Monday, March 23, 2009

Should banks and hedge funds be permitted to contribute to volatility of markets?

Forget the phony outrage about Wall Street bonuses. The real villain, to my mind, is the extent to which the big banks and hedge funds are permitted to contribute to the volatility of markets rather than requiring banks to actively seek to moderate volatility. Specifically, all of the big banks, especially those that were formerly Wall Street investment banks, operate in-house proprietary trading desks that seek to take a cut of market volatility, including the stock market, bond market, foreign exchange market, and commodities markets. Many (most?) hedge funds do the same. That by itself is no harm to markets if done on a small or modest enough scale, but with so many large players so active in the markets it is inevitable that many of those seeking a cut of volatility are in fact dramatically increasing volatility. More than simply taking a small cut of the markets, they are becoming the markets and even small "adjustments" by them can cause major market moves.

Increased volatility of markets has four harmful effects: 1) markets move up faster than they would otherwise, 2) markets move down faster than they would otherwise, 3) markets reach much higher peaks than they would otherwise, and 4) markets reach much deeper bottoms than they would otherwise.

Higher peaks, especially in commodities, mean higher inflation.

Lower bottoms, especially in stocks and bonds, reduce household wealth and restrict business investment. In extreme cases it can cause deflation as well.

To be clear, I would not propose that we seek to restrict markets from functioning normally and properly, but simply that we prevent "hot money" from major banks and hedge funds from artificially manipulating markets in a way that increases volatility and distorts the true value of assets.

Exactly how to regulate the major banks and hedge funds from "becoming the market" would be a matter of great debate, but the basic concept would be to funnel records of all trades through a central clearinghouse and subtract out all of the bank and hedge fund trading to determine the size of the normal, "organic" market for any security or basket of security, and limit total bank and hedge fund trading to be at most a small fraction of the normal, organic market. Maybe that fraction is 5% or 10% or maybe only 2% total across all banks and hedge funds, but it simply cannot be allowed to be 1,000% or any large multiple of the underlying organic market.

As a specific example, the futures market works best when actual producers and actual consumers are the primary sellers and buyers of futures contracts. Banks and hedge funds can reasonably take the other side of a legitimate transaction by an actual producer or supplier, but non-producer and non-consumers should not be permitted to "make" a secondary market priced separately from what actual producers and actual consumers are willing to offer and bid. Wall Street should not be permitted to "drive" commodities prices. Unlike stocks and bonds, commodities are the "real" economy and should not be subject to speculation beyond that offered by actual producers and actual consumers. Regulations should be clear that commodities themselves (as opposed to production and distribution of them) are not a legitimate form of "investment." Excessive hording or dumping of commodities is not a valid function of any bank. Hedge funds should indeed be permitted to "hedge", but only to the extent that they are not distorting the underlying organic markets.

One additional form of regulation would be to ban banks from making "trading calls" where they indirectly manipulate markets by advising their "clients" to buy or sell selected securities on a short-term basis for short-term gain. Obviously we can't legislate free speech, but we can put a ban on the financial equivalent of screaming "Fire!" in a crowded theater, as well as the flip side of yelling "Gold!" to kick off a rush into a market.

The ultimate goal is simply that we prevent the banks and hedge funds from "becoming the market" or otherwise manipulating markets.

There is no need for an outright ban of short-term trading, simply that normal markets be permitted to function normally ex the banks and hedge funds.

Of course, we also need to keep a watchful eye on mutual funds to be sure that they do not suddenly become a new hotbed for hedge fund-like hot money trading.

The bottom line is that the bulk of Wall Street needs to shift away from its current short-term trading mentality and back to a focus on long-term investment.

The real economy needs Wall Street to support real, long-term investment. The real economy does not need Wall Street to profit from disasters of its own making.

-- Jack Krupansky

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