Citizen Action Monitor

Global financial system at risk: Caused by economic power in handful of banks + flash trading

No 259 Posted by fw, August 23, 2011

Small stock market investors beware! Notice how much more volatile the stock markets are now? We’ve moved from investing to trading. So don’t get caught in flash-trading crashes.

“The bigger part of the issue is they [stock market flash-crashes] cause really gigantic movements that are disastrous. And they [medium-sized and smaller financial institutions] can’t survive those. But what’s different is these are what we call a systemically dangerous institution. It’s The Big 20 [financial institutions] roughly in the United States. This is where the administration and – it’s not just this administration, prior administrations as well – believe that if a single one of those massive financial institutions fails, the entire financial system globally is at risk of failing. And so they get bailed out. And so things are not symmetrical, and, you’re right, the result of all of this is the medium-sized players are crushed. Even the large players are crushed. And you get economic dominance which allows even greater ability to manipulate. —Bill Black

Bill Black, an associate professor of economics and law at the University of Missouri, Kansas City, explains how the changing world of financial investing has put the entire financial system globally at risk of failing.

A 10:38-minute video of his interview on the Real News Network, entitled Making Money out of Market Crash (August 22, 2011) follows along with my transcript and added subheadings.

But first, a definition of 5 key financial terms from Investor Words

    • option – The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.
    • shorting – Borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. Short selling (or “selling short”) is a technique used by investors who try to profit from the falling price of a stock.
    • leverage — The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders’ return on investment and often there are tax advantages associated with borrowing.
    • derivative – A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.
    • credit default swaps — A specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

TRANSCRIPT

Paul Jay – One of the characteristics of the current economic crisis that doesn’t get talked about all that much is just how much money there is to be made in a downturn. There are players – big players – that take advantage of crisis. Now joining us to talk about all of that is Bill Black. Bill is an associate professor of economics and law at the University of Missouri, Kansas City. He’s also the author of The Best Way to Rob a Bank is to Own One. What a lot of the big players do – investment banks, commodity traders, and such – it may not technically be fraud — although I know you argue that much of what happened in the ’08 crisis was actual fraud – but a lot of what goes on may not be actual fraud because there’s no regulations yet to actually make any of this illegal. But talk a little bit about how volatility makes you money if you’re big enough.

Bill Black – Well, for technical reasons almost all options are maximised in value if you get lots of volatility. So technical traders really like volatility if they’re involved in options and most of these plays are done in options. The most obvious way that people I’ve often heard about is shorting a security.

Paul Jay – Explain this for people who don’t understand ‘options’ and ‘shorting’ and all of this.

Bill Black – An option is, as the name implies, something that you have the right to take possession of but not the obligation to do so. And so there’s more chance that that option will be valuable to exercise if whatever I’m betting on is bouncing around a lot because I can wait until it bounces in the right direction and then I can exercise my option right there. So that’s the human explanation of how options and volatility work.

Shorting is I’m going to buy this security at some date in the future and so I’m betting that it’s going to fall in value between now and then and I want to increase the chances that it will actually fall in value. So I will engage in speculative attacks on it designed to cause it to fall in value. I’ll spread rumors in the press and such and I’ll get people coordinated in out behaviour.

Combination of leverage and derivatives have made this “a vastly more dangerous world”

What’s really changed in the modern era is two things: One, extraordinary leverage. In the old days it took a lot of money. The famous ones of people my age were the Hunt brothers trying to corner silver prices and such. That took among the wealthiest group of individuals in the world. But now a 26-year-old trader with extreme leverage can buy enough using financial derivatives to move world prices. So it’s that combination of leverage and derivatives that has changed the world into a vastly more dangerous world.

Clinton administration removed authority to regulate risky trading

And then we have to remember what happened in 2000 with the passage of the Commodities Future Modernization Act of 2000. You should oppose any bill that has the word ‘modernization’ in it because it’s always a disaster. Supposedly we’re smarter than we were in the past. The setting there was the head, Brooksley Born, of the Commodities Futures Trading Commission, was thinking ahead of time before the disaster had hit. She said — credit default swaps have the potential to be a disaster; we should have regulations in place to protect against them. And this unleashed – pick your cliché about firestorms in Washington DC, in which the Clinton administration worked with Alan Greenspan and Phil Gramm, the great anti- regulator, to pass a law in very short order that not only blocked that particular regulation that Brooksley Born was proposing, but actually said — Commodities Future Trading Commission, we are removing your statutory authority to regulate credit default swaps at all.

Remember Enron? — Let the market manipulation begin

It also created a regulatory black hole in energy trading derivatives which Enron’s Wendy Gramm, Phil’s wife on the board of directors, promptly exploited to create the California energy crisis, which was not an energy crisis. It was complete manipulation of prices plus the actions of a cartel to ruin a state economy and risk people’s lives by causing energy blackouts. That bill that became law – Brooksley Born was just turned into roadkill by these political forces.

Even more amazing, the new Dodd-Bill effectively ignored the regulatory black hole

The amazing thing is after it actually did produce not one but two crises – California and the current crisis – the Dodd-Frank Bill didn’t repeal it. So we are still in a situation where we have very limited authority and what has arisen in the last 5 years that has now made it even worse is hyper-velocity trading, and this is believed to have caused the flash crash or roughly a year ago when there was a massive loss of Dow Jones value in 5 minutes.

PhD and math geniacs are writing algorithms for computer-based flash trading 

Paul Jay – I interviewed recently Bart Chilton from the Commission and he was saying that of the 35,000 employees of a big bank – and I know the big bank is Goldman although he didn’t name it – of 35,000 employees, 1,000 are PhDs and mathematicians working on algorithms for this kind of flash trading.

Bill Black – And by the way, that’s one of the reasons why the US is far less competitive in making real constructive goods. Remember we have this shortage in math and science. On top of that shortage we divert the math and science experts we have to destroying value by creating these kinds of algorithms.

A small Kansas firm was likely responsible for the flash trade about a year ago

By the way, Kansas City area is the heart of a couple of these really massive hyper-velocity trading. Out here we do 25 percent of the trades of the entire nation. Nobody knows this. And a relatively small Kansas firm that is located a mile from where I’m speaking is the one believed to have triggered the flash crash with a large but not extraordinarily large trade.

Risky new trading practices have opened the portal to financial terrorism

Now, you want to talk about financial terrorism. Yes, this is financial terrorism but it also is going to become real financial terrorism because with a $41 billion trade you could cause the US economy to go into disaster, think what the People’s Republic of China with its math experts, what it could do if it gets upset and it decides that it actually wants to attack the US economy.

Paul Jay – The other thing I’ve been told in terms of volatility and profitability is that in these big tanks or big dips, big, big players even if they get hurt in the short run, they can always sustain these big hits and you may have to odd roadkill like Lehman Brothers, but the majority of the big players survive. And they survive where their competition – especially the medium-sized and smaller competition – can’t survive, and can get wiped out. So these big dips lead to more and more monopolization, more consolidation. Is this part of the issue?

Really gigantic market movements are disastrous, leading to greater ability to manipulate

Bill Black – That’s part of the issue. But the bigger part of the issue is they cause really gigantic movements that are disastrous. And they can’t survive those. But what’s different is these are what we call a systemically dangerous institution. It’s The Big 20 roughly in the United States. This is where the administration and – it’s not just this administration, prior administrations as well – believe that if a single one of those massive financial institutions fails, the entire financial system globally is at risk of failing. And so they get bailed out. And so things are not symmetrical, and, you’re right, the result of all of this is the medium-sized players are crushed. Even the large players are crushed. And you get economic dominance which allows even greater ability to manipulate.

Political dominance goes hand-in-hand with financial dominance, which is why Obama loves Wall Street

But you also get political dominance. And that’s why we’re getting no real reforms out of these things because finance is the largest single contributor to both parties. Now much has been made about how Obama is supposedly persona-non-grata in the financial community. In fact, Obama both in absolute dollar terms and in percentage terms is getting far more money from finance right now as he tries to create his billion dollar war chest than he got in the last general election.

Welcome to globalized plutocracy. Guess who’s in control

Once you get this kind of power – this is why Citicorp [now part of Citigroup] referred to the Unites States’ economy as a plutocracy a—a government of the wealthy by the wealthy.

My Comment — Thanks Professor Black and Paul Jay for helping us ordinary folks to improve our understanding of what the hell is going on in the financial hood. And I use ‘hood’ in the pejorative sense. Responsible, informed understanding is the first step to responsible, informed action.

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