Financial Reform: What Crawls Out of the Petri Dish?

I believe in financial reform. Let’s lose synthetic CDOs, credit default swaps, and other Weapons of Money Destruction. Let’s cut the leverage and focus on systemic risks to our economic order. But let’s be smart.

In the wake of last Thursday, it appears our government is tackling too many issues at the same time. The only thing we know for certain is there will be unintended consequences—especially when we have no idea how changes on one front will interact with changes on another.

Derivatives are a good example. Yesterday, The New York Times reported:

The financial legislation proposed by the Obama administration and passed by the House would require most derivatives to trade on public exchanges, in the belief that a transparent marketplace will be safer and cheaper. The scope of the exchange trading requirement has been the focus of the debate for months.

Sounds reasonable if exchanges make derivatives more transparent. Get those puppies out in the open.

But wait. Some pundits blame the exchanges for last Thursday’s 1,000-point slide. The New York Stock Exchange slowed its computer-trading, and humans took over. Meanwhile, other centers executed computer trades at lightning-fast speeds. Different standards operating at cross purposes.

We think.

The problem might be the investment style known as “high-speed trading.” But we can’t rule out fat fingers. The New York Times describes the difficulty in finding answers as follows:

As trading has been dispersed among a dozen electronic exchanges, the S.E.C. and other market regulators have maintained no centralized database of stock trades, order sizes or prices. That has made it more difficult for regulators to piece together what exactly happened on Thursday.

Connecting the dots isn’t pretty. It looks like proposed legislation will push derivatives, which often employ 100:1 leverage, onto exchanges that operate according to different standards where nobody (read SEC) is watching all the moving pieces.

Yikes. How are we better off?

Derivatives are only one issue. Other items on the reform agenda include: systemic risk and the thing we call “too big to fail;” proprietary trading desks at banks; ethical standards for our dealmakers; and you name it. So many different pieces.

The pending financial reform reminds me of a high-school science experiment where there are no constants. Where too many inputs are variable. Where no one knows what will crawl out of the regulatory petri dish. Wouldn’t it make more sense to focus on one core issue—like getting our exchanges right—before taking massive action across multiple fronts?

Norb Vonnegut

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