Why Wall Street Isn't Main Street

The Obama administration has taken great pains to blame Wall Street for the woes of the financial system. Representative Barney Frank and Senator Chris Dodd have held numerous hearings, pointing fingers at greedy capitalists and unchecked, unregulated risk-taking. What they should be doing is pointing their fingers at the American financial regulatory system that the committees oversee.

The rules of the game need to be changed so that the playing field is actually competitive. Structures need to be altered, and regulations written, so actual risk is being assumed or transferred when money is invested. Goldman now makes millions of dollars a day. It's the American way to make a profit.  However, those outsize gains are obtained through anti-competitive measures. The major investment banks have created an oligopoly. The average investor, customer, or smaller fund doesn't stand a chance. 

The investment world can be very hard to understand. There are lots of weird-sounding terms, and I will try to define them as simply as possible throughout this piece. The investment world is deliberately murky. The more the bank traders can muddy the water, the more inefficiency they can embed. More inefficiency means that banks can reap profits from customers more easily, without the customer even knowing what happened.

Many have called for the Glass-Steagall Act to be reinstated.  Some have argued for even stricter and broader regulation. This is the wrong approach. Better to ban dual trading, ban internalization of order flow, ban payment for order flow, and outlaw dark pools of liquidity. These changes will help restore faith in the system. Changes will make the market more competitive and capitalistic and also level the playing field. Markets will work better than the current poorly regulated and slanted system. The increased competition will decrease the amount of systemic risk and end the "too big to fail" problem the system has today. 

An investment bank cannot act ethically as a broker and a trader in the same marketplace. When banks fill orders and trade for their own accounts, it's called dual trading. Investment banks will always take advantage of this inherent conflict of interest to the detriment of their customers. The New York banks can blather on about "Chinese Walls" and other strictures they designed for themselves, but these internally designed limits don't work.

In a football game, it would be similar to the offense calling the opposing defense plays before the ball is snapped. Banning all dual trading in all marketplaces would have the effect of forcing banks to divest themselves of proprietary trading divisions. The bank would act as a broker, earning a commission from filling orders. Or the investment bank could forgo being a broker and then assume risk and trade. The competitive engagement that occurs between brokers acting in the best interest of their customer and traders trying to make a profit will ensure that the playing field is level for everyone.

Internalization of order flow is another unseemly practice the SEC allows. Investment banks use their own customer orders and send them to a proprietary trading desk away from an exchange. Prop desks take the opposite side of those orders and make a risk-free profit. The customer order never sees the light of day. If the prop desk can't make a profit from the order, it routes the order to an exchange. 

This practice is wrong. In baseball, it would be like stealing second base when your foot is still on first. Internalization should be banned. Orders should be brokered in the marketplace where everyone has a chance to interact with them. Banning internalization will bring more competition and transparency to the marketplace.

Payment for order flow is another SEC-allowed practice that tilts the playing field in banks' favor. NY banks pay discount brokers a small fee so the discount brokers will direct business to them. The bank routes the order to its own trading desk, trading against the order for a profit. This may give discount brokerage customers a lower commission, but it results in a poorer price for investment. Wonder why discount brokers charge more for a price order than a market order? Payment for order flow is the reason. To be blunt, investment banks are reaping a profit off the backs of their own customers. Banning payment for order flow will result in orders that are transmitted to the broad market that everyone sees, increasing competition and accessibility of information in the marketplace.

Dark pools of liquidity account for 7.2% of all stock transactions. Why? Only big banks can access dark pools. They utilize these pools to make deceptive profits, away from the main listed marketplace. Dark pools are like a private country club. The proprietary trading desks of the banks involved also don't want price and volume information to be communicated to the market in a timely manner, so the broader market is trading blind. 

Dark pools need to be shut down. Orders need to be executed on a public market where every investor has an opportunity to trade and interact with them. Transparency in the marketplace is imperative for competitive markets, and dark pools eliminate transparency. It's institutionalized cheating.

The current rules stack the deck against the average investor. Proprietary trading profits of the largest NYC banks have increased every year since banks began going public in 1999. Prop trading accounts for well over a third of Goldman profit. Anyone in the trading business knows that trading profits don't go up year after year. Profits are very variable, and sometimes there are even losses. Proprietary traders never lose. This is because they rarely assume any risk, and they can legally rip off their customers. That needs to change.

While banks had it tough last year, proprietary trading at all firms generated revenue. Even at Citibank, the top proprietary trader accounted for a huge amount of profit. Writing new regulations and passing stricter rules will only push Main Street farther away from Wall Street. Any new rules that have been proposed do nothing to alter the structure of the market. New rules and regulations will strengthen the stranglehold the big banks already have. What our government needs to do is level the playing field...but Main Street can't spend lobbying cash like Wall Street can.
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