Barking Up the Wrong Tree

After reading the news, participating in key industry conferences and doing some thinking, I’ve come to the following conclusion: the regulators – and Congress – are barking up the wrong tree. They would have you believe that the equity markets are rigged, retail investors are screwed and that the market structure is flawed. They would further argue that the equity markets are in need of dramatic new regulation, flash orders and high frequency trading are the root of all evil and that “dark pools” are something promulgated by Darth Vader. I have only two words to say to Congress, the SEC and the White House: Bull. Shit.

There are some problems to be sure, but they are not what the spin-meisters in Washington would have you believe…

Which markets stayed open for business every day in the teeth of the crisis? The EQUITY MARKETS. You know, the ones that are now in the cross-hairs of every member of Congress with a populist agenda in dire need of scoring points with their electorate. The markets that were virtually closed for weeks? The DEBT MARKETS, including the OTC DERIVATIVES MARKETS. Why was this the case? Uh, maybe because the equity markets are EXCHANGE-BASED and didn’t have BS entities called RATING AGENCIES that lobotomized decision-making and facilitated hundreds of billions to be deployed in assets investors didn’t really understand.

And which entities are receiving the most heat? The exchanges. The least? The OTC derivatives markets and the rating agencies. Why is this?

The exchange players have awful public relations. The come across as ultra-complex, technologically incomprehensible and in league with the reviled financial institutions and hedge funds. And clearly dark pools and high frequency traders fall into this category. Markets go up and markets go down. The main thing that matters is that they stay open, provide access to investors big and small and promote competition. The exchanges have done a masterful job of delivering on this for both institutional and retail investors. But Congress and the White House appear destined to focus on policies that ostensibly focus on the retail investor (though it is arguable as to whether the prescriptives will actually help; they most likely will hurt), though the retail investor has become increasingly less important in the overall scheme of the equity markets. Most retail money is handled through pension funds and mutual funds, effectively institutionalizing much of the potential retail flow. Further, the retail investor has never had better access or cheaper execution than they have today, yet the picture is painted that they are getting screwed at every turn. It just makes no sense.

In every era certain subsets of market participants made investments to gain an edge. Whether it was the stagecoach, the telegraph, cheap silicon, abundant fiber or co-location, innovators with capital have always sought to be one step ahead. It is this inexorable move towards better, cheaper, faster that delivers benefits to all, even if more benefits go to those who made the investments. Should the retail investor get the exact same execution as a smart algo that is the result of millions of dollars of development, leverages (and pays for) co-location and puts enormous amounts of capital at risk? Not in my opinion. If the ultimate goal is that every market participant, regardless of size, amount of investment or capital at risk is in the EXACT same boat, then we’ll see what happens to innovation: It will plummet to zero. The populist denizens in Congress and in the White House are pushing towards the lowest common denominator: mediocrity for all.

Why, oh why, haven’t the broken OTC derivatives markets and rating agency crimes been aggressively pursued by lawmakers and regulators? One reason: because they are far less sexy than the exchanges and don’t DIRECTLY impact the retail investor. Not too many mom-and-pops have purchased a 5 year GM CDS or stop by Moody’s for a report on the SocGen CMBS Non-Conforming Pool XII. They are far more likely to have a brokerage account, an IRA or a self-directed 401k. What’s more systemically important, banning “flash orders” or mitigating the counterparty risk associated with tens of trillions of over-the-counter derivatives contracts? We already know the answer, since Mr. Geithner and his friends did a back-door bail-out of Wall Street with taxpayer money via the AIG gift. This was due to credit derivative counterparty performance risk, friends, not because they had a lousy stock portfolio that they couldn’t liquidate. And why do rating agencies even exist? They have simply resulted in an abrogation of responsibility on the part of investors: THEY are the true WMDs, which is ironic considering Mr. Buffet’s long-standing position in Moody’s. Yet we seldom hear about this.

Sadly, we live in a world of sound bites, and Congress and the White House have found far better sound bites to attack the denizens of the equity markets rather than the derivatives and debt markets. And as usual, it will be this stupidity that will cost us all, except the Congresspeople who will have pandered to their constituents in order to get re-elected. Someday, perhaps, we’ll have a vehicle for measuring the efficacy of elected officials, not on the basis of success in getting their measures through but in the worth of the measures themselves. There will be many perceived winners when Congress and the SEC enact short-term popular and long-term stupid regulation that increases costs (including to retail) and stifles investment. Quite simply, they are barking up the wrong tree.

This is why I seldom blog anymore. Because just thinking about the irrationality and long-term consequences of this stuff makes me sick…

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