Legislators in both the United States and Europe have vowed to implement new regulatory regimes that will reel in the OTC derivatives market and beef up customer protection (see “Regulators: No more Mr. Soft Touch,” Futures, July 2009).
By year-end, the European Commission is scheduled to finalize sweeping reforms to the Markets in Financial Instruments Directive (MiFID) and fully implement the European Market Infrastructure Regulation (EMIR). MiFID primarily deals with existing markets, while EMIR aims to pull standardized OTC derivatives into a central clearing regime and impose higher capital requirements on those that aren’t standardized. Together they do in Europe what the Dodd-Frank Wall Street Reform and Consumer Protection Act is mandated to do in the United States.
A pattern of regulatory failure?
Isaac le Maire earned a place in history as the first person to manipulate the stock market when he sold more shares in the Dutch East India Company than he actually owned. That was in 1609 — seven years after the Dutch invented the modern limited liability company — and le Maire wasn’t shorting shares for speculation but to try and kill the company. His action sparked the first regulatory response to modern manipulation: A ban on naked short-selling.
There have been plenty of abusive cycles since, but University of San Diego Professor Frank Partnoy says our current ills began in the late 1980s. He lays out his arguments in “Infectious Greed: How Deceit and Risk Corrupted the Financial Markets,” which identifies three drivers of financial irresponsibility that he says became particularly acute in the last 25 years.
First, he says, we saw the emergence of complex OTC derivatives. Unlike the other drivers, these are unique to our time, and they pushed risk underground to avoid regulation.
Second, we saw a growing separation of control and ownership — the “agency risk” of which Adam Smith warned.
Finally, we saw the euphoric deregulation of the 1990s — which echoed the pure-free-market fundamentalism of the 1890s.
In his narrative, these three developments led to financial irregularities that sunk non-finance companies such as WorldCom and Global Crossing as well as derivatives players like Enron — and led so many of us to be seduced by “soft-touch” regulatory approaches that permeated markets up until the 2008 disaster.
The implosion of PFG highlighted failures within the National Futures Association (NFA) that the NFA — to its credit — readily admits and seems intent on correcting (see “In PFG fraud, everyone loses — except the lawyers,” October 2012); and the MF Global debacle highlighted failures at the CFTC and within the global bankruptcy arena.
But the Securities and Exchange Commission (SEC) topped them both when it didn’t just fail to notice Madoff, but seemed actively intent on ignoring him after Harry Markopolos blew the whistle in 1999… and again in 2001… and again and again… as recounted in “No One Would Listen: A True Financial Thriller.”
The most alarming, but least surprising, thing about his story is that everyone on Wall Street who knew anything about markets knew something was fishy with Madoff’s 1% a month returns, but few cared because they figured he was “only” front-running — which amounts to illegally skimming from your customers. Everyone did it, Markopolos says, but no one cared, and the SEC remained blind despite the fact that Madoff would have needed to control multiples of the open interest on the Chicago Board Options Exchange (CBOE) to carry out the strategy he claimed he was carrying out.
Compare that to the CFTC — which, even in Markopolos’s book, follows up on tips and nails the bad guys.