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Opacity crisis…

The wise man bridges the gap by laying out the path by means of which he can get from where he is to where he wants to go.” 

+ + 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.

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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.

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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.   

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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.

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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:

TRACE has made an outstanding contribution to increasing price discovery in the corporate bond market. This price dissemination system should be expanded to included all cash fixed income securities traded OTC or on an exchange. Securities to incorporate include Treasuries, MBS, repo, agencies, structured finance products and money market instruments.
The CUSIP system should be made into an open source system. This will be the foundation for the development of a vast body of information and disclosure for fixed income securities. 
All issuers of securities rated by Nationally Recognized Statistical Rating Organizations should be required to share non-public information with all NRSROs not just those compensated to rate the issue. For example, Lehman Brothers and AIG, should have provided non-public information to all NRSROs rather than the few they compensated. The SEC should examine whether Lehman and AIG were “ratings shopping” leading up to their failures.
All entities issuing public securities should file detailed disclosure with the SEC outlining all securities outstanding and the exchanges, ATS, ECN or OTC markets on which the filing company has securities. This would give market participants the information to assess the full capital structure and risk profile of the issuing entity. With this level of disclosure it would be possible to assess the liquidity of an issuers securities. This would provide critical information to market participants.
The Treasury Department, through the Federal Reserve, should make Treasury securities available for sale and purchase in an ongoing and regular basis to retail investors similar to their sales to primary dealers.
The SEC should require more disclosure of the various alternative trading systems, over-the-counter liquidity platforms and crossing networks. Access to these platforms should be made more universal. Trading venues should publish liquidity statistics for securities traded.
An integrated multilateral trading and clearing model will offer the best route to improved risk management and enhanced efficiency for all participants in the credit derivatives market and also for the underlying companies on which credit derivatives are based.
Additionally this will offer regulators the immediate information and transparency they need to prevent fraud, manipulation and market abuse. 
These central utilities will greatly reduce significant information asymmetries in the credit markets and protect the broader financial markets against systemic risk.
A recent study says about 25% of municipal issuers are chronically delinquent in filing their disclosure documents.  The Congress should consider means of enhancing disclosure. Information flow is vital for healthy markets and the protection of investors.
Photo image credit — Ocean Flynn

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