I been in the right vein. But it seems like the wrong arm. I been in the right world. But it seems wrong, wrong, wrong, wrong, wrong.
-- Dr. John
At a visceral level, the impersonal “invisible hand” of markets should find an easy partnership with the relentless efficiency of modern communications and computing technology. Financial markets might be expected to perform their theoretical disappearing act as technology increases financial efficiency. After all, banking and transactions costs are the financial analogs of friction in physics. Technological progress should relentlessly eat away at the profits of financial institutions.
As a generality, the evidence that this process is at work is substantial. Commissions fall. Cheap computers replace expensive traders and financial advisers. But the process seems to founder on the shoals of human morality. Both market practitioners and market regulators have found advancing technology presents surprising moral issues. It seems that markets can be hindered by both an excess and an insufficiency of ethical behavior.
The rapid evolution of financial markets has exposed a crippling inconsistency in stock and futures market regulation. Both important US market regulators, the SEC and the CFTC, have clung to the never-very-credible notion that for-profit exchange corporations can pursue profitability, yet simultaneously also take responsibility for self-regulation and for regulation of their clients, market users. The exchanges cannot do both.
Is self-regulation consistent with profit?
This regulatory paradox will ultimately enable the American exchange management firms – CME Group (CME), Intercontinental Exchange (ICE), CBOE Global Markets (CBOE), and Nasdaq Group (NDAQ) – to cross the regulatory SEC/CFTC divide. As these firms migrate into each other’s markets in search of profit – for example, all, save ICE, are in the hunt to trade cryptocurrency futures and ETFs – the walls between the SEC’s domain and that of the CFTC will crumble and fall. The result will be a regulatory and competitive melee. As with the previous regulatory debacle – the war between the SEC and CFTC over the regulation of derivatives markets – the humble trader, the markets’ customer, will likely be the primary beneficiary. The exchange management firms will be the big losers. But it’s high time. These firms are fat, complacent, cats, right now.
The two market regulators deal with the inconsistent exchange mission differently, but both fail. Why? The regulators have been influenced by the different priorities exchanges inevitably assign to their conflicting goals. The exchanges themselves cannot be blamed for assigning a higher priority to the profit motive than to self-regulation. The profit motive has become an existential matter for exchanges. No profit; no exchange. Self-regulation is inevitably political; a social motive; hence secondary to profitability.
The regulators, having presided over the creation of an unworkable exchange environment, can each take one of two paths. A regulator can enforce the rules, allowing the exchanges to fight it out for survival in cut-throat competition. Or a regulator can bend the rules, believing that protecting the exchanges from competing will free the exchanges to forego some profits to meet their self-regulatory obligations.
Both agencies have taken the easier path of bending the rules, failing to address abuses as the exchanges have gathered power. Both regulators have been captured by their regulated markets. And each market has taken advantage of the agencies’ decision, reaping monopoly profit; not self-regulating.
The building market regulatory crisis.
The original revolution in exchange trading, during the latter part of the 20th Century, was partly driven by the change in the economic landscape; partly, by the change in the technological landscape; partly, by human ethics or lack thereof.
First, the explosion in volatility across markets resulting from floating exchange rates, the creation of the London dollar deposit market, and OPEC, generated the rise of London and financial futures. Second, the internet created conditions for an explosion in trading efficiency – electronic trading. A third factor, human response to the dramatic change in winners and losers, not to mention the enormous increase in the magnitude of winnings, should not be minimized. The London dollar deposit market is self-destructing before our eyes, under an avalanche of corrupt behavior. This first technological revolution brought demutualization of exchanges, electronic trading, and OTC derivatives.
IEX and the death of LIBOR
A new regulatory crisis has arrived on the wings of a second technological revolution. At the nexus of high-speed data transmission and high-speed computers, we have reached the age of computer-driven finance. The once-populous trading rooms of financial institutions are closing, to be replaced by computer warehouses. And yet the age of the algorithm has proven creative of ethical dilemma too.
IEX is a new exchange that demonstrates, through its own self-defeating actions, how illogical a for-profit, self-regulating system of exchanges has become. IEX repeatedly demonstrates its sense of moral obligation to its trading constituency, at substantial cost to its ownership. IEX does this, first, through a few technological changes – the “speed bump” which slows incoming and outgoing IEX data feeds, and the “discretionary peg”, a means of pulling a pegged order in the presence of an unstable market – and then, second, through IEX’ policy of providing free access to its data and no fees for limit orders or for market orders.
Why self-defeating? Because these once-distinctly IEX rules all either discourage order placement and execution or reduce exchange revenues associated with execution. How ironic, that an exchange must deny its owners profits to meet its responsibilities to its customers! Were IEX to go public, it would very likely be met with a stockholder suit to be adjugated by the SEC. Such a lawsuit would put the SEC’s own conflicting obligation to assure exchange profitability while encouraging exchange self-regulation on full display.
In contrast to IEX’s commitment to its goal of meeting customer needs, with the side effect that stockholders lose profits, stands another market, the London deposit market, where bank traders have swallowed everything in sight until they consumed the market itself! Bank OTC traders, under a guise of creativity, have inflated the income from dealing with self-determined portfolio valuation and manipulation of the LIBOR rate. This market has fallen into such disrepute that the Bank of England (BOE) was placed in the uncomfortable position of requiring banks to submit estimates of the LIBOR rate. But BOE stopped short of requiring these banks to conduct interbank deposit transactions. The ultimate embarrassment was that BOE was forced to declare an end to its requirement to submit LIBOR rates, admitting that less than 1/3 of the LIBOR submissions are based on actual deposit transactions. LIBOR, once the world’s most important number, swallowed itself. This development has orphaned trillions in assets priced on a LIBOR basis, not to mention further trillions in Eurodollar futures and interest rate swaps.
Ethics in finance self-destructs. IEX, having chosen the moral high ground, daily loses business to its less virtuous competition. LIBOR, through its own corrupt behavior, embarrassed itself into oblivion.
An ethically compromised regulatory agency cannot produce a fair market. The agencies must abandon their protection of exchange profitability. Once this has been done, the ethically neutral forces of competition and technology will no longer present moral dilemmas. We will always need cops on the market regulatory beat. But the most sensational crimes of the recent past have been the side-effects of regulatory agency tinkering with the otherwise ethically neutral forces of competition.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.