Lawmakers Skewed Priorities in Proprietary Trading
By Jeremy Weltmer
Thursday, July 8, 2010 3:45 pm
As part of the Frank-Dodd bill for financial “reform,” financial institutions that benefit from government protections like federal insurance of deposits will be restricted from investing any more than 3% of the bank’s capital for the profit of the bank. As menacing as this may sound, it ignores two significant loopholes that lawmakers left in the bill.
Perhaps unintentionally when the bill was ramrodded through a partisan conference committee in the dead of night, lawmakers left a significant amount of ambiguity on the regulation surrounding the making of markets. Because large banks fill the crucial role of making markets and buying securities ahead of when customers demand them, markets and securities can remain very liquid. Likewise, banks can make a profit on making markets if the security purchased rises in value between when the market is made and when the consumer purchases the product.
In line with this, companies have been shifting traders
from proprietary trading desks to making markets for other divisions. One of these traders might trade a security for which he expects there to be demand in a week or a month and then unload that security if he no longer expects a demand for it, pocketing the difference for the firm. There is no easy way to curb this practice without harming market-making, which remains essential for financial markets to function, yet it either castrates the bill’s provisions relating to proprietary trading, or it leaves all the power in the hands of unaccountable regulators.
The second major loophole, which the Wall Street Journal characterizes
as big enough to “drive a trader's ego through,” does not prevent the proprietary trading of all securities, but it in fact allows for speculation on over 60% of the US bond market. Specifically, companies remain able to trade Treasurys, bonds issued by government-backed entities like Fannie Mae and Freddie Mac, as well as municipal bonds however they see fit, leaving them speculative access to a $20 trillion market.
Lawmakers left this exemption first and foremost because of the flawed perception of US debt as safe from losses, a view belied by the impending US credit downgrade
. Moreover, anyone with access to news media could testify to the riskiness of Fannie and Freddie, and financial news sources continue to warn about the overvaluation of the municipal bond sector. Nefariously, politicians left this exemption to allow the private sector to sop up as much government debt as possible as they do not foresee a time when the US will not spend more than it collects.
Yet when these banks leverage these positions, perhaps expecting US bonds to drop in value, the positions could become extremely risky or have very unfortunate effects on the US ability to borrow. While banks may not engage in these practices, the exemption simply shows politicians’ skewed priorities.
While the bill does allow for regulators to stop any high-risk trading that affects the soundness of the institution, one is then left with a conflict of interest in which the US government is telling banks how much US debt they can safely hold.