Rethinking Regulatory Structure www.ebook3000.com Zicklin School of Business Financial Markets Series Robert A Schwartz, Editor Zicklin School of Business Baruch College, CUNY New York, NY, USA Other Books in the Series: Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): Volatility Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): Technology and Regulation Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): Competition in a Consolidating Environment Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): The New NASDAQ Marketplace Schwartz, Robert A., Byme, John A., Colaninno, Antoinette (eds.): Electronic vs Floor Based Trading Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): Coping with Institutional Order Flow Schwartz, Robert A., Byrne, John A Colaninno, Antoinette (eds.): A Trading Desk View of Market Quality Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette (eds.): Call Auction Trading: New Answers to Old Questions Schwartz, Robert A (ed.): Regulation of Equity Markets For further volumes: http://www.springer.com/series/7133 www.ebook3000.com Robert A Schwartz Gretchen Schnee ● John Aidan Byrne Editors Rethinking Regulatory Structure www.ebook3000.com Editors Robert A Schwartz Zicklin School of Business Baruch College, CUNY New York, NY, USA John Aidan Byrne New York, NY USA Gretchen Schnee Zicklin School of Business Baruch College, CUNY New York, NY, USA ISBN 978-1-4614-4372-8 ISBN 978-1-4614-4373-5 (eBook) DOI 10.1007/978-1-4614-4373-5 Springer New York Heidelberg Dordrecht London Library of Congress Control Number: 2012940872 © Springer Science+Business Media, LLC 2013 This work is subject to copyright All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed Exempted from this legal reservation are brief excerpts in connection with reviews or scholarly analysis or material supplied specifically for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work Duplication of this publication or parts thereof is permitted only under the provisions of the Copyright Law of the Publisher’s location, in its current version, and permission for use must always be obtained from Springer Permissions for use may be obtained through RightsLink at the Copyright Clearance Center Violations are liable to prosecution under the respective Copyright Law The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use While the advice and information in this book are believed to be true and accurate at the date of publication, neither the authors nor the editors nor the publisher can accept any legal responsibility for any errors or omissions that may be made The publisher makes no warranty, express or implied, with respect to the material contained herein Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com) www.ebook3000.com In memory of Kalman J Cohen, my dear friend, colleague, and coauthor www.ebook3000.com www.ebook3000.com Contents Chapter Good Price Discovery, the Neglected Regulatory Objective Opening Remarks: Robert Schwartz Speiser Professor of Finance, Zicklin School of Business, Baruch College, CUNY Chapter The Case for Regulatory Reform Opening Address: Andreas Preuss CEO, Eurex AG Chapter Regulation’s Impact on Competition Moderator: Benn Steil, Council on Foreign Relations Steve Chmielewski, Jones Trading Institutional Services, LLC Gregory DePetris, AQS, A Quadriserv Company Joe Gawronski, Rosenblatt Securities Inc William O’Brien, Direct Edge James Ross, NYSE Euronext 17 Chapter Transparency in the Trading Markets Mid-Day Address: Alfred Berkeley Chairman, Pipeline Trading Systems LLC 33 Chapter The View from Europe Moderator: Bruce Weber, London Business School Robert Barnes, UBS Investment Bank Eric Noll, NASDAQ OMX Chris Pickles, BT Global Services Peter Randall, Industry Commentator Nic Stuchfield, SIX x-clear AG 45 vii www.ebook3000.com Contents viii Chapter View from the Regulators Moderator: Robert Colby, Davis, Polk & Wardell LLP James Brigagliano, U.S Securities and Exchange Commission Brian Peters, Federal Reserve Bank of New York Susan Wolburgh Jenah, Investment Industry Regulatory Organization of Canada 59 Chapter Regulation Going Forward Moderator: Harold Bradley, Ewing Marion Kauffman Foundation Ian Domowitz, Investment Technology Group, Inc Gary Katz, International Securities Exchange Tim Mahoney, Bids Trading Jamie Selway, White Cap Trading LLC Joseph Wald, Knight 75 Chapter Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran Closing Dialog with Donald Weeden, Chairman, Weeden & Co LP www.ebook3000.com 95 List of Participants James Angel Georgetown University Robert Barnes UBS Investment Bank Alfred Berkeley* Pipeline Trading Systems LLC *At the time of the conference, Mr Berkeley was Chairman of Pipeline Trading Systems LLC Steve Bookbinder* Deep Liquidity *At the time of the conference, Mr Bookbinder was with Deep Liquidity Harold Bradley Ewing Marion Kauffman Foundation Jay Biancamano* Liquidnet Holdings, Inc *At the time of the conference, Mr Biancamano was with Liquidnet Holdings, Inc James Brigagliano Steve Chmielewski Robert Colby Gregory DePetris* *At the time of the conference, Mr Petris was with AQS Ian Domowitz Joe Gary Gawronski Katz US Securities and Exchange Commission Jones Trading Institutional Services, LLC Davis, Polk & Wardell LLP AQS, A Quadriserv Company Investment Technology Group, Inc Alfred Eskandar* Liquidnet Holdings, Inc *At the time of the conference, Mr Eskandar was with Liquidnet Holdings, Inc Rosenblatt Securities Inc International Securities Exchange Tim Mahoney BIDS Trading Eric Noll NASDAQ OMX William O’Brien Direct Edge Brian Peters* Federal Reserve Bank of New York *At the time of the conference, Mr Peters was with the Federal Reserve Bank of New York ix www.ebook3000.com List of Participants x Chris Pickles* BT Global Services *At the time of the conference, Mr Pickles was with BT Global Services Andreas Preuss Eurex AG Peter Randall* Industry Commentator *At the time of the conference, Mr Randall was an Industry Commentator James Ross* NYSE Euronext *At the time of the conference, Mr Ross was with NYSE Euronext Stephen Robert Sax Schwartz FBN Securities Inc Zicklin School of Business, Baruch College Jamie Selway* White Cap Trading LLC *At the time of the conference, Mr Selway was with White Cap Trading LLC Benn Steil Council on Foreign Relations Nic Stuchfield* SIX x-clear AG *At the time of the conference, Mr Stuchfield was with SIX x-clear AG Joseph Wald Knight Bruce Weber* London Business School *At the time of the conference, Professor Weber was with the London Business School Donald Weeden* Weeden & Co LP *At the time of the conference, Mr Weeden was with Weeden & Co LP Susan Wolburgh Jenah www.ebook3000.com Investment Industry Regulatory Organization of Canada 88 Rethinking Regulatory Structure rules But if you don’t follow up on them, and if you don’t ensure that people are following them, then no form of regulation is going to work But otherwise, principles-based trading can work SELWAY: As an equities guy, the absence of information of the CDS market was absolutely incredible for me last fall BRADLEY: There were CDS indexes created by the investment banks for you to get that kind of information SELWAY: So, the basic stuff, price discovery, who owns what, was minimal Our little sleepy equity market, our infrastructure, whether it is the public tape, or DTCC, we are heading down that road We talk about systemic regulation, but we wouldn’t be in the business of having to bail out entire firms because of CDS unknowns if there was a place where Who cares if it is the CFTC, SEC, or OTS Remember, you could basically go to a place to get information to understand the size of exposure and make a judgment We don’t have that today because we operate in the unknown We had to make some incredibly expensive decisions We should be working on dark pools, flash orders, tweaking Reg ATS It’s fine but it should be the 69th thing on our list MAHONEY: We got it right in 1975 when they nationalized all the clearing Now there is only one clearing entity There were multiple clearing places back in 1975 You were also forced to consolidate the tape So, the SEC, with great insight, and with lots of help from people in the industry said, let’s a couple of things: We are going to allow competition, we are going to have multiple markets, and we are going to interlink them Maybe it didn’t work Still, conceptually, it was the right idea to have competing exchanges competing in terms of price discovery Price discovery is the art form in our business What 500,000 shares are worth and what 100 shares are worth is different How you work that out is through price discovery, whether it is through a dark pool, or high-frequency trading? It doesn’t really matter Settling the trade is about mechanics and it needs to be done in a nationalized way The reason that the market in Europe really doesn’t work is because there is no consolidated tape there There is no centralized clearing There is no single regulator in charge KATZ: The FTC or the CFCT? MAHONEY: So it is a rules-based vs a principles-based industry? SELWAY: Gary would know People seem to say a 1/3 SEC, 2/3 CFTC I think that is the CBO (Congressional Budget Office) answer KATZ: Everybody in the futures market votes CFTC; and everybody in the securities markets votes CFTC MAHONEY: It is principles based That’s the concept It is like the FSA, Financial Services Authority in the UK It is simpler to understand Chapter 7: Regulation Going Forward 89 BRADLEY: I came from being a micro markets equities specialist, to running an endowment where I end up negotiating ISDA swap agreements with high-priced New York lawyers With complete inability to exit the contract without then writing another contract on the other side My view is that Wall Street recognized what happened to their equity trading engines in the 1990s It has created a whole systematic structure around legal agreements which are nonstandardized, not fungible, and are really hard to net out That is necessary in order to stop the computerization of those markets and preserve their dealing margins, which are still very, very wide What’s wrong with that thesis, even though they are your biggest customers, Gary? KATZ: It is a good thesis This gentleman asks a great question today Why are we not looking at bonds? Andreas Pruess this morning, in the first slide he put up, showed 90 % off exchange, 10 % on Of the 90, 80 % is fixed income We haven’t talked about that There is no transparency There is no exchange model There is no central counterparty clearance A similar area is stock loan Greg DePetris and his group Quadriserve—a disclaimer, we own a piece of them I am not trying to advertise all the strategic investments that I own! [laughter] BRADLEY: Gary, they are all the right ones KATZ: But they are trying to bring some level of transparency and central party clearance to an area of the business that is probably, outside of fixed income, one of the most opaque protected areas of the business that exists today KATZ: On stock loan, in Europe many institutions had pooled collateral accounts and can’t get to their collateral because it was pledged in Europe to other parties So, the collateral didn’t even remain in a position of safety Here we have another issue, which is, just the cost to borrow The banks make a ton loaning it out and pay a pittance back to those who lend the securities What if we did away with stock loan? What would happen? KATZ: The options market would cease to exist and that would be a crying shame since I represent them MAHONEY: It would be hard to shorts too I think you need to be able to deliver stock The CDS market there was no force to deliver anything You could short more than the bonds outstanding BRADLEY: Ten or twenty times more MAHONEY: The discipline around the shorts and equities is that you have to deliver something There is a price to that Technically, you can probably short more than the outstanding shares, but it would be very expensive to WALD: A real theme of this panel has been the regulatory structure of the equity markets It is a model that works Take a look at Reg SHO (NASDAQ-Listed Securities Effective, on January 3, 2005, as defined in Rule 203(c)(6) of Regulation SHO, a “threshold security”), from that perspective, that’s it There are no more fails; 99.9 % happen now 90 Rethinking Regulatory Structure BRADLEY: That was only true, though, after the stimulus bill where there was a several hundred thousand dollar fine put in for anybody who failed, right? WALD: Yes But it has gone away The problem is not there I just hope that things don’t get messed up looking at the equity markets the way they are because today current regulatory structure is the most effective globally BRADLEY: Let’s open up for questions UNIDENTIFIED AUDIENCE MEMBER: If you abolished stock loans, you just get a contract for the difference instead, an unsettled securities transaction and that is what typically happens in London With fixed income, if anything, the situation has gotten worse In Europe there was the beginning of the development of a public and transparent government bond market If anything, that has gone into reverse Spreads have widened and liquidity has been withdrawn from that market It would be interesting to have a whole conference on fixed income BRADLEY: Gary, you attended the World Federation of Stock Exchange meetings a couple weeks ago What is on the minds of the executive who are your competitors around the world? If there was any coalescing of ideas that need attention, what are they talking about? KATZ: The greatest concern that the exchanges have right now is the concept of transaction taxes The profit margins of the players, whether they are high frequency, market makers, maker takers, liquidity providers, it doesn’t really matter We are not talking about picking up pennies any more in front of a bulldozer We are talking about half pennies and tenths of pennies If there is a transaction tax that business is going away That business cannot make money if there is a transaction tax It comes and it goes but, when it comes back again, it seems to get legs because everybody is so upset about the financial markets That’s one of the greatest concerns we have All these other issues we’ll be creative about, coming up with new ways of creating functionality that performs similar functions to flash But, what we can’t is bring back constituencies that provide liquidity if they can’t make money BRADLEY: Won’t transaction taxes just drive those who are not in OTC (Over-thecounter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities, or derivatives directly between two parties.) Derivatives and swaps into that direction? Because, if I can get long the Acqui index, calling one of my investment bank friends and striking a year swap; I don’t pay a transaction tax on that It’s an IOU KATZ: That may be the case for the institutional trade guys and players But now you are talking about the e-trade customer For 100 shares or 200 shares I am not quite sure that Goldman is taking their phone call and doing that trade upstairs for them The market will just go way We will have empty screens We have worked so hard over all these years to have the tightest markets Maybe not the deepest anymore because of what has occurred But, as a result companies like BIDS are formed Chapter 7: Regulation Going Forward 91 that fill a need in the marketplace But, if liquidity providers cannot make money those screens will be blank BRADLEY: Let’s have closing comments from the panel Then I’ll take questions from the floor WALD: I am pretty impressed with how effective the regulatory structure for the US equity market has been Not only with respect to the crisis, but looking back all the way from the early 1990s and into the 1970s How effective that rule-making process has been I just hope this crisis doesn’t get over politicized to the point where we now start causing real damage to something that is actually working well SELWAY: I would concur I would encourage everyone to their part with the press, with their senators, along those lines, to help solve those problems I would like to be the first kid on my block to get to the inaugural Bob Schwartz conference on fixed-income market structure! There is a lot of good work to there MAHONEY: I agree Competition has been so good for these markets Quite frankly, you and Holly and Pete Jenkins who is hiding in the back drove the business This is a market structure you encouraged and wanted to form and it really works It would be a shame to see this … BRADLEY: It was kind of fun It was a little nerve-wracking for a little while MAHONEY: It worked until last year But it had functioned so well and you walked away it look chaotic Imagine if you had to explain to someone from outer space how this market works: You have dark pools, you have exchanges, you have ECNs like Direct Edge becoming exchanges Imagine explaining all of this, and what they do? Every single day you didn’t like it, but you knew the value of your stock No company went out of business because they didn’t know the value of the stock they owned Lots of companies went out of business because they didn’t know the value of the bonds they owned KATZ: We love to bash the SEC The fact is they should be given credit for creating this competitive market structure I am not condoning what they did or did not with Bernie Madoff But when it comes to how they regulate exchanges, the changes they have made over time, and how they have adjusted to those changes, we are far better served working with them and helping them than looking for change This is a regulator that is here to stay with us DOMOWITZ: Amen Bob, are up BRADLEY: No Ian, finish, you’ve got your final thought We haven’t relinquished control yet DOMOWITZ: Oh, but we are trying MAHONEY: Safest sign in the world—Harold with a microphone! DOMOWITZ: I want to echo the call with the respect to fixed income I was part of the original committee that was put together that eventually came up with the so- 92 Rethinking Regulatory Structure called trace system On the very first day of that show, someone, who will remain nameless, from the legal staff of a very large firm, got up and actually said, ‘Not only we believe that we not have to report prices to the general public, we believe that we not even have to report prices to the SEC.’ That is the extent to which there is a belief system in the fixed-income market that amounts to this: Leave us alone and keep the market opaque It is going to be a tougher job than anybody believes in terms of opening this up BRADLEY: Of course, the Treasury is their friend Question from the floor? UNIDENTIFIED AUDIENCE MEMBER: Regulators, including the chairs of both the SEC and CFTC, have recently spoken on the benefits of having robust competition brought to derivatives exchanges Given your experience in equity markets, what steps you think might be implemented to accomplish this in derivatives and futures markets or, more broadly, what impact can that have on the competitive landscape? SELWAY: The big one that people are talking about right now, which is extremely controversial, is fungibility There is a venue called the ELX Futures exchange (ELX Futures offers a fast, efficient, and competitive alternative for global market participants trading futures contracts), which is trying to compete with the CME (CME Group is the world’s leading and most diverse derivatives marketplace.) On the equities side, to Tim’s point earlier, we have done some pretty bold strokes since 1975 We nationalized a clearing house CME has a lot of stock holders in the nationalization of the CME clearing house so there is going to be a problem But if we took notions like fungibility, trade-through, best execution, these kinds of obligations, and ported them from the equities market to the derivatives market we would get competition We would also get a lot of disgruntled legacy exchanges So, it is going to be a fight To be fair, you can also ask, are investors disadvantaged by the futures’ exchanges? Or, are they receiving value today? Some might argue that the futures have to compete with the cash markets so you could substitute out of equities into futures and vice versa and thus don’t need multiple exchanges JIM ANGEL, Georgetown University: I noticed the FTC (which you voted for on this panel as the preferred regulator) seems to send people to conferences like this to actually learn about, discuss, and think about regulation My question is, where is the SEC today? As I look over this room I don’t see a whole lot of SEC people We have one person who showed up for a panel and who then disappeared BRADLEY: Now Jim to be fair CFTC, hands Oh, two people are present from the SEC JIM ANGEL: This is the real problem with regulation Our regulators at the SEC not understand the economics of markets, nor they care MAHONEY: I disagree Not just because they are regulators, but having spent a lot of time in the industry, they spend a lot of time with us asking questions You can go down to Washington and talk to them about any rule and how it works They are open to you and receptive to this Chapter 7: Regulation Going Forward 93 They are very engaged I don’t think that that is a fair commentary whether they show up to this conference or not Bob Colby, who spent his life time doing this, has done some amazing things I don’t think that that is fair BRADLEY: Tim, when I look back at the people, there was amazing stability on the staff in the last 15 years However, in the last months every person I knew on staff is gone I have not received a phone call from anyone since MAHONEY: You still have Shulman there and when Eric Cerie left that was a big blow Eric was a practitioner, a very reasonable guy who really understood the interaction of markets BRADLEY: He was curious MAHONEY: There was a whole host of people who did a great job for a long period of time STEPHEN SAX, FBN Securities: Listening to this panel, I’m surprised that the SEC is going to get together tomorrow because it seems like there are no problems I want to make a comment regarding retail investors I agree that a retail investor buying 500 shares or 1,000 shares is definitely better served today with fragmentation the way it is But, there is another kind of retail investor who no one has touched upon That is what I am I am sure there are a lot of other people in the same boat Whatever they have their money in, long only mutual funds, pension plans, and insurance policies, that money accounts for a significant amount of the trillions of dollars under assets Listening to Harold and Ian with their numbers again it seems to me that those large institutions, looking at the cost involved for market impact, are all well served But, if you look at the active mutual funds, they really can’t compete with an index or ETF If everything seems fine with the market cost and market impact costs, then it looks to me that these people who I am paying to manage my money are not good stock pickers BRADLEY: There is a whole different problem between execution and the frictions of getting trades done and how you construct portfolios In my opinion, most of the institutional money management community—and I faced this as a CIO for a foundation—have gone to what are called institutional mandates, which, to me is a form of closet indexation They talk about what is called information ratio, can I add a lot of value and not take too much risk? The only way you can that is to reduce risk You have frictions over that you will fail to match the market over time I think the vast majority of money market managers are no longer active and are no longer trying to pick stock Bob, thank you Chapter Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran Closing Dialog with Donald Weeden, Chairman, Weeden & Co LP ROBERT SCHWARTZ: We talked today about how the revolutionary changes that have positively transformed the equities markets could the same for the better functioning of the broader financial markets Some speakers had different perspectives on that topic Of course, perspective is always important, and, a person who has lived through the momentous moments in financial history often has a most valuable perspective That person can be a counterweight to the conventional wisdom We tend to focus on current problems in market structure as if they’re new problems Yet a lot of them are the same old problems dressed up in a new form, a new guise One person who has a special, historical perspective on all of this is Don Weeden I’ve known Don Weeden since we were much younger guys in the industry The Security Acts Amendments of 19751 was the trigger for all the subsequent market structure debates Not long afterwards, conferences on market structure were started at NYU (when I was a professor there) and now at Baruch College and elsewhere From the start, there was a small group of people who I interacted with on the issues I’m thinking of Don Weeden; I’m thinking of Don Stone, a specialist and former vice chairman of the New York Stock Exchange; and of other terrific people like that They have been involved all along in the market structure debates, the regulatory processes, and the growth of the industry These are the people who were the industry pioneers In the 1975 Amendments to the Security Exchange Act of 1934, Congress directed the SEC to establish a national market system R.A Schwartz et al (eds.), Rethinking Regulatory Structure, Zicklin School of Business Financial Markets Series 10, DOI 10.1007/978-1-4614-4373-5_8, © Springer Science+Business Media, LLC 2013 95 96 Rethinking Regulatory Structure Don, in fact, had financed one of the first electronic trading systems That system was created in 1969, and it was called Instinet.2 Actually, it was introduced years before the introduction of another ground-breaking system, the NASDAQ Stock Market Don has written eloquently about his experiences and the history of market structure, and his thoughts are described in his excellent and informative book, Weeden & Co.3 Please welcome our distinguished friend, Don Weeden DON WEEDEN: Thanks, Bob Harold Bradley reminds me of a great story that dates back to the First World War A war loan drive was underway Enrico Caruso, the legendary Italian tenor had just sung an aria from Pagliacci in Carnegie Hall The audience was overwhelmed with his beautiful voice Who could follow Caruso singing? How about Al Jolson? He stepped up in his blackened face, then went to the center of the apron of the stage, sat down and, after everything went quiet said, “You ain’t heard nothin’ yet!” You know Al Berkeley was very nice to me today He gave me a little wiggle room in talking about market history, and whether or not it has some lessons for us at this particular conference which is appropriately titled, “Regulation, Competition and Technology.” These are indeed the key issues that are facing our marketplaces In some cases they need improvement and in other cases they are doing very well I thought I was going to make some comments about the other panels and speakers That is what Bob Schwartz asked me to I think they have done a very good job All of the panels and the speakers were insightful, interesting I can’t think of anything to add or to subtract Instead, I thought I’d give you nine and one-half minutes of my wisdom! And then let you get to the wine tasting In the name of full disclosure, the first thing I want to say is that I happened to have been born in early June of 1930 Assuming a normal gestation period, it puts conception about weeks before the stock market crash of October 1929 (laughter)! My parents had often joked that, if the Crash had come a month earlier, I would not be here! (laughter) I mention the Crash because one must go back that far to find similarities between that and the public’s reaction to what we have just experienced The Crash was the beginning of a long drawn out public condemnation of the bankers That continued through the election of President Franklin D Roosevelt in 1932—and beyond that “Weeden continued to pour money into Instinet upon my insistence (bordering on a temper tantrum on one occasion) and consistent support from my brother Jack Weeden at one time owned more than 90% of Instinet,” noted Don Weeden recalling Weeden & Co.’s early ownership in Instinet, in his book, Weeden & Co The New York Stock Exchange and the Struggle Over a National Market System, Donald E Weeden, 2002 In early 1973, influenced by the language in the proposed Securities Acts Amendments of 1974, Weeden & Co began work on its screen-based trading system known as the Weeden Holding Automated Market (WHAM) WHAM was completed in 1976 and introduced on the floor of the Cincinnati Stock Exchange Ibid Chapter 8: Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran 97 It continued up until as late as the 4-day nationwide bank holiday of 1933 passed by Roosevelt That prevented customers from pulling their money from the banks Back then there was no equivalent of the bank insurance deposit guarantee program of today that is operated by the Federal Deposit Insurance Corporation With the crisis boiling over, one observer of the public mood recorded, “apologizes, even resignations, satisfy us.” One US Senator opined, “The best way to restore confidence in our banks is to take those crooked presidents out of the banks and treat them the same way they treated Al Capone.” President Roosevelt said it slightly more eloquently, “Practices of the unscrupulous money changers stand indicted in the court of public opinion Rejected by the hearts and minds of men, these money changers fled from their high seats in the temple of our civilization.” There is a lot of similar language today and for good reason Back in the 1930s, the same kinds of feelings were directed toward the Wall Street gang of inside pool operators and specialists on the floor of the NYSE who were later exposed as having moved and manipulated the market The legislative results, expressing the public’s outrage, were several fold For example, the Glass–Steagall Act of 1933 was created to separate investment banking from the commercial side of the banking business There were other laws The 1933 and 1934 Securities Acts4 for the first time established government regulation and oversight of Wall Street The Public Utilities Holding Act of 1935 broke up the highly leveraged ownership of the utility industry which had been aided and abetted by Wall Street Looking back, most would now admit that all three regulatory acts were good law Each of the industries made their adjustments and prospered And the public investor benefited as well It should be noted that the new regulatory framework was the least onerous of the many recommendations then sent before Congress For example, the Municipal Bond business was completely excluded from any new federal regulation at this time I mention that because we are hearing a lot of extreme ideas now on how to correct the misuses, the lack of transparency, the excessive leverage, and the inappropriate marketing tactics that brought about the present crisis My guess is that we will end up with legislation that is less than the most onerous being recommended, but at least that is much better than what we have now.5 There will also be a determined effort by those in Washington to ensure that future regulators not evade their responsibilities and what they have been hired to Now let me fast forward to 1956, the year I came to Wall Street In comparison to the 1920s and the present environment, Wall Street was a rather sleepy business back then The New York Stock Exchange was averaging a couple of million shares a day The OTC market was made up of the so-called pink sheets that were distributed to industry members only These had the bid and ask prices of over-the-counter The Securities and Exchange was established by the Securities Exchange Act of 1934 On July 21, 2010, President Barack Obama signed into law the Dodd–Frank Wall Street Reform and Consumer Protection Act, commonly known as Dodd Frank 98 Rethinking Regulatory Structure stocks and the market makers who traded them Options had not yet exploded on the scene Options pricing data were tucked away in a corner of the newspaper They were typically minor transactions little used by brokers The Chicago Board Options Exchange—and NASDAQ—wouldn’t come on stream for more than 15 years As for Exchange Traded Funds and derivatives, those were not then in our lexicon The only transparency in the markets was the last sale ticker on the New York Stock Exchange Historical data on any security was hard to obtain Securities were then physically delivered or received by the individual brokers or dealers involved in the trades rather than electronically delivered as they are today Prior to their abolition by the SEC in 1975, commission rates were set by the exchanges at a level that provided plenty of revenue, particularly on large intuitional trades This all provided a comfortable, relaxed, reasonably profitable living for the partners of the firms who controlled most of the business, who came from good families and mingled together at exclusive country clubs The capital of Wall Street firms was almost all tied up in partnerships Weeden & Co was an exception, having incorporated in 1922 and sold issues in this non-traded publicly held corporation to the public in 1928 Venture investing and speculation was financed outside of the firm People within Weeden, if they engaged in this activity, did so as individuals It was not our business as a firm In 1956, the Great Depression was long passed but not forgotten The intervening war consumed everyone’s attention and slowed this business to a crawl Those who survived these two difficult periods were, for the most part, decent men of a conservative bent They were content with the improving atmosphere that slowly brought investors back into the markets There was no need or desire to return to the greed, to the speculation or the leverage of the 1920s Regulation of the markets was just as sleepy As with those on Wall Street, the regulators were comfortable with the way business was being done The early excitement of transforming and policing the industry was replaced with a satisfaction that its members had learned their lessons and were now behaving themselves Joel Seligman, in his epic, The Transformation of Wall Street, said that, during the Eisenhower administration, there was, “The assumption by the regulator that the business was over regulated and that large institutions like the New York Stock Exchange could discipline themselves.” I remember the intervening years having a certain ebb and flow in the level of regulatory oversight I have difficultly knowing the proper mix Should we attribute the excesses that created the recent turmoil in the financial markets to too little regulation? Were the excesses caused by something less definable and, therefore, more difficult to correct? Are there lessons to be found in the excessive behavior—the increasing speculative activity on the stock exchanges—of the 1920s or in the regulatory enactments of the 1930s? While I not have concrete answers to these questions, I will suggest that these changes and developments need to be understood and considered by the legislators as they wrestle with the issues of today Disclosure, sometimes referred to as transparency, has played an important dual role While providing a more equal playing field, more accurate information, improved Chapter 8: Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran 99 research and regulatory oversight, it also has another effect It creates enormous competitive pressure on public corporations, investment managers, advisors, bankers and their willing investors who have sought increasing returns Everyone seems willing to take greater risks They were like fighter pilots, willing to test the edge of the envelope Over the years, annual reviews became quarterly, became monthly, and became daily Now there are highly sophisticated algorithms analyzing market movements occurring in milliseconds The technology that enables this is the second great advance in the markets and in the way people operate on Wall Street Before the mid-1970s, both the buy-side and the sell-side had an abhorrence of the new electronic gadgetry that emerged in the late 1960s I am thinking of systems back then like Autex that assisted traders with trade information This new gadgetry was transforming the way information was distributed, trades executed, and how back offices operated While it led to lower costs and higher volume, the new gadgetry demanded new talents, new ways of thinking Ultimately, a new generation of players was needed who could cope with the new pressures and challenges being laid upon them Finally, in the late 1970s, we began to see this new breed invading Wall Street They were the best and the brightest from every business school in the country They were good, very good They are good They came from all corners of our society They wanted to succeed They were aggressive, hard-working, passionate, and sometimes insensitive to the results of their actions They wanted to make money and they created ways to it that had never been thought of before I am sure that they thought they were doing the right thing because the report card of the Street, that is profits, told them so And they were allowed to it because the regulators remained sleepy and unaware These bright young professionals were the biggest change of all And, in combination with the new technology and disclosure, the banking and securities industries will never return to what some old timers (older than I) said were the halcyon days of the 1950s If this be the case then, whatever new regulations are enacted, they must recognize the new complexities and sophistication that drive our financial markets today Any new legislation must find a way to control Wall Street’s propensity to excess, and to enforce its sense of responsibility Yet, at the same time, it must not discourage its new creative force, or deny reasonable incentives In this respect, the regulation enacted in the 1930s was successful in finding the right balance, and it should be the template going forward Thank you (applause.) Any questions? There shouldn’t be since I thought I answered everything! HAROLD BRADLEY (Kaufman Foundation): Don, you said earlier that most of the people you were competing against were in partnerships Two years ago, 65% of firms’ revenues owned by public shareholder went to pay the salaries on the inside, namely management, traders, salesmen, and some others Do you think that if they had instead been operated by partnerships today we would have avoided this meltdown? WEEDEN: Yes I think the partnerships are a much more controlled and disciplined entity The fact is, it is the partners’ money The partners are working together and take a look at the distribution of profits in a different way than when you are rolling 100 Rethinking Regulatory Structure the dice with someone else’s money There are no problems in the partners doing whatever they want to However, when you are using someone else’s money, you should not speculate with it If you are using someone else’s money I think you have a responsibility not to that And, if you are providing a financial service where people have traditionally looked to you as conservative in the way you operate, you have a responsibility not to speculate The leverage that came out of the last or years is just unbelievable What was done and what was not picked up by the regulators was amazing I remember 20 years ago Milton Friedman had his M1 money supply theory.6 He was the big monetarist, and we all kind of knew what was happening We watched M1 Then slowly the idea of the M2 money supply was introduced Then we had to watch M1 and M2 because that included other piles of money that weren’t in the traditional piles, where you could pick it up and see it The Federal Reserve Board had no idea of the turnover of money, the velocity of money, nor did it have any idea of the amounts of money in circulation! Moreover, the Federal Reserve Board had no idea of who was controlling that money supply Do you know how many M’s are out there today?7 If you believe, as Freedman did, that this was the most important thing affecting the economy—the amount of money supply plus the volatility or turnover of it—then everybody would like to calculate all the Ms that were never picked up These were piles of money that were off shore, or off the balance sheet, or someplace else That was of no concern to the regulators who were moving in this hypercapitalist theory that the industry can regulate itself They really don’t need us following them, doing our job of analyzing, exposing, and regulating this excess, which could only come to the end that we saw I have to say that I was not in that business We became very much equity oriented I was getting older and feebler, and I never saw that I never saw what these credit default swaps were We at Weeden & Co don’t anything in derivatives, ETFs, or that sort of thing Those are just leverage opportunities When I came to Wall Street, we provided a service, whether as a broker, an advisor, or as a dealer We didn’t happen to be a dealer, but we had customers, and we had a relationship with them If we didn’t act properly we didn’t get any business from them Yes, we took positions But we took positions because it was necessary to service our customers, not because we wanted to load up and speculate and make a lot of money There was a lot of money and there is still a lot of money to be made on Wall Street We don’t have to make one hundred million dollars a year unless that is necessary to satisfy our ego I sometimes go down to Greenwich, along North Street I pass the Stanwich Club and see these enormous mansions there, and there are no lights on I don’t know where the residents are I don’t know why they need the mansions Anyway, that is enough of an answer to Harold I hope that will keep him quiet for a while! Friedman advocated, “strict rules to control the amount of money created.” The US money supply is represented by M1, M2, and M3 M1 is the narrowest measure and M3 being the broadest Chapter 8: Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran 101 STEVE WUNSCH (Wunsch Auction Associates): Ian Domowitz of ITG said at the conference today that when the markets started to go haywire, when volatility started to go up, roughly in August 2007, there were three new rules that the SEC had implemented a couple of months prior The coincidence of the timing may make you wonder if these three regs had anything to with what finally tripped all of the bad mortgages into a tailspin—so much so that, a couple of months later, we were in recession and the market was collapsing Does it seem possible to you that anyone of them tripped us up, tipping us into recession? One was removal of the uptick rule for short selling The second was the unfolding of the trade-through rule under Reg NMS, which requires that the best electronically available bids or offers across markets be protected They can’t be traded through by an exchange or broker In other words, Reg NMS was suddenly electrifying and computerizing the New York market at a rapid clip at the same time as their market share was declining very quickly It was becoming a very fast moving electronic market like NASDAQ had been for years The third reg was the introduction of a very strict interpretation of the fair-value or market-to-market accounting that the SEC caused the Financial Accounting Standards Board to adopt That was all within a couple of months of the beginning of the markets going haywire Any thoughts about this? WEEDEN: First we have to understand that the problem in this case was not in the equity markets It was in the other areas, such as the equity derivatives markets which have grown enormously as a percentage of the overall market in equities and equity derivatives volume Regarding getting rid of the uptick rule, there are two arguments I lean on this side: I don’t think it makes much difference I believe that there is enough volume in the market and enough players so that, if anything, it builds a demand for the stock, giving somewhat of a bottom to the downturn Because there are a lot of people who have to buy that stuff back again I happen to believe (like Gary Katz at the International Securities Exchange) that the SEC has done a terrific job I think that Reg NMS was introduced 30 years later than it needed to be Still, it finally opened up competition to the New York Stock Exchange’s listed market Despite the fact that New York has gone from over 80% market share to some 23%—that is not counting it’s affiliated Archipelago unit— volume has gone from about two billion shares a day to in excess of that!8 It means that competition did come in and provide something that was not there before Take, for instance, the fast market people, the high-frequency traders They had no opportunity prior to all the changes to come into the NYSE and what they had been doing in the NASDAQ market That was very helpful in creating liquidity in NASDAQ, a marketplace that had a capitalization of about one-eighth of the capitalization of the stock listed on the New York Stock Exchange And so, it was NYSE Euronext US cash products of NYSE, Archipelago, NYSE Amex accounted for 2.5 billion shares in October 2011, up 5.6% from a year ago, but down 2.4% compared with September 2011 Source: NYSE Euronext 102 Rethinking Regulatory Structure clear that the NYSE volume would go up and that is what subsequently happened On the third one, on the banks and the fair value I can’t say anything on that, I just don’t know MOTT ALANZO (Baruch Graduate): As I recall from The Wall Street Journal, the SEC had lifted the ceiling on leverage for Wall Street firms But until 2004–2005 this leverage was in the low teens, and then it went up to about 30 When you were running your company, what was the leverage of your firm? WEEDEN: You know that we got into trouble when our leverage went up sevenfold And we did so just at the wrong time—when the bond market and stock market went down We were as dumb as anybody, but we learned a lot of lessons from that We merged with Moseley, Hallgarten, and Estabrook in 1979 and, after rethinking our economic model, we reemerged later with the Weeden name and corporate structure in January 1986 We were in the penalty box for about years.9 There was the 30 times or 40 times leverage at Merrill Lynch in the 2008 and 2009 period I remember they were a broker, and how they abhorred inventory commitments, but somehow this competitive pressure got a hold of all of these managers who didn’t understand the risks The problem we are now facing and have to work out of will take a much longer period of time than it took us to work out of our previous problems The important thing is that we learn from our lessons as they did back in the 1930s It took a lot of public outrage back then to get Congress and the Federal Reserve to create new legislation and new regulation that eliminated as much speculation as possible You could double your bets in stocks But, that was all you could under the Federal Reserve regulations With respect to the banks, Congress separated the speculation involved in investment banking from the commercial banking activities It took over 60 years but, finally, those commercial banks got back into the business of speculating Now we rue having repealed the Glass–Steagall Act of 1933.10 That is not even talked about So little attention was paid to the things that brought about the problems we have today Things like excess speculation, and these controversies associated with trading in dark markets As you know, there are two types of orders that come into the markets One kind is the retail order and does not have any troubles in being executed; then there is the big institutional order that has to be carefully, carefully handled The Street has demonstrated over decades that other traders want to get a little information about these blocks that are in the market or being demanded so that they can take advantage of them It is a natural human tendency, so you have companies like Liquidnet, the institutional electronic marketplace for block trading that try to solve that problem See, Weeden: The Story, http://www.weedenco.com/about-weeden/the-story.php The Banking Act of 1933, commonly known as the Glass–Steagall Act, was repealed on November 12, 1999, by the Gramm–Leach–Bliley Act Glass–Steagall introduced banking reforms, some of them designed to curb speculation 10 Chapter 8: Regulatory Needs, Then and Now: The Perspective of a Wall Street Veteran 103 We need an outcry for the kind of regulation that really gets the banking and securities industry back on track and restores the confidence of the public Frankly, we all live off the public, and we ought to correct our mistakes and get back to where they like us again Thanks very much ROBERT SCHWARTZ: That concludes the conference Thanks tremendously, Don, for being here today, it is so good to see you ... (eds.), Rethinking Regulatory Structure, Zicklin School of Business Financial Markets Series 10, DOI 10.1007/978-1-4614-4373-5_1, © Springer Science +Business Media, LLC 2013 Rethinking Regulatory Structure. .. (eds.), Rethinking Regulatory Structure, Zicklin School of Business Financial Markets Series 10, DOI 10.1007/978-1-4614-4373-5_2, © Springer Science +Business Media, LLC 2013 www.ebook3000.com Rethinking. .. Structure, Zicklin School of Business Financial Markets Series 10, DOI 10.1007/978-1-4614-4373-5_3, © Springer Science +Business Media, LLC 2013 17 18 Rethinking Regulatory Structure the USA and