hoto Illustration by Jakub Porzycki/NurPhoto via AP
An investigation should answer the questions: Are markets fully transparent to all? Do they provide the same information on a timely and complete basis to everyone in the marketplace?
In his former role as chief accountant for the Securities and Exchange Commission (SEC), Lynn Turner was the principal adviser to the SEC chairman and commission on auditing, financial reporting, and corporate governance.
Robert Kuttner: Since the reforms of the New Deal, two regulatory pillars of the financial system are that information should be transparent, so that ordinary investors have the same opportunities as insiders; and that we should avoid the kind of systemic risk that comes when there is too much high-risk speculation with too much borrowed money. Today, is there too much hidden leverage in the system? And are too many insiders trading based on privileged information at the expense of their customers and the public generally?
Lynn Turner: We need a comprehensive investigation to answer these and other questions. It needs to include the SEC, the Federal Reserve, and the Financial Stability Oversight Council, which is chaired by the secretary of the Treasury. The ultimate question is whether the markets are fair for ordinary people who are actually putting their money into the markets. That’s the only way you can have not only fair markets, but markets that are efficient in the long run. An investigation should answer the questions: Are markets fully transparent to all? Do they provide the same information on a timely and complete basis to everyone in the marketplace?
But that’s not the case today for a variety of reasons. With exceedingly high-speed computers and sophisticated software, market insiders can gain an advantage by getting access to information on who’s trading what. They can trade ahead of others in the markets—what’s commonly referred to as “front-running.” So this is a systemic problem in the marketplace that affects us all and allows some people to game the system and make profits at the expense of the rest of us.
There needs to be a comprehensive systemic study of the broader issue of the fairness in the markets. The SEC’s own Investor Advisory Committee pleaded with the Commission to study the settlement of stock trades. For example, you and I might place our orders to purchase or sell stock, but it takes three days before that order is settled and the stock actually changes hands. The Commission brought that down to two days, but trades could be settled immediately. The abuse here is that there’s money to be made by insiders by delaying the settlement so they can trade ahead of their customers.
Does the SEC have the authority to deal with issues involving abuses such as the settlement of stock trades, payment for order flow, use of risky options and margin requirements, and “soft dollars,” or do they need new legislation?
You could deal with most of it by regulation under existing law. The SEC has looked at the abuses in payment for order flow, which was an issue in the recent GameStop debacle. Robinhood told retail investors they were able to trade for free. But that is misleading as Robinhood sends their stock trades to trading platforms, who can then sell trading data to very sophisticated firms, who gather that data in a split second and “trade ahead” or “front-run” on the information. In addition, the trading platforms get a percentage of the bid/ask price, which impacts what the retail investor receives. So in reality, as is usually the case, nothing is done “for free.”
But the SEC has failed to stop practices that are abusive to retail investors, such as front-running, which should be illegal. And the SEC has failed to modernize the settlement of trades, which would be beneficial to investors. As a result, we need a comprehensive study, and then a strategic plan for how you’re going to address those practices that create an unfair market. This needs to be completed in a reasonable time period, such as a year. This also needs to include recommendations for both rulemakings and legislation.
In 1998 during the dot-com craze, we at the Commission saw instances where analysts on Wall Street were getting tipped off to important information provided by management that wasn’t available to all investors. Wall Street would in turn give the tip to the prime brokers within a firm and those their preferred high-wealth clients. In doing so, they alerted clients to that tip who would then buy or sell that stock, whichever made the most sense in that instance based upon that inside tip.
At the Commission, we adopted a new rule prohibiting these practices. We had to get comments in from the public, which were very helpful, and we modified our proposal some. But we got to a final rule completed in just over a year, so I know this is doable. I know the Commission can do it if you’ve got a chairman who has the courage to take on these issues.
We are getting a new chairman in Gary Gensler. Do you think he could be that person?
He was previously chair of the Commodity Futures Trading Commission, where he did an absolutely marvelous job. Gary Gensler is known as an extremely smart, sophisticated, and courageous regulator who has a good sense for doing the right thing. He is not afraid of being an advocate for investors, doing battle on their behalf. As you know, he worked on Wall Street for many years, so he knows better than just about anyone in Washington, D.C., how the market’s plumbing works. I think he’ll be a fine plumber, but of course history will always be the judge.
From what I’ve seen, one recurring challenge is enforcement. One problem seems to be the delegation of so much enforcement by the SEC to the industry’s own combination trade association and self-regulator, known as the Financial Industry Regulatory Authority, or FINRA. And FINRA is notorious for slaps on the wrist. Could the SEC just take back some of this delegated authority and do more regulating directly?
FINRA is what is known as a self-regulatory organization, or SRO. This kind of self-regulation arose almost a century ago as a result of the stock market crash which led to the Great Depression. It is a bad and outdated idea. There are terrible conflicts of interest in FINRA. Members of the board are from the industry itself. FINRA forces investors into arbitration and denies them access to the federal and state courts.
FINRA’s mediocre regulation needs to be eliminated by folding it into the Commission and eliminating its inherent conflicts. I suppose that as a practical matter, if the SEC did that, the Commission would be sued by the industry and the case could end up at the U.S. Supreme Court. I would not be willing to bet that this Supreme Court would uphold the SEC. But if that occurred, then Congress could legislate, hopefully before that happened.
Well, since this is really a legislative question and not a constitutional issue, Congress could presumably clarify its legislative intent on the scope of self-regulation. Wall Street keeps coming up with new abuses. One innovation that has been in the news lately is called SPACs, which stands for “special purpose acquisition companies.” These are basically empty shells. Investors give their sponsors money, and they turn around and buy up actual companies.
Bob, these are not new at all. The only thing new is that Wall Street has changed the name. SPACs used to be called “blank checks” or “blind pools.” I am not a fan of SPACs, but it would probably take action by the SEC or an act of Congress to outlaw them. I would favor outlawing SPACs because in the long run, many of these are going to generate losses or poor returns for investors. Unfortunately, last year, SPACs received more money in initial public offerings from the public then any other type of entity.
I’m worried about that from an economic perspective. When you take money into a company that isn’t able to get investors a return that they might otherwise be able to get, for example if they invested their money in a very sustainable, well-run company, then that misallocates capital. It results in a bad outcome for investors and for the economy as a whole, just as occurred in the U.S. dot-com craze.
Let me return to the broader question of too much leverage in the system. In the 1930s, the issue was fairly simple—buying stocks on margin, and it was fairly straightforward to regulate. Today, with many kinds of derivatives, mostly opaque both to the public and to regulators, there are multiple ways to speculate with borrowed money. How should we address that?
Again, this is another reason why we need a comprehensive study of the entire system with recommendations for reform. The SEC and the Fed certainly have the authority to put limits on margin. Some of the day traders that got into the recent GameStop situation probably had no business whatsoever getting into these extremely risky trades, in a company that has very transparently been shown to be in a serious financial situation. Too much trading in that type of stock is not based upon fundamentals. People are making or losing money, but it ceases to be a financial market; it becomes a casino.
Is this mostly about fair markets and protecting investors, or at what point does it start becoming about potential systemic risk if there’s too much leverage in the system as a whole, as in the case of Long-Term Capital Management’s collapse in 1998, or the meltdown of the entire financial system in 2008, which were both the result of too many highly leveraged nontransparent bets going bad?
It becomes a systemic problem if an investor borrows large amounts of money to enter into a transaction. When that investor fails and no longer has the wherewithal to make good on the transaction, people lose confidence in the markets. Other investors in the market will be concerned that their transactions could fail and they will be left high and dry. People lose faith in the market and run away from it, and then the whole market collapses.
That is what happened in the financial crisis with Lehman Brothers and Bear Stearns, as well as the subsequent collapse of MF Global. It also happened during the corporate scandals at the start of the century when executives borrowed large sums of money using their company stock as collateral, only to see the value of their stock disappear as the executives’ fraud came to light. Use of any type of leverage in the markets, without complete and timely transparency, should be outlawed. And use of leverage by unsophisticated retail investors, to enter into risky transactions, such as options where the counterparty is likely a huge Wall Street bank, is as unfair as setting up a football game between a high school and an NFL football team. You know the outcome before the game ever begins.
Is there a distinction between traditional bona fide hedging of risk and the use of these instruments for pure financial plays that start shading off into gambling? Can you constrain the one without constraining the other?
In the 2008 financial crisis, we found that too many people on Wall Street were gambling based on large volumes of ill-advised mortgage loans that had been made and were never going to get repaid. Congress stepped in to legislate based on the advice of Paul Volcker, perhaps our greatest Fed chairman ever. Volcker urged Congress to adopt a law prohibiting large banks from trading like a casino on some of these highly toxic financial instruments. Congress did that in 2010 in the Dodd-Frank Act with what is known as the “Volcker Rule,” but only after the government bailed out the banks.
Unfortunately, under the most recent administration the Volcker Rule was not enforced, exposing everyone in America once again to toxic trading risks by the largest banks. I have been able to see data which indicates the top 40 banks in the world are so interconnected with one another through some of these instruments and loans that if we ever had another financial crisis like we did in 2008, the banking regulators will have no choice but to once again bail out the banks, as a result of their interconnectedness. So if we don’t act, we will likely see a replay of 2008, only worse.
