For some time, I have criticised the quantum and complexity of regulation. I now feel somewhat beleaguered, post the announcement of losses on hedging transactions at a major US bank. After all, many in the US are stressing the need for the Volcker rule to avoid such risks. Others even think that somehow trading should be done away with for the benefit of all mankind.
I am not sure if the Volcker rule would have voided the position – it appears to have been a hedge and not a pure proprietary trade. The latter is the focus of the Volcker rule. And I doubt that the abolitionists realise that trading in securities does benefit society. The problem is we are moving, in society generally, towards rigid definitions of right and wrong. Real life, even in banking, is much more complicated.
First of all I should be clear that I believe in strong regulation. The problem today is that we do not have that, we have chaotic regulation. Any global firm is regulated functionally and geographically, across similar products, by different regulators depending on the organisation structure of the firm. Chaotic regulation means that certain actions are permitted in some businesses and not others (i.e. the controls on the shadow banking sector are non-existent whilst those on mainstream banking have proliferated). Chaotic regulation means capital requirements, both in quantum and in computation, vary according to the geography of the regulated body (i.e. the planned diverse application of Basel 3).
The regulation the market needs is not more regulation but less regulation, clear regulation and applied regulation. Looking back at all the major problems of the finance industry of the last decade, none were caused by lack of regulation. They are mainly attributable to non-compliance with regulation or failure to follow the simplest of risk management rules.
Madoff was regulated, audited and approved; regulation failed, perhaps for understandable reasons, to identify that the funds were a Ponzi scheme. Long Term Capital Management collapsed in the late 90’s due to two fundamental errors – excess leverage and a belief that 99.9 per cent plus certainty meant total certainty. Those two elements were behind the collapse of Lehman, Bear Stearns and several commercial banks a decade or so later. The regulatory structure was often there to take action but no action was taken.
And the collapse of markets is not driven by hedge funds and proprietary traders. There are issues in respect of trading, but the fundamental cause of market crashes is not weight of money but unsound economic fundamentals. Where organisations corner markets (and attempts have been more common in commodities – tin, copper, silver – than financial markets), there is high risk and, in many cases, substantial loss as the perpetrators sought to unwind their long or short positions. If substantial positions are built up and then markets moved by associated rumour, there are regulations in place to take remedial action. Insider trading is also illegal. If markets are concerned that certain types of programme or high frequency trading could create false markets, there are easy ways, through most existing rulebooks, of taking action.
Trading has value as it creates liquidity. If there is no liquidity, issues would be at higher prices or higher yields. Corporates and Governments would pay premiums for funds. All appreciate that is not a good scenario; yet no one has yet identified an alternative way of ensuring liquidity.
It is possible that some believe in introducing restrictions to calm down markets. Unfortunately, all empirical evidence suggests that trading (which by definition is two way) is not the main cause of volatility. The main reason for market volatility is uncertainty in high risk periods or event risk (both positive and negative).
A recent review of the much maligned hedge fund market by the UK Financial Services Authority stated that “ the footprint of hedge funds within markets is generally small, when measured by the value of their exposures and by turnover, suggesting that, in aggregate, hedge funds do not have a major presence in most markets.”
The report, it is true, states that they do have a major footprint in convertible bonds, interest rate derivatives and commodity derivatives. However, the biggest risk mentioned was not leverage (around 2.5 times). It was not credit (average prime brokerage margin requirements are ten percentage points higher than pre-Lehman and excess collateral is near an all-time peak at 100% of the base margin required). The biggest risk was one shared with long only funds; liquidity risk in the event of material concurrent investor liquidations.
Paradoxically hedge funds, with their sophisticated investor base, can adopt liquidation firewalls much more easily than large retail funds.
As in all markets, a careful analysis is needed of the cause of risk. Otherwise more regulation will increase the cost of compliance without reducing the risk to investors. And on the trading side, regulators and legislators should be wary that an unintended consequence of their action is not reduced liquidity and increased cost of borrowing for governments and all.
John Gubert
Chairman Global Securities Services Executive Committee UniCredit