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Markets for the Digital Generation

A pretty provocative cover and leader from the Economist this week:

It is good that the world’s leading market faces competition; bad that it has done so little to confront it

NOT since the 1980s, when the nation was in a spin about the coming of the Japanese, has there been such anxiety in America over foreign competition. The familiar concern that China is going to steal the country’s remaining manufacturing jobs has been compounded by a newer fear: that Wall Street is losing its grip on the world’s money. Bankers and politicians worry that business will drain away from America’s capital markets to financial centres overseas, particularly London and Hong Kong. Several committees are sweating away on reports, the most important of which is to be published next week, on how to stop the rot. America’s treasury secretary, Hank Paulson, made it clear in a speech on November 20th that he shares their concerns.

Their analysis focused, like many commentators, on the suffocating and complex regulatory environment, culminating in the dubious benefits of the Sarbanes-Oxley legislation:

Regulators could also do with an overhaul. Here there are two problems, both serious. First, the Securities and Exchange Commission (SEC) is good at the tough stuff, bringing plenty of “enforcement actions”. But in its zeal to keep pace with crusading state attorneys, who exploit high-profile campaigns to win votes, it has lost sight of its other supposed goal—ensuring that markets run smoothly and efficiently. One way to address this imbalance would be to replace some of the SEC’s vast army of lawyers with economists. That would also lead to better cost-benefit analysis of new regulations—an area where the SEC trails behind Britain’s Financial Services Authority.

Second, the regulatory structure is too atomised. Too many agencies monitor the markets. There are four separate banking regulators. State and federal regulators tread on each other’s toes. The SEC’s duties overlap with those of the Federal Reserve, the Commodity Futures Trading Commission (CFTC) and others. Since it no longer makes sense for the increasingly entwined cash and derivatives markets to be policed by separate regulators, a sensible first step towards streamlining would be to merge the CFTC and the SEC.

I’ve been wondering now for several years when public awareness of the significant shortcomings of the US financial system would start to grow. To be perfectly frank, I’m somewhat surprised that - if the cover of the Economist is a fair bellweather - awareness is emerging now, as everything seems at first glance to be going so well (usually people only start to see all the spots the morning after the party ends…) Financial services firms are making record profits. Wall Street is employing record numbers of people and bonuses are set to be bumper. New hedge fund and private equity giants have emerged from the canyons of Manhattan and its suburbs. Interest rates are low. Stock markets are high. “…Hey. Wait a second,” you say. “If these are ’shortcomings’, give me more please. You obviously don’t have a clue…” Well perhaps I don’t, but I’ll come to that in a moment. My guess is that the disproportionate angst surronding IPO’s and stock exchanges is driving the emergence of this meme somewhat prematurely. (Not that IPO’s and stock markets aren’t important for a financial system, it’s just that they aren’t quite as important as the public imagination tends to think they are.)

So what if something is wrong with Wall Street? Why does it matter? Well probably for a many reasons, but two stand out in my view:
firstly and obviously, given America’s position as the world’s richest and most powerful economy, what happens there matters to us all; secondly and more indirectly, America historically has been seen and projects itself as the shining champion and example of free markets and their benefits - if this position is exposed as a hypocrisy, the resulting blow to the credibility of market systems generally could be very unwelcome (at least if, like me, you believe in the power of markets to improve the human condition.)

My analysis is slightly different than that of the Economist, albeit in the same general direction. In my view it is not only the thicket of regulations and the omnipresence of lawyers that is holding Wall Street back; more importantly (althought the two factors are necessarily intertwined) is the lack of competition, especially on the ’sell-side’. Yes Virginia, the great irony of Wall Street - that supposed bastion of free markets and unfettered Darwinian competition - is that it is in fact in many respects a shining example of a good ol’ oligopoly. Now I sincerely hope this won’t come as a shock to any (many?) of you, and if true I must point out this takes nothing away from the remarkable achievements, profits and progress in US wholesale financial markets over the past few decades and the fantastic contribution they have made to the wealth and prosperity of the US and world economy. But… But success breeds complacency and sometimes contempt, meanwhile the students have learned well and are starting to outdo the master…an angst provoking turn of events in any story to be sure.

Oligopolies are good at many things. And they are not always at all times a bad thing. But a cursory look at the fee and commission structure practised on Wall Street versus fees and commissions charged for identical services in Europe or Asia, would confirm that the price discovery mechanism is not working perhaps as smoothly as one might expect, especially from an industry that specialises in helping the economy set efficient, market clearing prices… And it is not just the level of prices (fees) that is interesting, it is their uncanny uniformity. The stock answer from the Street on this subject is basically ‘you get what you pay for (and if you want top quality, highly specialized services you need to pay for them…)’ - and I would completely endorse this concept. My observation is that some services (not being differentiated) are wildly overpriced, and for some truely unique and excellent products and services the customer is probably getting a bargain. Basically, the market is not being allowed to work.

Let’s leave Wall Street for a moment to look at another giant (sector) of the economy.

For many years, AT&T had been permitted to retain its monopoly status under the assumption that it was a natural monopoly. The first erosion to this monopoly occurred in 1956 where the Hush-a-Phone v. FCC ruling allowed a third-party device to be attached to rented telephones owned by AT&T. This was followed by the 1968 Carterphone decision that allowed third-party equipment to be connected the AT&T telephone network. The rise of cheap microwave communications equipment in the 1960s and 1970s opened a window of opportunity for competitors—no longer was the acquisition of expensive rights-of-way necessary for the construction of a long-distance telephone network. In light of this, the FCC permitted MCI (Microwave Communications, Inc) to sell communication services to large businesses. This technical-economic argument against the necessity of AT&T’s monopoly position would hold for a mere fifteen years until the beginning of the fiber-optics revolution sounded the end of microwave-based long distance. (source: Wikipedia)

At the time of it’s break-up, AT&T’s defence (of it’s monopoly) could be summarized broadly by a sign that apparently was hung in their offices:

There are two giant entities at work in our country, and they both have an amazing influence on our daily lives . . . one has given us radar, sonar, stereo, teletype, the transistor, hearing aids, artificial larynxes, talking movies, and the telephone. The other has given us the Civil War, the Spanish-American War, the First World War, the Second World War, the Korean War, the Vietnam War, double-digit inflation, double-digit unemployment, the Great Depression, the gasoline crisis, and the Watergate fiasco. Guess which one is now trying to tell the other one how to run its business?

Hmmm, obviously deregulation must have been a mistake… we should have listened to all those smart Bell folks…

For me the parallels between the two industries are significant. Given this is a blog post and not an essay or book, rather than defend this thesis robustly, please indulge me and allow me this summary. AT&T c. 1975 to Skype c. 2006. (btw if you are interested in following some of the key elements in the current evolution of the industry and regulatory structure of the communications sector today, you could do worse than starting with Gordon Cook.)

One key element that has driven and continues to drive the transformation of the competitive structure of the telecommunications sector is the economics of abundance. This is clearly also playing out in financial services, nowhere more so than in the arena of securities (in the broadest sense, ie including derivatives and foreign exchange) trading. As technology and concommittant transparency has driven costs down, volumes have increased even more quickly. And without the regulatory barriers to entry, these costs imo would drop even further, even faster. Please don’t misunderstand me - I wholeheartedly endorse the principles behind regulation of financial markets. What I take issue with is the complexity of form and implementation of these regulatory principles. I don’t have all the answers. I would just observe that for instance, the FSA’s approach is much more conducive to innovation and new entrants than the kafka-esque multi-jurisdictional regulatory gauntlet needed to be navigated in the United States. And - importantly - no less effective (I would even say perhaps more effective) in achieving broadly the same regulatory goals and outcomes.

In the course of my career I have met many extremely bright, ambitious, entrepreneurial and innovative people working in the giant firms that sit astride the US wholesale financial system. This has clearly been and continues to be a great strength of and of great benefit to the US economy. But at the same time, quite possibly due to its great success (ie if it ain’t broke, don’t fix it), there is a profound conservatism and attachment to maintaining the status quo, mixed in with a reasonably strong dash of parochialism (especially in middle management) that will not serve the industry well as the paradigm shifts from managing (arbitraging) scarcity to managing abundance. To fix ‘what is wrong with Wall Street’ ultimately means tackling head-on an entire ecosystem that evolved - extremely successfully I might add - to deal with a different economic and technological environment. Moore’s Law or Kurzweil’s Law of Accelerating Returns might well govern technological progress, unfortunately I’ve yet to see such smooth trendlines in the laws governing political, cultural and legislative outcomes… It means adopting a “destroy-your-own-business-model” mentality (to poach a phrase from Jack Welch), something that I’ll freely admit is extremely difficult to do when basking in the light of tremendous success and power.

My prognosis? In the short term it’s not going to happen. The forces aligned against change are too strong and the benefits (to those who would change) are few if any, and (to those who would profit) too diffuse. Turkeys just don’t vote for Christmas. So the locus of progress and innovation and market leadership will shift to London, perhaps to Asia in time. The fact that the big US firms are global leaders and leaders in these markets and geographies will in itself be a significant hedge for them, and paradoxically probably reduce further the pressure from within the industry to press for change at home. However for American politicians, institutional, corporate and individual consumers of capital market products who must deal uniquely through a domestic regulatory and industry prism, the results will be increasingly less satisfactory. In the long term however I believe that ultimately there will be a catalyst that allows profound change and - when the levee breaks - I suspect that all the positive elements of the American business psyche will come to the fore, propelling financial services in America to the forefront of innovation and competitiveness once again.

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