Rob Carr/AP Photo
Former senator and longtime Biden chief of staff Ted Kaufman speaking in 2009
The stock speculation scandal dominating the front pages vividly reveals what critics of extreme financialization have been saying for decades. All of this hyper-trading produces no benefits to the real economy. It creates and then pops financial bubbles, roils markets, harms actual businesses, enriches insiders at the expense of bona fide investors, and leads to extreme concentration of wealth.
One of the most astute critics happens to be Ted Kaufman, who was Joe Biden’s longtime chief of staff and then spent two years in the Senate filling out Biden’s term in 2009 and 2010. Sen. Kaufman emerged as one of the key leaders on the Dodd-Frank bill, and specifically championed reforms of the kinds of issues that have emerged in this scandal, like high-frequency trading.
Kaufman has no official role in the Biden administration, other than as part of the kitchen cabinet. But he did lead the Biden transition, and my sources say that the relatively progressive cast of Biden’s key financial regulatory appointments reflects Kaufman’s continuing counsel. One can hope that he will be chosen to make his voice heard on needed financial reforms going forward. Rather like the New Deal–era Pecora Commission investigating Wall Street’s runaway speculation and predatory practices, this time we could have a Kaufman Commission.
The details and techniques of the Robinhood/Reddit/GameStop affair are blindingly complex, but simple enough at their core. Giant hedge funds, with little capital of their own, borrow money from big banks to “short-sell” stocks. They do this by borrowing the stock, selling it in large volume in the hope of depressing the price, and then making money when they buy it back at a cheaper price.
This time, some small fry beat the big fish at their own game, working in concert via the Robinhood app to bid up the prices of the same stocks, costing the hedge funds billions when they had to buy stocks back at higher prices. But despite the Robinhood name, this is no David-and-Goliath story. There are hedge funds and extreme market manipulation on both sides of these transactions.
In fact, there is good evidence that Citadel, the financial firm Robinhood tasks with managing order flow, was “front-running” the trades milliseconds before clearing them for the Reddit guys—making its own trades after seeing from its clients which way the market was going. Citadel then bailed out one of the large hedge funds harmed by the exploding price increases in GameStop. They were playing both sides of the deal. Meanwhile, Robinhood, which facilitated the run-up in GameStop and other stocks, abruptly shut down trading on them, preventing users from buying more. Other online traders followed them, giving the impression that only retail investors are allowed to lose money, not the guys in the fancy suits.
But where’s the harm? Isn’t this just a zero-sum game with rival wise guys fleecing each other?
In fact, there are several harms. One is extreme market instability, which harms bona fide investors and makes actual companies the playthings of speculators. As is often the case, Keynes said it best:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
A second harm is the very stability of the banking system. Before deregulation, hedge funds simply could not come up with the scale of money needed to finance this level of speculation. They were minor players.
Today, the hedge funds that dominate these short-term speculative plays borrow money from the big money center banks, which in turn get effectively free money from the Fed. If this game blows up and causes massive losses, as it did in the collapse of Long-Term Capital Management in 1998 or the general financial collapse of 2008, the entire banking system is insolvent and has to be bailed out by the government.
One good way to shut down the extreme speculation game would be to enact a financial-transaction tax on very short-term financial plays, stiff enough to make them unprofitable. The economy did very nicely, thank you, during the postwar boom, when hedges were merely a legitimate tool to protect sellers and purchasers of commodities against unexpected price swings. But a financial-transactions tax takes legislation.
Short of writing new law, however, there is a great deal that regulators can do to drastically limit these abuses based on existing authority. The Dodd-Frank Act put in place several mechanisms to combat excessive systemic risk, and now is the time to use them.
One good way to shut down the extreme speculation game would be to enact a financial-transaction tax on very short-term financial plays.
As it happens, the stars just might be aligned for some radical reforms. For starters, the incoming chair of the Securities and Exchange Commission is Gary Gensler, a foe of financial manipulation and a onetime Wall Street trader who knows exactly how the game is played.
Another key player is Treasury Secretary Janet Yellen, who also functions as head of the Financial Stability Oversight Council, which was created by Dodd-Frank to deal with systemic risks. Bank financing of speculative activity has long been a concern for Yellen.
When she was Federal Reserve chair in 2014, Yellen gave a major address to the International Monetary Fund, in which she warned that if the Fed was going to be giving massive advances to banks at very low interest rates, regulators had to pay more attention to what banks were doing with the money.
In those years, the Treasury was more protective of the big banks. Now Yellen, as Treasury secretary, is in a position to act.
While the government does not have an explicit mandate to shut down extreme short-selling or high-speed options trading, it has plenty of authority to rein it way back. For starters, the excessive reliance on bank borrowing by hedge funds is an express threat to the system’s safety and soundness.
Yellen, in her FSOC role, working with the Fed and the Office of the Comptroller of the Currency, the national bank regulator, could act to drastically constrain bank lending to hedge funds. (This is all the more reason to make sure we get a progressive appointed to head the OCC.)
Secondly, the SEC has the authority both to crack down on market manipulation and to protect investors against both corrupt schemes and excessive market volatility. Once confirmed as chairman, Gensler could begin with a full-scale investigation of market manipulation via “pump and dump” or short-sale schemes run by hedge funds and apps such as Robinhood via Reddit chat rooms—complete with subpoenas to collect all the details.
And there is a perfect person to lead such an investigation. His name is Ted Kaufman.
