In the early 1990s, when Britain was in deep recession and banks and investment banks were under nasty financial pressures, the new Chairman of the Securities and Investments Board started a crusade against insider dealing. We all thought his obsession bizarre as London was then widely regarded as being the cleanest securities market in the world. Largely institutional, dominated by 25 or so market makers and fewer than 200 significant fund and pension managers, abnormal conduct was easily detected and brutally sanctioned. Since the average trade size in the cross-border market exceeded $270,000 and in UK stocks exceeded $80,000, it was very difficult for anyone to undertake a pattern of activity that went unscrutinised by their peers. NatWest (Blue Arrow) and Goldman Sachs (rigging the FTSE 100 options expiry) found to their cost at the time that their market counterparties and clients were very unforgiving of misconduct. A director of Goldman Sachs complained to me then that London was their least profitable operation globally.
Nonetheless, the SIB Chairman instigated a crusade, rallied the government, demanded tougher investigative powers and tougher penalties, and carried on as if London were a cesspool of corruption. We scratched our heads and wondered at it. He was and is a good man, even if we thought his efforts then over the top.
While insider dealing prosecutions never picked up much, he succeeded in imposing strict new transparency rules on the London Stock Exchange which quickly eroded its global dominance of equity markets. Transparency made market making impossible, as market makers need time to work a large order to quote a fine spread in institutional size from their own capital. Market making on the basis of quotes was gradually abandoned in favour of electronic order routing systems that transacted thousands of small orders dribbled out piecemeal into automated execution systems instead of finely priced large orders in size. From over 85 percent of global cross-border equity trading going through the London Stock Exchange at the peak in 1991, London’s market share collapsed as trading fragmented to smaller, more opaque markets elsewhere and to derivatives. Goldman Sachs profitability soared as the London Stock Exchange declined.
In this week’s announcement that the SEC will remove insider dealing enforcement from exchanges and concentrate it in two mega systems policed by NYSE and FINRA, I get an echo of this earlier era. I hope I am wrong, but it would not surprise me if once again police powers of regulatory authorities are used – with or without their conscious collaboration – to rig the market in favour of preferred models of interaction and preferred intermediaries.
Insider dealing is no more a threat to market integrity now than it was five years ago, ten years ago, or twenty years ago. If anything, insider dealing is more rampant in bull markets than bear markets.
On the other hand, it is true that insider dealing was much easier to detect when all dealing in securities was concentrated on exchanges rather than fragmented to multiple automated systems, dark pools and cross trading networks. It is also true that insider dealing was easier to detect before half the market volume fragmented to 8,000 unregulated hedge funds.
My concerns may have started with an echo of the UK in the 1990s, but they are aggravated by the pattern of state control and abuse of information observed over the past twenty years in the USA. George H.W. Bush created the “War on Drugs” in 1981 as vice-president of the United States to gain federal authority to monitor bank transactions and telecommunications and to seize property from anyone targeted by his special squads of DEA agents who were empowered to act outside normal due process and judicial review. Reagan then declared the “War on Terror” which Bush intensified as president later that decade, arrogating to himself and US intelligence agencies even broader powers beyond the review of democratic checks and balances. That morphed into the “War on Terror” under George W. Bush, who gained even more powers for the state to spy on its citizens and treat everyone as guilty until proven innocent, extrajudicially arrest and detain citizens and non-citizens alike, render them for torture globally, and otherwise abuse government powers.
It all started with sweeping up huge streams of data into unreviewable hands weilding huge power to seize and redistribute wealth. Forgive me then if I am sceptical when the SEC wants to protect investors by further concentrating both information and police powers.
The imposition of huge data sweeps in the name of “anti-money-laundering” in the banking sector and combating “insider dealing” in securities markets reeks of the same tactics and objectives as telecoms or internet search engine sweeps to the NSA.
Ronald Reagan once quipped that the biggest lie was, “I’m from the government and I’m here to help you.” Given the pattern of abuse in his administration, and the subsequent treatment of US workers and taxpayers, he may have been more truthful than he knew. So what should we think when we hear, “I’m from the SEC and I’m here to protect you”?
Needless to say, the more data collection and police powers are concentrated in a single authority, the more difficult it becomes for anyone to contest an investigation or enforcement action by that authority. Without objective protections, alternative sources of confirmatory data, guarantees of judicial review and due process, it becomes impossible to challenge the arbitrary use of authority or the deliberate misuse of authority.
Think of just one scenario: a target firm becomes the subject of a very public investigation and charges. Its share price collapses, and investors flee. Enter a well-funded vulture fund who takes out the very best assets and a very well-connected competitor who sweeps up the choicest clients.
I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.
I would like to see more substantiation of the rationale for centralising data collection and enforcement, and more controls on the abuse of information and powers, before trusting that the regulators are acting in the interests of investors and of the greater economy as a whole.
Why not have an open database of anonymised transaction data that is reviewable and searchable by all market intermediaries and investors? That would allow anyone to investigage suspect patterns of transactions for reporting. But then that might catch the wrong people in the net and expose too many to scrutiny.
It has taken me many years to understand my discomfort with reforms in the early 1990s recession. I am worried that the proper function of markets in the intermediation of capital investment so critical to the prosperity of any economy may be further distorted and eroded. If competition is so good for capitalism, then surely markets should have to compete to demonstrate their ability to uphold efficient price discovery and market integrity. Regulators too should have to compete if only to promote vigilence in each other by maintaining reputation risk.
Harmonisation of market structure and regulation may be harmful if it tends toward sub-optimal choices. Without competition and independent data collection, we may never be able to prove that the choices our regulators make for us are not in our best interest.