Sean Park Portrait
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Will the CFTC “Do the right thing?”

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… that aren’t prediction / event / outcome market affectionados, might not have realized that the CFTC recently asked

…for public comment on the appropriate regulatory treatment of financial agreements offered by markets commonly referred to as event, prediction, or information markets.

During the past several years, the CFTC has received numerous requests for guidance involving the trading of event contracts. These contracts typically involve financial agreements that are linked to …

Markets in everything, Part 471: Hooray for Hollywood

The LA Times published an interesting article yesterday discussing the arrival of two new exchanges focused on helping hedge box office risk:

Two trading firms, one of them an established Wall Street player and the other a Midwest upstart, are each about to premiere a sophisticated new financial tool: a box-office futures exchange that would allow Hollywood studios and others to hedge against the box-office performance of movies, similar to the way farmers swap corn or wheat futures to protect themselves from crop failures.

The Cantor Exchange, formed by New York firm Cantor Fitzgerald and set to launch in April, last week demonstrated its system to 90 Hollywood executives in a packed Century City hotel conference room….

…On Wednesday, Indiana company Veriana Networks, which says its management includes “veterans of the Chicago exchange community,” unveiled the Trend Exchange, its own rival futures exchange for box-office receipts.

These are exactly the kind of novel risk management marketplaces that will continue to emerge over the next 5 to 10 years as technology enables robust, easy and cost-effective trading and settlement mechanisms and data (which is the raw material of any exchange or risk management toolkit) continues to grow in size, richness and availability across every sector of the economy. Indeed the greatest impediment to the development of such markets is cultural: there is still an irrational, sometime hysterical, aversion to any risk management tool that is non-traditional and can be characterized as gambling. Of course gambling, trading and hedging are indistinguishable in practice and can only be differentiated in context, and really only represent differences in intent. As such, it is very difficult to proscribe one while allowing the other(s). There are however reasonably good, tried and tested regulatory frameworks that have been developed over decades to manage unhealthy practices (insider trading, market abuse, etc.) in traded markets for outcomes and commodities. Using these, regulators should be happy to quickly approve as many new marketplaces or exchanges as creative entrepreneurs and traders invent and let a thousand flowers bloom. I don’t think it is for the regulators to second-guess who might be interested in trading such markets and why, as long as the market rules and framework are robust, transparent and participants are swiftly held accountable for any abusive behavior.

But that certainly isn’t the way the establishment sees things and even those that are developing new markets often see their market as an exceptional addition to the risk management landscape rather than a specific example of a more general case. (Although to be fair this may be simply a tactic to curry favor with the forces defending the status quo in order not to appear to be too heretical and so smooth approval for their specific new initiative.)

“The day that a widow or orphan bets against ‘Finding Nemo 3’ — that’s not a good day,” said Rob Swagger, Veriana’s chief executive.

Why? Why shouldn’t anyone be able to put their knowledge and insights to work to make a return. Why is it ok for a ‘widow or orphan’ to bet on GE’s future performance (by buying or selling their shares) but not to bet on the potential return of a film? It simply doesn’t make sense. Or the view that certain risks or outcomes are worthy of being traded and managed but not others?

Government authorities have generally approved only those futures exchanges that allow for the redistribution of a preexisting risk. Sports betting is not approved because, unlike a farmer selling a futures contract to offset losses from crop failure, neither party involved in the wager has an economic interest in the underlying event.

This statement is of course patently ridiculous. Many, many agricultural risk contracts are traded amongst principals who are neither producers nor end consumers, and to say that there is no ‘real world’ economic risks that could be managed via sports trading is just silly given that sports is an enormous, global business with hundreds of billions of dollars of capital at risk. And if that weren’t enough, it is happening anyways, with admittedly high risks of fraud and abuse. Wouldn’t it make more sense (in the context of protecting vulnerable market participants) to encourage regulated, robust, well monitored marketplaces rather than cling to the current Potemkin-esque prohibition? (Disclosure: I am a shareholder in Betfair.)

In any event, I can only endorse Cantor’s vision of creating a new, more vibrant and useful market for managing risk and structuring finance in the entertainment industry:

Now Cantor hopes for its exchange to be the first of many complex financing products for the entertainment industry. In one of the more ambitious plans, Jaycobs wants to team with filmmakers to create something like an initial public offering of stock in a specific film, staking out a potential new way to finance production.

And I hope they (and Trend Exchange,) working along side the CFTC are able to quickly illustrate that well-built and well-regulated marketplaces can mitigate the potential dangers while at the same time providing a powerful and useful set of tools for managing risk and generating returns. Perhaps this will help pry open the door to seeing more and more outcome markets develop of the course of the next several years.

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Clowns to the left, jokers to the right.

Clouds and silver linings and all that… Yes, it would seem that the US might finally get a more intelligent, less balkanized regulatory environment for financial services. Before the announcement yesterday, Forbes reported that Treasury Secretary Paulson would be unveiling a comprehensive ‘overhaul of US financial regulation’:

Paulson’s plan would give the Fed regulatory authority over all financial institutions that operate with government guarantees such as deposit insurance for banks and would cover the insurance industry. A new regulatory agency would oversee consumer protection issues while the Office of Thrift Supervision, which supervises thrift institutions, would be folded into the Office of the Comptroller of the Currency, which regulates banks.

The plan is also understood to include merging the Securities and Exchange Commission with the Commodity Futures Trading Commission, and to provide for tightened regulation of mortgage origination.

The proposals are likely to generate intense scrutiny in Congress and within the financial services industry. Past efforts to change how regulation is handled have met with strong resistance, especially those affecting the insurance industry which has fought off past efforts to switch its regulation from state to federal level.

In the event, this was pretty close (via Reuters):

The proposals, in the form of a 218-page “blueprint” that was started before markets unraveled in August, offer no quick fix for the credit contraction that threatens to tip the U.S. economy into recession. The plan was already meeting some resistance from Capitol Hill and competing corners of the government bureaucracy as a potentially protracted debate took shape.

Under the proposals, the current patchwork of as many as seven federal regulators would be consolidated under three agencies: the U.S. Federal Reserve, a newly created financial regulator, and a third agency for consumer protection and business practices.

As a starting point (and without having read the underlying report), it would seem like this is a fairly sensible direction. Of course and unsurprisingly, the reactionaries in the room are already crying foul; in trading that’s called “talking your book.” Indeed if your competitive advantage and or your livelihood is predicated on maintaining and/or navigating a thicket of over-complex and over-lapping regulatory regimes, it is hardly surprising that you aren’t exactly going to enthusiastically embrace simplicity and transparency. I mean without the kafka-esque and byzantine system of state insurance regulation, you might get far too many upstarts innovating and competing…that wouldn’t do at all…and it is logical to assume that no one but the CFTC could properly regulate futures markets right?

While removing unnecessary complexity from the regulatory environment is a good thing in and of itself – a necessary but not sufficient – response to contemporary financial market stresses, it doesn’t really get to the heart of what drives most (if not all) systemic crises in financial markets. In my opinion, the combination of substantial leverage with significant hubris lies at the root of the excesses that are now being unwound. Of course I am not alone in articulating this opinion, and there are many who would in fact look to specifically target regulation with the goal of limiting both of these elements. I would strongly caution however the law of unintended consequences is likely to apply in spades and so would be loathe to try to manage either of these via legislation or prescriptive regulation.

That said, for any institution that is either ‘too big and/or complex and/or interconnected’ to fail (and thus subject to a de facto government or central bank bail-out) it would seem reasonable to expect them to have their leverage signed off by a regulator. The key is to make a distinction between allowing someone to blow themselves up (no problem, no need for outside interference) and allowing someone to start a chain reaction (due to their size/complexity and/or connectedness) – and this irrespective of what kind of institution they are (bank, securities firm, hedge fund, insurer, etc.)

Hubris is harder to manage or regulate. Mandating what bonuses are to be paid would be a fools game, solve nothing and almost certainly give rise to toxic unintended consequences (not to mention the ‘wasted’ creativity dedicated to navigating around whatever rules were invented.) If a private company wants to line it’s employees pockets in a highly asymmetrical fashion that is a matter for its shareholders to take-up with management… Instead, I would suggest that the only way to mitigate hubris in the financial markets is to allow creative destruction has to operate over time. Clearly the compensation paradigm of the investment banking industry is inappropriate to the nature of the business and risks that they run. The least worst form of organization and compensation structure for the industry is I believe the partnership. (It is not surprising that Goldman Sachs is consistently the most successful bulge bracket investment bank given that it was the last to end its formal partnership and still to this day maintains by far and away the culture and compensation policy closest to that of a traditional partnership.) It is also unsurprising that on average, the investment banks have fared far worse than hedge funds over the last year. So if this is true, why did partnerships largely disappear (or become marginalized) over the past 20-30 years? Firstly, the rise of OTC derivative markets and other facets of ‘modern’ finance required ever larger balance sheets and capital resources to the extent that these became out of reach for even the largest and most successful partnerships. Secondly, the sustained bull market (and quick intervention of the Fed in times of duress) papered over many of the intrinsic advantages of partnerships – ie banks (and bankers) could have their cake and eat it too.

I would speculate however that the next decade or so might see a return to prominence for small and medium sized banking and investment partnerships. Indeed to some extent this is already happening. Don’t get me wrong, I’m not suggesting that the giants are going to disappear, just that they will inevitably refocus on the elements of the business where large financial resources are a true sine qua non and/or competitive advantage and retreat from the elements of the business where these are just a license to take inappropriate risk. For example, instead of a monolithic Citigroup as we know it today, you might have a galaxy of small to medium size firms orbiting the core Citigroup balance sheet and banking functions (payments, deposit taking, etc.)

For a number of years I’ve been saying that fundamental change in the investment banking industry was inevitable; it was only the timing that was uncertain. As long as record profits kept rolling in (however fragile or unsustainable they may have been in the long term) nothing was likely to change. Unfortunate but understandable. But turbulence and losses typically catalyze change; this just might be the beginning of the new paradigm I’ve been waiting for. 😉

What’s wrong with Wall Street?

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

Wall Street Bull wrapped in red tape.

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.

A rose by any other name…

or tomAto, tomAAAto, version 341…

Was going over some old emails this morning and came across this news from a few weeks back:

The CFTC has issued a no-action letter permitting the offer and sale in the US os the Sydney Futures Exchange‘s one-day option contract based on the Chicago Board of Trade’s mini-sized Dow Futures contract.

Assume it will be analgous to their SPIDO product (Australian sharre index underlying.)

So how is this fundamentally different from a spreadbet on the daily closing level of the Dow (or any other financial underlying)? I’ve discussed these semantics previously here and here:

In my eyes the difference between investing and gambling, betting and trading lies not in the underlying but in the approach of the person dealing in whatever instrument. Investing or trading involves a careful and analytical approach to decision making and risk taking. Betting or gambling involves a purely impulsive or emotional speculation. The irony is that many ordinary people are much more informed about sports or politics or the weather than macro-economic trends or the financial prospects of this or that company, and yet are encouraged by the prevailing culture and legislation to risk their savings investing in the latter through bonds or stocks while being chastised and in many cases legally prohibited from seeking to profit from their detailed knowledge of particular sporting or political outcomes.

Given that this semantic gap is largely driven by culture, religion and emotion, it is extremely difficult to speculate as to when – if ever – it may change, again especially in the US. However, I think it ultimately will if only due to the borderless nature of the internet; it is already happening in the UK and increasingly elsewhere. For instance, it is estimated that Betfair ‘traded’ just under $10bn in volume in 2005 and regularly executes between 2 and 5 million trades a day which is more than any financial exchange in the world (and this without accepting any business from the US – clearly potentially the biggest market in the world.) The market in Europe alone is predicted to top $150bn. I think it will become hard for the US stay aloof. Another factor that will drive this in the longer term will be generational change. The digital generation now growing up I think will not have the same historical prejudices as to what assets – real or virtual – can or should be traded. Indeed, sometime in the next decade or so I would expect ‘prediction’ markets more generally to become ubiquitous.

As far as I can see the main difference (only difference?) is that one is permitted (in the US) and one is not (or at least is on more shaky ground.) And as far as I can tell both [types of trading/betting] can be done “in your bathrobe!!!” (thanks Jon Stewart again), so that can’t be the reason Congress likes one better than the other…