Tuesday, June 03, 2008
Lamenting Smoke and MIrrors
The talk of the town today regards the apparent rueing by hedge funds over the imminent loss or curtailment of "vital tools" or "important weapons" in their arsenal that allow them to employ derivatives and swaps to obfuscate what they are doing in the marketplace by circumventing existing laws and regulations that require reporting, limit position size in addition to avoiding tax and other sundry benefits.
Of course it is not merely hedge funds that use them. In Japan, as I've detailed in the past, large long-only investors (like Fidelity) take advantage of OTC option structures with executing brokers to delay the disclosure of position changes until AFTER the majority of the position has been bought or sold. But recent squabbles, particularly those involving activists, have illuminated (surprise! surprise!) the more-than-widespread contrapreneurial use of option-combos, equity swaps, etc. to help Peltz, Icahn, TCI, and other other raiders/activists accumulate positions without the hindrance of fatuous details like reporting or compliance inflicted upon mere mortals. And everyone knows the ubiquitious use of equity swaps to wash dividends for offshore funds thus avoiding withholding and other tax-treaty requirements, as well as transmute ordinary income into whatever tax-preferenced delicacy is desired or required. Needless to say, those broker-dealers, and banks, already reeling from their loss of income derived from all manner of securitisation and all its milk-teats, leveraged deal-flow, Prime Brokerage, and quant hedge-fund washouts, are moaning and wailing now as they stand to lose yet another dubious source of income, the "greyness" and envelope-pushing smoke-and-mirrors which would make even the great David Blaine blush with embarrassment.
There may, indeed are, some legitimate arguments to the case suggesting that in general OTC derivatives markets contribute to better and more efficient financial intermediation. However, in the main, they are if not primarily, then very nearly, mere cynical loophole enabling, tax-avoiding, spirit-of-the-law bending, super-leverage enhancing, regulatory-busting, guideline-circumventing, gray-area-exploiting, piles of pooh that make worthless all of mankinds collective efforts to attempt to set investment, tax, and transparency, guidelines, regulations, laws, restrictions ostensibly for the benefit and protection of respective jurisdictional public interests, in general, and those of markets in particular.
Some may suggest the problem lies in regulation itself. Liberate all from the confines of restriction. Let everyone do as every one chooses, let chaos ensure and information will eventually flow freely. Like drug laws, that themselves allow criminal organized elements to profit, and not the state, so too, they would argue does financial regulation allow the banks and brokers to concoct yet another scheme to intermediate where none is actually required. Yes this demagoguery is seductive, but I don't buy it. For at the heart of capitalism lies two important concepts: reasonable market efficiency and reasonable fairness. The former requires that collusion, monopoly, and oligopoly be tamed, while the latter is essential for working people to arise in the morning and NOT do a smash-'n'-grab on the bosses house, wife, and warehouses or factories. Revolutions while perhaps conjured by fanatics, are nurtured and ultimately fed by unfairness, whether real or imagined.
I think the problem is inherently American - the result of excessive calculating legalistic rent-seeking, an unbridled feeling of financial exceptionalism by the "best and brightest" trained to and capable of exploiting the system, and a State that at once, has been made impotent by a biased demagogic philosophy that says "The Best Public Interest is No Public Interest" thereby not only allowing but encouraging the organs of the State to be invaded and run by the parasites themselves. It starts with a legal approach that gives primacy to the letter of the law rather than the spirit. This immediately places the burden of proof upon The State, allowing Genie, Genie & Genie Esq. out of the bottle and encourages yet more of our brightest minds to waste their lives and intellect conjuring loopholes and exceptions from the finite drafting of regulators with the full understanding that The State cannot possibly marshal the resources to draft every law, regulation and directive to include each and every possibility combination and permutation. Were the spirit pursued and enforced rather than letter, the house of litigious cards falls down. The operative word here are both spirit and "enforced" because the spirit, in itself, as England has shown is insufficient, as they've sold their souls to capture the wealth of intermediation by predating other financial centres. Indeed one could argue, London is not "better", nor climatically or culturally more desirable, just more practiced (and determined!) at looking the other way.
Australia, Germany and France have perhaps the correct approach: Combine the spirit with enforcement. This is precisely why the Russians, despite their historic affinity for things French, are living in Chelsea and NOT Parc Monceau or the XVIth, and why the Chinese are stashing their collected bribes in Singapore (or heaven forbid Dubai) and not Sydney. For if it looks like fish, and it smells like fish, and its in the water, it probably IS a fish. No amount of attempted transmutation or air-freshener can change the fact that its a fish. The SEC, CFTC, IRS, even ERISA have hand-wrung, kvetched, and gone down rat-holes to point of looking up their arses - everything except to do the obvious, which is to say that transactions doing XYZ where the spirit and purpose of XYZ has been set-forth in spirit will not hold up under scrutiny, and that violators will be forced to pay make whole what they've attempted to transmute in full with hindsight, ALL public enforcement costs, and pecuniary and not-so-pecuniary fines appropriate for the severity of the attempted transgression. The authorities should also speak with one voice, and to avoid misunderstanding by, as indeed Inland Revenue has been known to do, vetting schemes BEFORE employment.
This may not solve the problems of the markets and the world completely, but it will wholeheartedly make The People think the system is, at the very least, attempting to be Fair, and that we are not running a parallel universe - one for ordinary citizens, and one for the eagle-eyed opportunists who can buy and manufacture loop-holes at will to serve their parochial financial interests.