It Makes No Sense For Banks To Act As Traders And Brokers At The Same Time

Virginia filed suit against the Bank of New York ($BNY), charging it with not giving them the best price on currency transactions.  California and Washington have also filed separate lawsuits against other companies for impropriety.

This goes right back to a post I did a few days ago.  What the big banks do is legal, but it certainly isn’t ethical.  Ripping off your customer is standard business practice.  It’s codified in the rules and regulations, and in the culture of Wall Street.  Goldman ($GS) famously sold their customers sub prime loans and promptly shorted them, trading against them and earning huge profits.  But Goldman isn’t the only one.  When a big customer order comes in everyone acts like ravens to a carcass.  Dinner is served.  Bonuses are made.

This sort of activity happens in every marketplace regulated by the SEC.  It doesn’t happen in CFTC regulated futures, but it certainly happens in over the counter (OTC) products. Banks can only make so much profit from doing the actual investment advising, connecting, lending and valuation services that they provide.  Juicing profits by trading against their customers is easy money.

The settlements so far are peanuts to what is being made with risk free arbitrage. State Street ($SST) paid out $11.7 million to the state of Washington for 10 years of transactions.  I guarantee, they definitely made a lot more than that.  Banks are so good at hiding their profits behind accounting numbers that they obscure the real activity.

Banks will enlist a cadre of economists and finance professors to write opinions on how much more efficient the market is because of the current slanted playing field.  They will say that there is “slippage” in the market, that commissions would be higher, that markets would be spooked if banks were not allowed to trade against their customers.  Banks will smugly nod their collective heads and say, “I told you so.”.

The academics’ written opinions will not be that much different than Marxism or Keynesian economics.  Some theories work really well on a blackboard.  In practice, they don’t.  Trading markets for 22 years has given me a pretty good taste of what works, and what doesn’t.  Trading against the deck only works for the principles engaged in it.  It’s bad for the overall marketplace.

In the case of currency, bond, stock and futures markets, they work better when everyone competes against everyone else.  squirrelling away orders and risklessly arbitraging them against someone else’s bid/offer is not good for the long term health of the market.  Finally, customers are wising up.  Even BlackRock has decided to begin to internalize order flow.  This ought to be a message that the way the marketplace currently is structured isn’t working for everyone.  There is no reason in the modern electronic trading world that everyone can’t play in the same pool.

Dark pools originally existed to keep anonymity.  That’s fine-but now they exist as a profit centre for those who run them.  In an all electronic trading world, it’s easy to have anonymity.

Once a bank is given an order, it’s no longer a trader-it’s a broker.  No one in the bank should be able to trade against that order.  It should be bid competitively in the open market.  Producing trade registers the next day should be easy so that in the case of a market melt down, it’s easy to decipher what went on.  Part of the reason for the poor analysis of both the financial melt down in 2008, and the Flash Crash of last year was the record of data was so convoluted the biases of the people doing the analysis weighed more heavily on the outcome than the data itself.  Now we are left with pointing fingers and political spin.

Proponents of the current system will say this can’t be done.  As the system is structured now, they would be correct.  Hence, there is an urgent need to change the rules and the structures of the marketplaces to make them more competitive.  Information in the form of price/quantity/time need to be reported faster, and more accurately.  Clearly defined roles need to be established.  An entity cannot be a broker and a trader at the same time.

The end result will be that accounting costs will look like they went up.  Commission rates will probably rise. But, the “all in” costs of trading will go down.  Markets will be tighter, more liquid, more transparent and more competitive than before. The markets will become even more efficient, allowing higher volumes of trade to occur.

This post originally appeared at Points and Figures.

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