Trading by Market Making Companies is Unconstitutional

and Financially Suicidal to Taxpayers

March 31, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

March 27, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid and Richard J. Durbin

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Trading by Market Making Bank Holding Companies is Unconstitutional and Financially Suicidal to Taxpayers[1]

Dear President Obama,

The proposed banking reform bill may not prevent future market failures and depressions.  This memo argues for a constitutional system of market making and clearing to prevent future crises. 

1.     Current market making system is unconstitutional

Currently, it is illegal for the MMs-market makers in NASDAQ, specialists in NYSE or CBOE and dealers in CME and CBOT-to trade for profits.  The FBI had once caught the dealers, at the CBOT trading pits, illegally trading to profit from both the sellers and the buyers of futures and forwards. 

But a bank holding company (BHC) can bypass the illegality by forming a bankruptcy remote, fire-walled subsidiary (sub) for market making.  The MM sub, per se, may not be trading illegally.  But a market making BHC that uses its non-MM subs to trade based on valuable information obtained from order flows at its MM sub is operating effectively illegally on a consolidated basis, backed fully by the regulators.  

This effective illegality is exactly like the violation of the FDICIA-1991 bank capital requirements through a BHC structure that has brought us perilously to the brink of another Great Depression.[2]  I have used numerical examples to show how a banker can increase return on equity ten-fold through a BHC structure by effectively diluting its consolidated capital to one-tenth of the FDICIA-1991 minimum capital requirement.  Such deep leverage effectively piles huge risk on taxpayers as bared during the Great Recession.  The regulators had explicitly permitted such effective transgression of the minimum bank capital law until the end of 2007. 

Consciousness dawned on the regulators only after the Congress pressured in early 2008, thanks to the writings from yours truly about how the taxpayers were committing financial suicide by unknowingly underwriting such regulatory transgression of the FDICIA-1991.[3]  The 2008 backdoor capital infusion into banks was thus natural to hide the truth from We the People. But people from the Left, Right and Center have vividly seen the picture of regulatory failure and patch up. 

2.     Enormous losses due to the current market making system

We the People should appreciate the public admission of regulatory failure at the Federal Reserve Board and other agencies.  But will this lead to a catharsis of a regulatory-backed, effectively illegal financial system?  It will not, even if the banks are recapitalized massively by some magic wand and the proposed banking reforms are passed as new laws. 

As an ordinary soul within We the People, I see vividly the truth that the market making BHCs have abused their MM subs as fronts to gather information from order flows to trade from their non-MM subs.  Such regulatory-backed trading is illegal on a consolidated basis because the BHCs use their MM subs, legally barred from trading, as fronts to trade within their non-MM subs with valuable information gained from order flows unavailable to individual traders.  As a result, both the buyers and the sellers of securities lose, with gains flowing to the BHCs, thanks to the current regulatory-backed, effectively illegal financial system.

The unconstitutional shenanigans of the market making BHCs produce significant profits, but they are miniscule as compared to the foregone profits on the household investments.  Such shenanigans thus generate significantly less tax for the Treasury (and less political contributions) than possible if they were disallowed.  Empirical studies show that more than 90 percent of mutual funds underperform as compared to the market. The recent meltdown has wiped out many hedge funds.  University endowments have been decimated.  People have lost an estimated $50 trillion worldwide.  A recent news report shows that most Americans did not benefit from the 70% rise in the stock market indexes.  The report does not say if the Tea Party activists and their strong sponsors are angry because of losses from short selling. The powerful supporters of the current market making system in either party have perhaps gained from time to time, but most are now poised to lose, if they have not already lost a bundle.

3.     Risks hereon

How is the current financial system (even after the proposed reforms) going to be financially suicidal for taxpayers and households hereon? 

The market making BHCs are not discriminating in their strategy of rigging the prices of their long positions upwards and of their short positions downwards.  This increases the value of their marked-to-market portfolios and capitals needed to survive.  That the market making BHCs failed to foresee the true values of their holdings was vivid during the Great Recession.  The market broke down and the government had to step in with the Federal Reserve owning many portfolios with overpriced long positions and underpriced short positions. Selling of the overpriced long positions and covering of underpriced short positions will only result in losses to the Fed. Merging BHCs will only let the losses accumulate in a bigger scale within the consolidated BHCs.  That the government regulators and academic thinkers failed to see the market meltdown and are failing to see the massive accumulation of risks simply illustrate a failure of their philosophy on self-disciplined market making.[4] 

Market making BHCs do not make money by strategies which may be considered rational for the truly productive household investors, ordinary hedge funds and mutual funds.  A market making BHC’s portfolio comprises overpriced long positions and underpriced short positions.  If liquidated, these portfolios will produce only losses.  The Federal Reserve has direct experience about such losses as the values of all the seized collaterals during the Great Recession have shrunk.  That is why the managers of the market making BHCs take away as bonus whatever they can from the profits schemed in the markets as long as no one is complaining.  This is why I rang an alarm bell about banking executive compensation in my Safe Banking paper in 2003[5] and appraised the Congress about it.[6] 

At the end of this super economic cycle, potentially leading to another Great Depression, a super market making BHC (if not a few such BHCs) will emerge like we had in early twentieth century.  The surviving super BHC emerging with government facilitated mergers will have a gigantic portfolio of mostly overpriced long positions and underpriced short positions.  This super BHC will then control the indebted households, banks, hedge funds and non-financial firms because it can and will thrive only by rigging downwards the prices all assets held by debtors.  The profit maximizing super BHC will rationally liquidate or seize the debtors’ assets by selling the assets short and then by covering at fire-sale prices at will. 

For example, when the prices of a mortgage bank’s securities (its assets) are rigged downwards by its lender (the super BHC), the mortgage bank loses its equity and control.  The super BHC then acquires the mortgage bank for pittance to control all mortgage loans made to households.  Through many such concocted acquisitions of mortgage banks, the super BHC then artificially chokes credit to households leading to a collapse of the housing prices.  The scared households then surrender their homes for nothing.  The super BHC then acts benevolent by claiming that it has written off the mortgage loans (acquired by rigging the system) and rented the repossessed properties (seized through an unconstitutional market making system).  The super BHC will seize homes only after the households have lost jobs and savings.  Such rigging will thus result in losses of all savings and investments of most households with the proceeds and controls of their businesses and homes transferring to the super BHC.  The Congress and President will then have no power as in the Great Depression. 

4.     Capital is destroyed continually by the current market making system

We are at the brink of a potential Great Depression.  We need to preemptively exorcise the evil process of mutual capital destruction.  I continue to pray that the calamity does not unfold.  But prayer within my Universal Religion means searching for the truth about how We the People should govern ourselves.[7]    

An understanding of the capital destruction process can make the needed constitutional reform transparent.  The market making BHCs make money because of a lopsided financial system instituted by a conniving regulatory regime.  The system helps the market making BHCs wangle away hard earned savings of the households by piling losses on taxpayers:  A market making BHC irrationally raises the price of a security it holds long to entice ordinary short sellers to sell the security short at rising prices.  The BHC then raises the price further to scare the ordinary short sellers to buy back the security at a fictitiously high price from the BHC. 

By inducing ordinary short sellers to sell a security short through media blitz about the security being overvalued and then by rigging the price artificially upwards using block bids based on taxpayer-insured funds, a market making BHC can scare even the large professional hedge fund short sellers to force the latter to buy a short-sold security at a fictitiously higher price to cover short positions at losses.  This tactic transfer enormous wealth from households, hedge funds and mutual funds to the market making BHC in addition to raising the value of the BHC’s portfolio.  A market making BHC can likewise gain from ordinary holders of securities (pension funds and household investors) by irrationally dropping the prices to scare the buy-and-hold passive investors to sell their holdings at substantial losses. 

The market making BHCs can thus rob the hard-earned savings of the households, hedge funds, mutual funds and even large investment banks.  The taxable profits of the market making BHCs may be significant, but they are miniscule as compared to the foregone profits of the rest.  The current unconstitutional system thus generates lower taxes for the government than feasible if it is reformed constitutionally.  Furthermore, the market making BHCs use taxpayer-insured deposits, FDIC-insured debt and regulatory support to impose massive losses to taxpayers as well as investors. 

Many banks have already failed during the Great Recession.  The large investment banks that had survived the wrenching Great Depression fell one by one during the Great Recession, until the government stepped in to save Goldman Sachs and Morgan Stanley. 

5.     A constitutional market making system

Pointing fingers at banks or individuals does not exorcise the real evil from the system: the regulatory-backed, effectively illegal market making process which results in unconstitutional transfer of hard-earned wealth of the productive households, who prop a nation, to a few indolent schemers who tend to weaken the nation.   

Many households lost heavily during 2000-2001.  They then stopped playing in the financial casino.  They invested in homes.  The schemers then followed a concerted strategy to rig the household wealth by trading mortgage backed securities, credit default swaps and debt and equity issued by mortgage banks.  Many mortgage banks then failed.  Capital became too scarce for mortgage banks to fund housing.  This resulted in the Great Recession.  The schemers seized many mortgage banks illicitly.  This Great Recession also ruined many mega investment banks, millions of jobs and trillions of dollars of wealth worldwide.  It has taken the economy to a more precarious predicament with the consolidated mega BHCs that destroyed others’ wealth and jobs commanding greater power over the deprived. 

The path we are in now is obviously reminiscent of the one traversed from the point when banking panics occurred in 1907 to a subsequent consolidation in the banking sector and then the Great Depression.  The new regulatory power, proposed in the reform bill, to limit the size of mega BHCs or to dismantle the ones that flounder seems quite superfluous and specious.  The proposed bill seems eerily silent on how the regulators have willy-nilly connived in the current process of formation of mega BHCs and supported the unconstitutional market making.

We have no option but to reform the prevailing, effectively illegal and unconstitutional system of market making, clearing and trading: 

1.      Follow effectively and aggressively the current law on illegality of trading by market makers.  This means holding companies that trade from subsidiaries or parent company must not be market makers, directly or indirectly through affiliated proxies or subs. Every market maker must be independent, directly and indirectly, of the traders.   

 

2.      Allow no trading house to control or own, partially or fully, the market clearing operation for any security.  This means that the government must set up an independent market clearing agency answerable to the public and Congress.  The independent market clearing agency must be chartered to guarantee a smooth transfer of traded securities from the sellers to the buyers at the time of transactions or as soon as possible, electronically or physically.  The independent market clearing agency must compile trading data to facilitate monitoring of any abuse of the prevailing law on illegality of trading by the market makers. 

3.      Do not contravene the current law on market making even through specious regulatory means, for example, to permit a market maker to trade via affiliated non-MM offshore holding companies or proxy subs for exploiting valuable information garnered from the flow of orders. 

6.     Conclusion

The prevailing process of market making must have decimated the savings of people in the Left, Center and Right to be as angry as the media reports.  The anger is misdirected towards one another and is rapidly degenerating.  It must be channeled towards reform.  This is possible only if the angry people are told the truth about the mutually destructive financial system and about the needed reform. Only the government has the resource to articulate the truth publicly.  

Even the Great Depression era Robber Barons were afraid of preserving their accumulated wealth because most of it was in the form of credit extended as debt to We the People.  Credit is nothing but the mutual trust of the creditors and debtors.  The trust has eroded badly due to the Great Recession.  It can be restored only by truthful and transparent governance. The constitutional reforms proposed here and in my previous memos[8] are the tenets of such governance that the creditors need more than the debtors.

 

With profound regards,

Sankarshan Acharya

Here is a great video report of current shenanigans: http://rt.com/About_Us/Programmes/Keiser_Report/2010-04-01/558424.html



[1]The basic ideas of this memo are from my book “Prosperity: Optimal Governance, Banking, Capital Markets, Global Trade and Exchange Rate,” published by Citizens Publishing. 

[2] http://pro-prosperity.com/Mythology%20of%20Market%20Discipline%20Unraveled%20by%20Market%20Crash.html

[3] http://pro-prosperity.com/Research/Sub-optimality%20of%20Lending%20Taxpayer%20Funds%20to%20Hedge%20Funds.pdf

[4] http://pro-prosperity.com/Research/MoralHazardLiberty.pdf

[5] http://pro-prosperity.com/usa/safe%20Banking.pdf

[6] http://pro-prosperity.com/Global%20Economy%20Chatterbox/Warning-USCongress-In-2003-On-Home-Mortgage-Debacle.html

[7] http://pro-prosperity.com/Research/A%20Unifying%20Philosophy%20of%20Governance.pdf

[8] http://pro-prosperity.com/Destruction%20of%20Capital%20and%20Short%20selling.html

March 28, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid and Richard J. Durbin

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Trading by Market Making Bank Holding Companies is Unconstitutional and Financially Suicidal to Taxpayers[1] [EXAMPLE]

Dear President Obama,

My memo on the above subject, faxed early today, states:

“A market making BHC’s portfolio comprises overpriced long positions and underpriced short positions.  If liquidated, these portfolios will produce only losses.” 

Underpriced means a lower market price than the true value and overpriced means a higher market price than the true value

Market price is the price determined in the current market with the market making BHCs playing their noosing games as described in my memo of March 27. 

True value is the price determined in a constitutionally free market economy, i.e., after my proposed constitutional reforms are implemented to unshackle the market from the unconstitutional noose of the current market making BHCs.    

A numerical example:

An ailing market making BHC has 100 shares of IBM long and 500 shares of Intel short.  The current price of IBM is $130 per share and of Intel is $22 per share.  The current market value of this portfolio is 100 x 130 – 500 x 22 = $2000. 

If this portfolio really comprises overpriced long positions and underpriced short positions within the current unconstitutional market environment, it would mean that the true value of an IBM share will be less than $130 (say $120) and the true value of an Intel share will be more than $22 (say $25). 

The true values will prevail if my proposed constitutional reforms are implemented to free the market of the noose imposed by the current market making BHCs.  The true value is approximately equal to the liquidation value that the government can fetch by seizing the portfolio and closing the positions.  The true value of the BHC portfolio is 100 x 120 – 500 x 50 = –$500.

Seizing and liquidation of this BHC portfolio will result in only losses for taxpayers.  The net cash flow to taxpayers on liquidation of this ailing BHC portfolio is its true value, –$50, minus the amount to be paid for acquisition based on the current market value, $2000:  –500 – 2000 = –$2500.  The net cash flow to taxpayers for closing out the BHC is thus a loss.  The loss is due to the overpriced long positions and underpriced short positions held by the ailing BHC. 

The market making BHC executives thus game to transfer wealth from households, pension plans, mutual funds and smaller hedge funds and banks.  They then pay themselves the transferred wealth as bonuses, as long as the system does not collapse.  When the system collapses, taxpayers discover only junk in the portfolios of the market making BHCs.  The wealth transferred from households, mutual funds, pension plans, smaller hedge funds and banks is nothing but the value of hard work of the effective producers.  The effective producers simply discover, after losing their savings and jobs, that they were engaged to toil for the schemers and that they have no option but to line for breads distributed by the schemers during a depression.   

Without an access to the private trading books of market making BHCs, one cannot claim for sure that the BHC portfolios indeed comprise overpriced long positions and underpriced short positions.  But this is my rational inference based on how the market making BHCs make trading profits while the rest lose on average. 

Regulatory agencies can easily test my rational inference based on their privileged access to the private trading data of the market making BHCs.  I had implored the SEC to let me have such data for research in 2001.  I was too naïve to harbor cooperation from the SEC.  The Federal Reserve has firsthand experience about the values of portfolios it acquired in 2008 as collateral to lend money.     

With profound regards,

Sankarshan Acharya



[1]The basic ideas of this memo are from my book “Prosperity: Optimal Governance, Banking, Capital Markets, Global Trade and Exchange Rate,” published by Citizens Publishing.