor will they.
Talking about leopards and their spots never changing leads me to today's FT. The front page tells us that oil trading companies have "quietly" stopped supplying petrol to Iran. The paper says this is a clear sign that Washington's efforts are paying off.  Of course they are (sarcasm alert). The naivete of some journalists (and obviously politicians) makes me want to scream. The "small Dubai-based and Chinese" companies that are reportedly replacing the US/UK/Swiss trading companies as suppliers to Iran will be backed by the very same suppliers which are claiming to be getting out of Iran. The profit margins on supplying petrol there are simply too high to lose. This is how it has always worked, and I can't see it changing anytime soon. Ask any London cabbie, he will back me up.

The 51% Rule of Trading

An oil trader friend once told me that his job was to make money 51% of the time. That way he would probably keep his job and his employer (an energy division at an investment bank) would be happy. If the 51% rule is the standard for traders then Goldman Sachs has nailed it. It made over $100m in net trading revenues on 131 out of 263 trading days in 2009. It lost money on only 19 days. Total earnings of more than $13bn came from net revenues of $45.2 bn that more than doubled the previous year's.
To make these record earnings Goldman Sachs also took on more risk. In VaR terms, the bank said it estimated the most it could lose on any given day was $218m, compared with $180m in 2008. The bank also noted in its financial statement that reputational risk (i.e. bad PR) might be a negative factor going forward. I'd say that if taking on more risk against the government's wishes and spinning it into gold while weathering some of the worst PR Goldman Sachs has ever had creates a profit of $13bn, then they are doing something right. The traders' jobs are safe - for the time being.

Florida Bound

I'm off on a week's holidays tomorrow - to the Sunshine State. I never thought I would say this, but I am seriously thinking of buying a place in Florida. New England winters get harder to take all the time, and the choices of destination with sunshine, warmth (after a fashion) and cheap direct flights under 3 hours are few. The Caribs is 5-6 hours and expensive. I don't fancy Arizona. California is as far from here as Paris (and frankly Paris will always win even if it is cold). So Florida it is. The real estate market there has plunged to a level where it is beginning to look attractive. A two-bed, two bath condo in the Tampa/Clearwater area can be had for less than $100,000 US. I saw a very nice one today for $65,000 - a two bedroom, 2.5 bathroom 1,100 square foot townhouse. That is only about 40,000 pounds - 48,000 Euros. Do you know what 40,000 pounds buys in England? A garage in Chiswick - maybe. In Paris? Nothing. Really - nothing. My son's rented chambre de bonne - a studio converted from a maid's room - is worth 78,000 Euros.
And since the cold winters they have been having lately in Europe might convince them to start looking for places in Florida, I want to get ahead of the game. Florida won't be the beginning of the recovery in the property market, it will probably tag along at the end of it, but cheap is cheap. See you in a week!

Party Political Broadcast

I rarely comment on American politics but a headline in today's Financial times prompted me to venture into this murky (and largely uninteresting) territory. I remember watching TV as a kid when suddenly a commercial would pop up and a man would say "The following is a party political broadcast." Screams of dismay would ensue and my siblings and I would run to the kitchen for a snack until it was over. It was invariably some party drone refuting what some other party drone said about him or her and went on for what seemed to be hours. That said, it was the only time I had to be exposed to politics unless I went looking.
Today's media, which treats national politicians like rock stars, shoves the stuff down our throats 24/7. Politicians have become stone figures cast in the form of their party's image (read 'spin') and their utterings and policies rarely vary from the PR dogma. One party's depictions of the other party is also mostly unchanging from year to year, century to century. But today when I saw the FT I had a sinking feeling that our politicians were really not paying the slightest bit of attention to the world outside their little bubble. And it now seems that they are once again going to bend to the special interest groups - this time to derail financial markets regulation.
The FT said: "Republicans are opposing a plan to impose tougher capital and liquidity requirements on companies that pose a risk to the financial system." My God, but their memories are short. Investment banks that were leveraged 30 to 1 debt to equity (some were thought to be as high as 60 to 1) nearly brought the country and the world to its financial knees.
Further: "Republicans say they are unconvinced that any regulator can even define systemic risk. They are happy to set up monitoring of possible bubbles but say the whole concept is too vague for an immediate introduction of sweeping powers." At the risk of sounding like John Cleese in Fawlty Towers - Too vague? Too VAGUE?! Was the demise of Lehman Brothers, Bear Stearns, and nearly AIG too vague a concept? Was the worldwide credit crunch and recession and loss of gazillions of jobs too vague to grasp? Call me gobsmacked. And it isn't just me. Former Treasury Secretary Henry Paulson sees it too. He writes in today's New York Times:
    "Congress must pass financial regulatory reform. Delays are creating uncertainty, undermining the ability of financial institutions to increase lending to the businesses of all sizes that want to invest and fuel our recovery. Our overriding goal in restructuring our financial architecture should be that taxpayers never again have to save a failing financial institution.
    This calls for two vital changes. First, we must create a systemic risk regulator to monitor the stability of the markets and to restrain or end any activity at any financial firm that threatens the broader market. Second, the government must have resolution authority to impose an orderly liquidation on any failing financial institution to minimize its impact on the rest of the system.
    Together, these two reforms will enable the regulatory system to better prevent the kinds of excesses that fueled our recent crisis, restore market discipline and keep the failure of a large institution from bringing down the rest of the system."
Thankfully there is a logical voice of reason shouting through the gloom that is our American political system. Henry Paulson was there when it happened. He saw how the system failed him and his colleagues, who had to do the best they could in a terrible situation with a total lack of tools at their disposal.
It is time to tell Congress and the Senate to butt out and listen to the experts. Politicians are not experts in anything apart from party dogma and good hair.
Senator Evan Bayh from Indiana said it best when he quit his job yesterday: "...I do not love Congress.....There is too much partisanship and... too much narrow ideology in Washington, even at a time of enormous national challenge, the people's business is not getting done."

Lessons Not Yet Learned

As it is a holiday today in the U.S., I took the latest copy of the Economist to the gym and read it on the treadmill (as you do). I was particularly interested in the special report on financial risk. The Economist is not a usual source for articles about risk and risk management, but I have a great deal of respect for the publication. But I must say this report stunned me silent (for a minute). Warning about asset class silos and the challenges of enterprise risk management has become one of my specialty subjects (where is Chris Tarrant when you need him?). If you took every article that I have written for Financial News and Traders Magazine and Securities Industry News about moral hazard and risk and financial markets over the past three years or so and threw them together into one - this would be the Economist's article.  One particular article that I wrote in Financial News in December of 2008 pointed out that financial firms had been using VaR incorrectly in the years leading up to the financial meltdown: "Failure of risk management strategies proves Murphy’s Law is alive and well". In it I said: "Valuation models such as value-at-risk were overused or not updated when market conditions changed."
According to the Economist this still holds true today. Shock, horror. Not only that, but they still have not figured out stress testing and continue to be stumped as to how to manage risk across the various asset classes. The Economist's article said: "Two-thirds of the banks surveyed said they were only partially able to aggregate their credit risks." Call me naive but they knew this ten years ago, and the whole trend toward enterprise wide risk management was in response to this issue. Technology to aggregate, analyze, display, signal and manage risk across product silos is exactly what enterprise technology is about, and it has improved by a billion gazillion percent since the first, tentative platforms.
I can only hope that in seeing an article of this granularity, dumbed-down for the masses, some simple risk manager is reading it while he is on the loo. Maybe the light bulb will be illuminated in his poor, addled head and he will say to himself, "Oy. That Economist might have something there. Maybe VaR is not enough. Maybe I should look at - uhhh - operational risk! And liquidity risk! And moral hazard risk (or not, the boss would HATE that)."
What I wrote in Financial News sums it up: "Anglo-Irish author and philosopher Edmund Burke said: “By gnawing through a dyke, even a rat may drown a nation.” By ignoring basic risk management tenets, investment banks and other financial institutions failed to manage credit risk, which turned into market risk which turned into liquidity risk and ultimately systemic risk. They took down not only themselves but global markets.