Another View: Market Makers or Market Gamers?

INVESTMENT BANKING
Another View: Market Makers or Market Gamers?
May 4, 2010, 1:56 PM

Michael Stumm, the chief executive of Oanda, argues that weak requirements on transparency and disclosure have enabled a conflict-of-interest culture to dominate the financial industry.

Now that the securities fraud investigation of Goldman Sachs has reached the Justice Department, the financial industry has hit a new low in public opinion. It’s never been easier to hate the banks.

The leaders of governments around the world have taken note and are using this anger to court favor with voters. Naturally, they’re pushing for greater legislative control over the banking system.

It remains to be seen if Goldman Sachs did knowingly and fraudulently sell junk securities to unsuspecting clients, or if, as Goldman contends, the firm did nothing wrong in the mortgage-related deal and provided proper disclosure. I would argue that the final outcome of the Securities and Exchange Commission’s civil fraud suit matters little. The fact that an American regulator is questioning the trustworthiness of a sterling Wall Street firm means we’ve already crossed the Rubicon.

There is no doubt that serious changes are coming. They will be expensive and complicated, and they may not even fix the problems they’re intended to solve. And when these changes come, we in the industry will have no one to blame but ourselves. It may be trite to say this now, but it did not have to be this way.

Most of the world’s leading industrialized countries, with the notable exception of Canada and Japan, have come out in support of new fees and taxes for the banking system. One such idea is the “Tobin tax,” which would attach a fee to every financial transaction. Another is set out in a document recently leaked from the International Monetary Fund, which advocates for two new taxes on the banking system. Money from these would pay for a potential future economic crisis.

To our industry’s discredit, some of the largest names in the business have earned reputations for relying on questionable practices to make oversized profits. As President Obama warned in his recent address to Wall Street, if your business model is based on bilking your customers, it is time to change how you do business.

Transparency is the distinction between making a deal or a market, and gaming a deal or a market. A business that shows its customers how things work behind the scenes is able to prove its operations are honest. Transparency ultimately equates to fairness.

There are times when a market maker must take the opposite side of a client’s position to ensure an active market. However, this should be accomplished through technology that automates the process to ensure there is no conscious manipulation to bet against clients. If the firm offering the security holds a position — or if any affiliated entity holds a position — this information must be made available to the prospective buyer. Full disclosure with respect to the underlying securities must also be published.

In the case against Goldman Sachs, the S.E.C. contends the firm deliberately suppressed information about the quality of the underlying securities and did not disclose that the hedge fund firm Paulson & Company was taking a short position. If true, it means Wall Street’s most respected investment bank sold a product to clients at worse odds than if those clients walked into a casino and bet their money on a single spin of a roulette wheel — worse odds because casinos at least acknowledge to their patrons that the odds are stacked in favor of the house.

It is shameful that the investment industry has been reduced to deliberate attempts to prey on the vulnerabilities of investors in order to profit. Gone are the days, it seems, when banks and investment firms operated on principles of adding value to the investment process. Now these firms make the majority of their profits through proprietary, or “prop,” trading, in which in-house traders conduct transactions on behalf of the firm. This is an inherent conflict of interest that has propagated a new operating philosophy based on making money any way possible, even if it means taking advantage of your client.

The weak requirements around transparency and disclosure have enabled this new culture to dominate the industry. But I can tell you firsthand that fairness and profit need not be mutually exclusive. Oanda’s core value is transparency, so we publish open and short positions for each supported currency pair on our foreign-exchange trading platform. These are positions held by actual clients, and having access to this information makes it possible for traders to gauge real market sentiment.

In contrast, those who attempt to profit by gaming the market will obfuscate the truth — or purposely misrepresent facts — to prevent customers from making informed decisions. Too many market makers fall prey to this temptation. They increase their rate of “wins” over clients by hiding information or using technology in what I can only describe as a perverse way.

The investment industry continues to concentrate development efforts more on creating advantages for themselves, rather than committing to an efficient market. There is a technology “arms race” under way on Wall Street, as evidenced by the adoption of high-frequency trading that favors those with the largest information technology budgets. Deals with exchanges that allow for an early look at market prices or the creation of dark pools that hide the trading activity of the large firms have served only to put smaller traders at a disadvantage.

Transparency and fairness for all market participants? Hardly.

Such government moves as extracting new taxes and taking aim at executive bonuses, while undoubtedly proving immensely popular with a jaded public, detract from the main issue. Though it may sound naïve and even a bit simplistic, what is needed is greater transparency to force a change in the way business is conducted. While it is impossible to mandate “fairness” as a business requirement, transparency can be both legislated and measured, and this will do more to level the field than any other administrative requirement.

The current investigation against Goldman Sachs is still in the early stages, but the damage to the industry’s reputation has already taken its toll. I remain optimistic however, that the day is coming when transparency is seen by financial executives as a competitive goal to strive for, rather than something to avoid.

Michael Stumm is the chief executive of the Oanda Corporation, a provider of online foreign currency exchange trading and services and the source of the currency rates used by leading institutions including PricewaterhouseCoopers, Ernst & Young and KPMG.

http://dealbook.blogs.nytimes.com/2010/05/04/another-view-market-makers-or-market-gamers/?ref=business