+ + John Pierpont Morgan + +I'm giving a talk in Washington this week entitled... "U.S. Bond Market Basics & Recent Events"... timely... I've been developing some thoughts about the regulation of fixed income markets... Fixed income markets are very "murky" and the stability of the US and global financial system would benefit from an increase in transparency... recently financial firms have been challenged to accurately price their mortgage backed securities and collateralized debt obligations. This has created a lack of confidence in the balance sheets of many firms. Price transparency in fixed income markets would improve the ability of firms to mark assets to market... price transparency would protect investors... enhanced disclosure would strengthen confidence in the health of institutions... We are in a "opacity crisis" ... we need more light... I'll leave unspoken the issues related to excessive levels of liquidity in the system and matters such as accounting rules and banking regulation.
# # #As a general premise I believe that financial markets must be overseen by a law enforcement agency (i.e. the SEC). I believe that it is necessary to have effective enforcement tools, like civil and criminal penalties, available to discipline market participants. I believe that the securities laws currently in place must be more rigorously enforced and possibly extended to other market participants (hedge funds). Markets are very concentrated and a small number of financial institutions have inordinately large balance sheets and risk profiles. The failure of Lehman Brothers and the partial nationalization of AIG demonstrate how institutions "too big too fail" can destabilize the global financial system. The failure of all these institutions is due to poor management and the lack of transparency... these firms collapsed in the "opacity crisis". The fixed income markets must have enhanced disclosure and price transparency. The derivatives markets also should be made more transparent and regulated. Lawmakers and regulators should examine the concentration of control in the fixed income, foreign exchange, commodity and derivative markets.
# # #The instability that comes from excessively concentrated prime brokerage activities (e.g. Bear, Lehman, Morgan Stanley and Goldman Sachs) must be reviewed. Prime brokerage activities were highly profitable in periods of excessive liquidity but expose highly leveraged prime brokers to significant risk in unstable market conditions.
# # #I'm opposed to either the US Treasury or the Federal Reserve regulating financial markets. These organizations have never held this responsibility and I believe that their mandates should focus on issues related to fiscal and monetary policy. I'm opposed to regulation which enshrines "market stability" as a central organizing premise... this would be an extension of approach that the Federal Reserve has taken in regard to their primary dealers.
The most obvious example of the failure of this approach was the multi-year attempt at coordination with the major dealers on a central clearing mechanism for credit default swaps ... this effort went no where... and now the global financial system is severely destabilized as this asset class deflates.
# # #The investment banks and dealers do not value "market stability" over their own competitive and profit incentives... it's folly to imagine any securities dealer would put an abstract value ahead of their bonuses, EPS or ranking in the league tables... The elevation of “market stability” as a central regulatory premise would represent a landmark shift in our approach to regulating the securities markets. The ‘33 and ‘34 Acts embody the principles of disclosure, transparency and the varied responsibilities that parties operating in the markets have towards each other. Granting a regulatory entity the responsibility for “market stability” was not the focus of lawmaking in the aftermath of the Great Depression. We can assume that Congress and the Roosevelt administration believed that financial markets would inherently regulate their own stability if they operated in an open and transparent manner. If markets are going to regulate their own stability the truth is that some firms will fail through difficult parts of a credit cycle. Markets naturally create successful and unsuccessful firms and the failure of Bear Stearns, Lehman Brothers, and AIG can be considered ordinary, although difficult, market events. These firms counterparties and creditors acted on their belief that the firms were over-leveraged and unstable. The counterparties sought additional collateral or compensation for the risk of transacting or in many instances “backed away” from lending and trading which they had formerly engaged in. Prime brokerage clients moved their accounts en masse from the unstable firms. Bear’s, Lehman's and AIG's counterparties, who trade and lend to the firms on a daily basis, were in the best position to judge their stability. The firms' counterparties were in a much closer relationship to judge the creditworthiness and stability than a regulator who operates on secondary and delayed information. No regulatory structure can eliminate the possibility of a financial firm failing. Commercial banks fail on a regular basis. Because financial firms innovate and concentrate risk there will always be firms which collapse. The regulation of financial markets must continue to focus on ensuring disclosure, transparency and the protection of investors.
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Recommendations for additional regulation of the fixed income markets:
- Expand the TRACE trade reporting system to incorporate all cash fixed income securities
- Open source the CUSIP nomenclature system
- Expand "equivalent disclosure" to all asset classes rated by NRSROs
- Require public entities to maintain an public XBRL file detailing their outstanding securities and where these are traded (exchange, ATS or OTC)
- Create a facility for retail investors to purchase Treasury securities from the Federal Reserve
- Develop more oversight and transparency for all trading venues (ATS, OTC, crossing networks)
- Repeal the Tower amendment to improve municipal disclosure