Friday, May 17, 2013

The CFTC Makes Money Managers Do Their Jobs

The CFTC Makes Money Managers Do Their Jobs

The Commodities Futures Trading Commission finally approved a compromise version of regulations subjecting derivatives to greater scrutiny.  Two weeks ago, I wrote about the enormous lobbying effort undertaken by the banks to kill or weaken the proposed rules (“Caring About Derivatives Regulation [May 2, 2012]”).  There’s one key feature of the compromise that is well worth examining.  Under the CFTC’s original proposal, money managers would have had to seek five bids before placing a derivatives order.  In the final rule, this figure has been reduced to two bids, but will eventually rise to three bids at the end of 2014.  This requirement is important because five banks control more than 90% of the derivatives market.  Clearly, too big too fail is alive and well.  The requirement is designed to generate greater price discovery (these are usually complex derivatives) and foster competition.  Of course, the big banks hate what competition does to their bottom lines.

Mutual FundBoard Q&A (1999)

In the end, this is probably a decent compromise.  Without it, we either would have had no rule or years of litigation.  Moreover, the compromise achieved a four to one vote by the CFTC Commissioners, which gives the regulations a much-needed tinge of bi-partisanship.

Nonetheless, I find the minimum bid requirement kind of strange.  The money managers acquiring these derivative positions are supposed to be sophisticated investors.  Those are the kinds of people that the SEC and CFTC think should be able to invest in complex financial instruments.  In addition, the managers are almost always investing their clients’ money when they ring up a bank to put in an order,  so they have a fiduciary duty to get the best possible execution on the trade.  Even without the CFTC’s new rule, I would have expected the managers to solicit a number of bids before selecting a bank to do the trade.  I’m sure that when these money managers have their kitchens renovated, they seek out bids from multiple architects and contractors.  Apparently, when it’s others people’s money, one bid suffices.   So in effect, the regulation is simply telling money managers to do their jobs properly.

Money managers are generally an energetic bunch, so this is not a case of laziness.  Rather, money managers have tended to have a cozy relation with the big banks.  Aside from the usual assortment of Broadway tickets and ringside seats, the big banks provide money managers with a variety of vital services, including prime brokerage, leverage, custody, borrowing securities, and accounting.   Moreover, many of the money managers executing these trades worked for the big banks before they decided to cross to the other side of the Street.  So the money managers have an incentive to keep their favorite bank happy.

Money managers and their banking counterparts have had a lucrative relationship.  The money managers fattened up on fees and carried interest, and the banks made huge profits on the trades.  The capital to pay for all of this largesse came from the usual sources: pensions, endowments, foundations, and corporations.  Ultimately the risk of having five banks control this multi-trillion market was, of course, borne by you.

The new regulations are an improvement, and the relationship between the big banks and money managers will open up a tad.  However, even with the new rule, you’re still on the hook.

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