So listening to some of GS testimony yesterday -- it becomes clear where the new financial regulation should focus: Market Making.
Mr. Volcker, of course, led the idea of banning proprietary trading at banks/i-banks. But I think that he really meant market making.
Please consider:
- GS listens to clients, and potential clients tell them how much they want to buy/sell and at what price (with particular access to larger "block" trades).
- In more complex transactions, like derivatives, clients tell them about their portfolio and how they may want to adjust the risk profile of such portfolios.
- GS gathers all this information -- and under the "guise" of internal risk management -- determines key trends, anomalies, the smart, and the stupid in the market place.
- Armed with this information, GS will broker trades and, when profitable, take one side of the trade for its own account (in the name of market making). And many would say that a "tip" from an influential GS trader can move the markets -- another convenient tool in profitable market making (If GS wants to unload a bunch of MBS, it can spread tips on how great this stuff is so that GS can get a good price).
- It seems to work well -- GS seems to represent half of the profits made on Wall Street from proprietary trading (I would guess that much of this flow through market making).
Perhaps there are issues of disclosure, very much one-sided information, insider trading?, ethics, laws?
As we all know now, this all intensified in the last 15 years when GS (and others) bought up market makers, became an exchange unto themselves, and raised capital to replace third-party counterparties to market making activities. Mr. B has said that it was a matter of survival -- well it clearly worked.
As most know -- these changes coincided with the shift in power at i-banks from the investment bankers to the traders/sales departments. It would seem that there was a shift from clients first to . . . survival.
The U.S. must have the support around the World for effective reform. Korea, in its leadership of financial reform in the G20, must consider a separation of broking and market making. Exchanges and interdealer brokers (that trade on a no-name basis) became overwhelmed by the "too big to fail" financial institutions and investors.
There seems to be grassroots/populist lobby, the banking lobby -- but where is the institutional investor lobby? Perhaps they are embarrassed that "sophisticated investors" have so long been taken advantage by their trusted advisors and trade execution providers. I would guess that real financial reform will happen when the institutional investors say -- enough.
