The G20 group of the richest countries in the world will meet this week in Pittsburgh to consider several major issues facing the global economy. One main item to be addressed is what to do about regulating banks and other financial institutions in the wake of the “Great Recession.” The European Union (EU) group of countries wants to place tough limits on compensation paid by banks and other financial institutions to traders and others. The theory here is that excessive compensation, and particularly bonuses, induced these people to take too much risk in making investments that led to the recession.
Given that the private financial sector thoroughly botched the job of managing the almost exponential growth in credit generated from securitized debt and turned to the several key governments to save them, one would think that these players would be acquiescent in accepting new rules to make this market more transparent and stable. But such is not the case. The banks and financial houses are putting up a strong battle against the new rules.
While pondering their response, I finally hit on why banks oppose new rules for trading derivatives, securitized debt, credit default swaps and similar financial instruments. They want to keep these markets opaque and lightly regulated because this is exactly why these markets are so lucrative. The open stock markets and bond markets, where transparency and rules control the action, are clear to all investors. One can get all the information he wants and has the certainty that the rules will protect him, at least in most cases. Investing in these is thus so straight forward and simple that one can do it over the interenet for a few dollars a trade.
The world of derivative trading is almost terra incognita to the average investor, thus the traders hold the keys to the action. One does not buy a share in a securitized debt or credit default swap over the internet. The more arcane the market, the less most investors are able to enter it, leaving those inside to control access.
If the trading of these investments were done on an open, transparent market, the control enjoyed by the insiders would be severely diminished, if not overcome all together, thus allowing many investors to enter, thereby increasing competition and, in the process, lower commissions for traders.
I believe the G20 would be well advised to concentrate on making securitzed debt and other derivative trades transparent markets with rules similar to those controlling the sale of stocks and bonds, rather than waste time trying to limit trader compensation per se. This will insure that compensation is not excessive and, more importantly, allow better government control to guard against another “meltdown” as we had in 2008.