Wall Street is at it all over again

New financial rules are creating novel opportunities for risky profits
Charles Reinhardt
David Viniar, former executive vice president and chief financial officer at Goldman Sachs, waits to testify before the Senate hearing on "Wall Street and the Financial Crisis: The Role of Investment Banks" in Washington, April 27, 2010. (Jim Young/Reuters)

On Tuesday, April 16, Bloomberg, the financial news and data giant, filed a lawsuit against the Commodity Futures Trading Commission, one of the most important regulatory bodies overseeing U.S. financial markets. The lawsuit was about new rules governing financial instruments known as swaps—rules, which, according to Bloomberg, will push investors toward new hybrid financial products that “have less regulatory requirements, less transparency, but pose much higher investor risk” than swaps. These adverse and “presumably unintended” consequences, the legal statement goes on to say, are a good enough reason to halt the rule’s implementation.

There’s a feeling lately among long-time Wall Street observers that U.S. financial regulators seeking to tame the industry’s excesses are engaged in a cat-and-mouse chase in which the mouse is often one step ahead.

In the five years since the financial crisis bankrupted Lehman Brothers and precipitated the federal bailout of Wall Street, the stock market has rebounded to all-time highs and major Wall Street firms ended 2012 with the second best earnings reports on record. Behind these successes is the industry’s ability to swiftly shift business strategies to adapt to new regulation, but also exploit loopholes and accidental gaps between rules from different markets and jurisdictions in unexpected ways. The raft of financial regulation inaugurated by President Barack Obama’s 2010 Dodd-Frank reform act has thwarted some risky practices—but also created opportunities to try out new ones. As each new plank of the reform comes into effect, a recurring theme has been that of unexpected consequences.

In part, that’s because the new regulation is extremely complex. The challenge for U.S. financial authorities is to strike a balance between excessive simplicity and too much detail, says Matt Simon, a North American-based senior research analyst at capital markets research and consulting firm TABB Group. “You don’t want to come out with something too simple that is harmful to the industry overnight,” he says, “but if you create too detailed a mechanism, everyone winds up finding ways around very small aspects of it.” He believes the 2010 financial reform has been erring on the side of the latter, causing confusion, delays and uncertainty: “with a lot of money on the line, a lot of people are trying to figure out what to do when you have many different markets that are starting to evolve as a result of deadlines and rulemaking that have not even been finalized.”

Regulatory delays and uncertainty have provided fertile ground for creative workarounds. Take the yet-to-be-implemented Volcker Rule, a section of the Dodd-Frank Act that imposes strict limits on how firms with federal deposit insurance engage in proprietary trading, that is, buying and selling with their own money rather than on their clients’ behalf. The regulation, which is aimed at ensuring such firms can’t take on too much risk, is expected to prevent them from making short-term bets—where short-term is defined as two months. Early this year, however, Bloomberg’s Max Abelson broke the story that Goldman Sachs created a $1 billion investment unit, called Multi-Strategy Investing, that continues to trade with the bank’s own money and is possibly one of its biggest sources of profit. All it had to do to comply with the Volcker Rule was extend the expected maturities of its investments beyond 60 days.

And Goldman hasn’t stopped there. The bank has also started a new $600 million “business development company,” called Liberty Harbor Capital, which uses its own capital to provide private financing to middle-market businesses, Reuters reported.  Now, that also doesn’t contradict the letter of the draft Volcker Rule, which allows proprietary trading with businesses below a certain size — the exemption was meant to ensure that regulation doesn’t dry up financing for small and medium sized enterprises. Goldman’s Liberty Harbor Capital, though, will focus on struggling businesses with weak credit ratings, whose debt is naturally high-risk.

Goldman’s business development company might also be exploiting another piece of financial legislation known as the JOBS Act, a law ostensibly intended to encourage the  creation of new businesses. The one-year-old regulation drastically reduces financial reporting requirements for “emerging growth companies,” which are defined in such broad strokes they includes businesses with revenues just shy of $1 billion.

The success of Goldman’s ventures remains to be seen, but if they do well, others are likely to follow suit.

And complex, long-anticipated rules are also believed to be creating opportunities for dangerously risky bets in the swap market, as Bloomberg noted. Swaps are financial contracts investors use to protect themselves against interest rate moves and price swings in financial assets. For example, if you’re a municipality that owes money to a company at an interest rate that might change, you can buy a swap from a bank, which will allow you to pay a fixed rate to the bank, which will in turn pay the difference to your lender if the interest rate does rise.

Swaps have traditionally been “over-the-counter” products, traded and negotiated privately between sellers and buyers without intermediaries. Dodd-Frank Act introduced a variety of rules aimed at increasing transparency and regulatory oversight, in the swaps market, but risk seems to have quickly migrated elsewhere.

Meet the “swap futures,” a financial product that two large exchanges, the Intercontinental Exchange and the Chicago Mercantile Exchange, have been aggressively marketing since late last year.

Futures are smaller, more standardized, and more frequently traded contracts that allow investors to agree to buy or sell a certain product in the future at a price determined earlier. If you’re a transport company and you’re worried about oil prices rising, for example, you can buy a futures contract agreeing to pay a price closer to today’s for oil, say, 90 days in the future.

This is where swap futures come in. They’re futures contracts that come in two varieties, so far: one type promises the purchase or sale of a swap, (rather than gas or some other product), at an agreed price and time in the future — the value of these swaps futures corresponds to the expected value of that swap at the time of delivery. Most buyers of these products will be purchasing them with the intention of selling them onward in turn, rather than taking ownership of the swap itself, according to Sean Tully, managing director of interest rate products for CME Group. The end result is a product tied to the swaps market that is much cheaper and quicker to trade. The second kind is Intercontinental Exchange’s energy swap futures, which are essentially energy swaps tweaked to be future contracts.

But if swaps and swap futures are so similar, why are regulators only focusing on one of them? David Frenk, director of research for Washington D.C. consumer advocacy firm Better Markets, sees the move from swaps into swap futures as a potentially dangerous development. “Futures exchanges like to boast about their track record of stability, compared to other exchanges, especially during the financial crisis,” he says. However, he adds, “the swaps market is many times larger than the futures market, so a move from swaps into swap futures could grow the futures market to a gargantuan scale.” A larger futures market might invite riskier behaviour in pursuit of larger profits, and Frenk worries the exchanges may not be up to the challenge of maintaining stability in a much bigger and more dynamic market.

Some, like TABB’s Simon, see this process of trial and error (emphasis on error) as a function of the sheer size of the U.S. financial system. New financial instruments, rules and strategies are often tested first in the U.S. Canada, in this regard, he says, has it easier: “You have fewer players, different technology and a greater concentration among those players.”

Still, the complex granularity of the incoming Wall Street reforms is starting to look like a mirror image of the chaotic financial system they are trying to bring under control. Unless regulators are willing to risk large-scale disruption in pursuit of simpler, farther-reaching reform, they might never catch up to Wall Street.