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With all the news out this week about Big Pharma mergers (not to mention stem cell research), it got me thinking about that industry, specifically the patent process. After all, these companies are all about their pipelines and their intellectual property. Why does the patent process exist? Does it make sense? Clearly, we'd all pay much less for drugs if we didn't have to wait around for years to be able to buy generics as opposed to brand names. It would be a good thing to scrap patents altogether, wouldn't it?
Wait a minute ... who would innovate? Who would sink the time and resources into R&D if they knew they would not be able to capitalize on their efforts without adequate protection? Wouldn't we just stagnate where we are? Of course, the government could step in and take over the R&D process ... is that what we want? What we'd be saving in drug costs we'd be paying for in terms of larger government. That is an economic system known as socialism.
Of course, I am being a bit facetious. In order to stimulate risk-taking -- the historic lifeblood of the U.S. economy -- we need to offer some protections for risk-takers. Yes, there is a cost -- we know we will pay higher prices for new drugs for a number of years. But there is a benefit -- we see greater innovation and we have people constantly at work trying to solve a variety of health issues. I am a diabetic, so personally I want to incentivize the pharma and biomedical device companies to come up with better treatments. If the treatments they develop are not efficacious, I will not pay for them, and the companies bear that risk ... but we need them to try to develop new ideas for the chance at temporary monopolistic profits.
Any economist will tell you: Incentives matter. So we weigh the costs vs. the benefits, and society is better off as a result. That is an economic system known as capitalism -- yes, even capitalism is enabled with a modicum of government framework.
In both economic systems there is a role for government; it is just a matter of extent of involvement. With patents, government helps protect the innovator, the risk-taker. Government sets and upholds standards; it helps protect the users of the products by regulating them to ensure efficacy and confidence. Even the most die-hard free-marketeer recognizes a role for government.
So it is striking to me that in capitalism, we recognize the need to incentivize risk-taking in companies, but put in place
for risk-takers in the capital-formation process for those companies. (Of course, you had to know this wasn't going to be a column on pharma ... but I think it is a useful allegory.)
Just as we promote risk-taking through protections such as patents, we also need to help protect risk-taking in the capital markets. There was a comment in Columnist Conversation last week along the lines of managements learning valuable information from their share prices. Whether their shareholders are pleased with that "message" or not, I'll leave to the side for now. But I will say there is a fundamental difference in trading commodities and trading companies. Companies are living, breathing things. They employ people, they pay taxes and they contribute to society and the economy. While I think we want complete markets -- including the ability to sell short both shares and credit -- we also want markets that do not discourage capital formation.
There are a number of fairly small steps that, in combination, may be able to level the playing field just enough to prevent capitalism from eating itself. Unfortunately, these come at the intersection of "too little, too late" and "better late than never." Many of these have been mentioned as of late; I have written on some of these in the past, as have many others on the site, so I will be fairly brief on background but long on suggestions.
Reinstate the uptick rule
. There has been quite a bit written on this by myself, Jim Cramer, Doug Kass, Scott Rothbort and others. I have been lucky enough to be a proofer for Bill Furber's new three-part
series on the topic. If a picture tells a thousand words, just take a look at the chart Bill has included that shows the VIX before and after the removal of the uptick rule. That should tell you something. I realize that the reinstatement will not be a magic bullet, but at least the bullets the other guys have will be shot from a pistol and not a machine gun.
As I wrote in my piece regarding
the fall of the uptick rule and the rise of the UltraShorts, these levered short-sided ETFs were certainly enabled by the uptick rule. I think trading should be suspended in the levered, narrow-sector, short-side ETFs until a thorough review can be done to examine the impact these have had and the potential for market manipulation. Examine all the flows (and adjacent flows) related to these -- the extent of hedging (and "pre-hedging," if you know what I mean) and the impact these narrower sector-based ETFs have had on the underlying shares. As a hint, look at the sectors where the volatility has so overwhelmed the returns that the products themselves have had miserable term performance. And please square these with the margin rules...
My mom used to tell me that watching TV after dinner was a privilege, not a right. I can't help but think of that in the case of short-selling and the uptick rule. The
itself made the observation that short-sellers with an uptick rule were liquidity providers, but without an uptick rule were liquidity takers. Let's bring it back so that we can properly earn the privilege; it is a small olive branch to offer. Besides, many opponents of the uptick rule argue that it will not have much of an effect, so that's good -- they won't notice the difference then, and just maybe we can affect investor psyche.
Credit default swaps
: I wrote a
piece on this market, which I think helps complete the fragmented debt markets, and concluded that the vast majority of vanilla CDS should be moved to an exchange to curtail counterparty exposure and add transparency to the market. The CBOE Risk Management Conference on Monday involved serious debate as to whether these should be "insurance" products, traded on an exchange, etc. I have a relatively simple interim step.
Since no one regulates this market right now, there is no authority. However, the
(and its counterparts internationally) do regulate the institutions at the center of all the trades. So why doesn't the Fed put out suggested guidelines for the margining of trades? The market will not get there on its own due to self-interest ... many firms compete on margin terms. But my guess is there may be a silent sigh of relief if the Fed issued guidelines on margin terms.
The main issue is on margining when a counterparty buys protection (shorts credit). If someone buys protection from me, I am only at risk of them making their premium payments to me, and if they stop paying, I stop protecting. This is much different from my potential exposure the other way around, where I am at risk to them making me whole if the underlying credit defaults. Therefore, segment the buyers of CDS protection into five categories (which could then be aggregated and reported):
true hedgers -- holders of debt instruments deliverable into a CDS contract,
counterparty-risk hedgers -- swap counterparties, etc.,
capital structure trades -- debt vs. equity,
paired trades -- Ford vs. GM , and
pure speculative shorting.
Have progressively higher initial margin requirements as you go down the line. Shift the burden of proof onto the buyer, making it necessary to have their prime broker or trust bank feed the dealer with the other side of the trade ... else, pony up the higher margin.
The concept is not new -- in the past we have altered margin requirements to contain excess speculation in frothy markets. But there is a need to control margin for two structural reasons. The problem with CDS is there are asymmetries that skew the market toward greater propensity for people to buy protection. The first is the asymmetry of debt, where it matures at either par or recovery -- so one is typically shorting at "max" recovery value, giving a lottery-style payoff. The second issue is in who the participants are in the market. Two of the largest takers of credit risk are insurance companies and mutual funds. Insurance companies do not like to take risk in derivative format because of the mark-to-market implications. Many mutual funds do not have the capability in their prospectuses to take synthetic risk, so they do not participate either.
Although many buyers of protection are not constrained (i.e., hedge funds), many sellers are. Because the broker-dealers are constrained by competition to act selfishly in terms of margin, and because of the structural asymmetries of the market, someone needs to referee the margin process to control excess speculation. We don't regulate the market, but we do regulate those at the hub. We will still have capacity issues, but at least this might rein in the pile-on speculation.
: This is a little tough for me because I grew up in a mark-to-market environment, and I think the discipline of the daily mark heightens people's sense of risk and reward. Plus, I am not sure we are really fooling anyone by just flipping the switch.
That said, though, we are clearly in an untenable situation, and if we can relieve some pressure by allowing banks to earn their way out of problems over time, we should probably do so. Of course, banks without sustainable earnings power will need more direct intervention. But ultimately we should move closer to the restoration of Glass-Steagall, where we have riskier institutions subjected to mark-to-market accounting, and more traditional lending institutions that use book accounting methods.
When you get right down to it, people always reminisce about days of yore. We had a number of rules that were developed with a great deal of thought back in the 1930s that have served us well for decades. We chose to dismantle them -- Glass-Steagall, the uptick rule -- for various reasons, including complexity of today's markets. But we should think more about the new incentives that we have created and ask if this is what we expected with their removal.
Maybe instead of removing these safeguards, we should have looked at how to adapt them -- keeping in mind why they were put in place to begin with. Protect risk-takers, just as we do with patent law. Incentives matter.
Know what you own: Companies in the banking industry that would be affected by these proposed changes include Bank of America (BAC) - Get Report, Citigroup (C) - Get Report, JPMorgan (JPM) - Get Report, Wells Fargo (WFC) - Get Report and U.S. Bancorp (USB) - Get Report.
At the time of publication, Oberg had no positions in the stocks mentioned.
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.