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Bankers Should Be Afraid of Their Own Shadow

For Barclays, a Wednesday $451 million settlement with regulators in the U.S. and U.K. on its alleged manipulation of short-term interest rates bodes even worse.

In reaction to the settlement and the prospect of lawsuits and a government backlash that could cost CEO Diamond his job, Barclays shares tumbled over 12% in Thursday trading, erasing its year-to-date gain.

The trading loss and a prospect of widespread manipulation in self-regulated interest rate markets are separate instances of the same problem: the shadow banking system - a moniker for esoteric swaps, repo and money market-based trading - is the largest, most profitable and least regulated corner of the financial system. As it stands, the world's largest banks that operate in such markets are believed to have the savvy, the controls and the judgment to operate without the need of burdensome regulators.

But comments from the likes of CEO Dimon in assessing JPMorgan's trading loss and a regulatory investigation by the Commodity Futures Trading Commission, the U.S. Department of Justice and the U.K.'s Financial Services Authority, underscore that such confidence is misguided and drastic intervention is needed.

In testimony to a U.S. Senate Committee on Banking, Housing and Urban Affairs, Dimon told lawmakers that the trading loss was a result of a strategy that, "was poorly conceived and vetted." Mirroring issues that caused some Wall Street titans to go belly-up during the crisis, Dimon added that when the unit's trading position soured, the bank's traders, "incorrectly concluded that those losses were the result of anomalous and temporary market movements, and therefore were likely to reverse themselves."

"In hindsight, CIO's traders did not have the requisite understanding of the risks they took," said Dimon, adding that the losses culminated from a strategy that went largely unknown to the firm's management and risk teams. Dimon's comments seem to be a clear acknowledgement that over-the-counter trading, which goes largely unseen to regulators, ordinary investors and even Wall Street's top brass should be brought into the light of day to avoid future blowups.

Allegations of Barclays' manipulation of one of the world's most significant but lesser known financial instruments raises an even greater alarm. Even if banks can be proven to be able to properly monitor their risk taking in shadow markets - or can be proven financially capable to bear the brunt of any losses - revelations of possible widespread collusion in setting Libor and other short-term rates signals that Wall Street cannot be left to police itself.
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