Thursday, 26 May 2011

Concentration, Manipulation and Margin Calls

Over the past 25 years the financial markets of the world have become highly concentrated in the intermediation of a handful of firms, and regulation has been harmonised in the interests of these few firms. As Adam Smith - that great proponent of free markets - cogently observed:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Sadly, these few global firms have been for some time in "a conspiracy against the public", and have subverted the organs of public governance and the infrastructure of the financial markets to their purposes. Regulators and legislatures have done what they were asked to do in rubber stamping the policies that promoted further concentration, assured the whole time that it would result in "efficient markets", when the reality has been entirely otherwise. Exchanges were demutualised, and their new owners installed electronic trading systems to a common design, with provision for co-located HFT servers right next to the exchange's boxes to better front run their client orders. Clearinghouses were demutualised, and their new owners installed common margin algorithms and collateral rules that created a liquidity bias in their favour, reinforcing their control of global liquidity. Regulators liberalised over-the-counter markets, off-exchange trading and shadow banking so that the real trade flows that drive global markets occur well out of sight or supervision.

Four global banks are intermediaries in 85 percent of OTC derivatives transactions. The same banks dominate prime brokerage. The same banks own large equity interests in the now demutualised exchanges, clearinghouses and even warehouses of the global markets. Naturally, the same banks dominated underwriting of securitised assets. The implications have scarcely been grasped of what this portends in terms of the information asymmetries and the opportunity to manipulate markets without risk.

Each of these roles gives these few banks a view into the positions of market investors. They know who owns what, using what leverage, under what terms, and trading in which markets. Knowing that, the manipulation of prices to impoverish investors and enrich the ruling banks is child's play with a bit of ill-transparent HFT through proprietary dealing desks and connected hedge funds aligned with the firms.

These banks will protest that there are Chinese walls between their trading desks and the market infrastructure they own. The problem with Chinese walls is that they have chinks in them. (Apologies to PC crowd, but it is an old Wall Street joke I'm quoting.) We have seen from what is now reported about securitisations, that these banks structured products to trade against their clients, often colluding with hedge funds to share the profits. Is it likely that when they balance the public interest in market integrity against next year's bonus they become much more altruistic?

In October 2008 the global financial markets crashed. The story in the media is that it was a panic caused by the insolvency of Lehman Brothers. This is not the truth - or at least not all of it. The crash actually followed a $2 trillion margin call by these four global banks on their prime brokerage clients and OTC counterparties - effectively a 30 per cent increase in required margin. It was the margin call that forced liquidation of global portfolios of all asset classes - and particularly the high quality, most liquid asset classes.

Eligible margin is defined by bilateral agreement for both prime brokerage and OTC derivatives. According to the ISDA Margin Survey for 2009, the eligible collateral at the time of the crash was predominantly US dollar cash, euro cash and US Treasury securities.

Bilateral agreements are not made public, and neither are the margin calls. This is why the $2 trillion dollar margin call did not make the news. Each prime brokerge client and each OTC counterparty dealt with their margin call as a bilateral obligation, despite it being systemically the most important event in the history of financial markets.

As the markets crashed, the US Congress was threatened with chaos and martial law if it did not pass the Paulson Plan to grant $700 billion to Wall Street banks without any formal process or review. The Federal Reserve in parallel innovated a series of secret, extra-legal measures to give money to the same banks in exchange for assets which would never be disclosed, publicly valued or audited. The need to raise dollar liquidity globally to meet margin calls in US dollar led to the innovation of central bank dollar swaps - to preferred central banks only, of course.

After all the global liquidity had been sucked into the hands of these few global banks, and the dollar surged to strength along with US Treasuries, the game of increasing leverage started all over. The firms sitting on all the margin cash and global liquidity bought up all the quality assets lying about the crashed global markets at deep discount, then they started lending again. They have been reporting huge profits consistently ever since as their clients and counterparties take the assets and exposures in this "recovery" on terms very profitable to those running the markets and liqudity business.

And remember, these few firms see all your positions and know all your clearing balances better than you can. And they chair all the margin committees at all your clearinghouses and exchanges too. And they even own the warehouses where you believe your gold, silver and other hedges against financial chaos are supposed to be stored.

We are now nearing the same global levels of leverage as prevailed in summer 2008. The political situations in the US and in Europe are unstable, and China is slowing. There is money to be made in instability.

It isn't the leverage that causes a crisis, but the margin call.

In the past few months we have seen a pattern of increased margin calls in exchange traded derivatives. It makes me wonder what is happening unseen in the OTC markets. The dollar is strengthening from its lows, indicating flows back to US counterparties. Perhaps another round in the game of liquidity manipulation has begun.

Leaving that aside, how would Adam Smith recommend that we protect ourselves from the well-entrenched tyranny of a global elite of manipulators? The only resilient solution is local, transparent markets with disintermediation of the controlling banks. Eliminating the information asymetries which allow them to see everyone's positions, leverage and trading activity - and trade and ration liquidity accordingly - would go a long way to preventing further concentration.

How to do this? Would the co-opted regulators allow markets that disintermediated reliable paymasters? Those are the questions we will grapple with after the next crash I suppose.

A timely example of the public spirit of exchange executives:
SEC -- Antonia Chion, Associate Director of the SEC’s Division of Enforcement, added, “Johnson brazenly stole nonpublic information from NASDAQ and its listed companies in breach of his duties of confidentiality to his employer and clients. Johnson assured at least one corporate official that she could share material nonpublic information with him because he was obligated as a NASDAQ employee to hold such information in confidence, and then he illegally traded on it.”