That financial markets have changed, few need to be convinced. The most important evolution has been the development of securities markets. Securities allow more efficient distribution of risk among investors; they also allow better dissemination of information, because they are traded (at a price) and are, much more than loans and other contracts, standardised.
Securities have drastically transformed the way financial markets work. Between the securities issuers and final investors there are a number of intermediaries. The functions performed by these intermediaries are usefully separated in two categories: broker-dealer business and capital management. Broker-dealers buy, sell, and synthetically produce (through the use of ad-hoc dynamic portfolios) securities for their clients (of course they also assist clients in the issuance of securities). Capital managers buy securities, short securities and use leverage with the objective of producing returns (asset managers are a simplified version of capital managers, using no leverage). Their returns can be explained by many different factors: some short liquid securities and buy illiquid securities, thereby helping the market as a whole to be more liquid and obtaining a reward for the liquidity services they perform; others build long or short positions in securities based upon value judgments, thereby producing returns that reflect their skills and are not affected by general movements of the markets where the long and short positions are traded; finally, others combine long and short positions in securities to produce exposure to certain risk factors that may have especially attractive returns.
Capital managers have boomed in recent years, in tandem with the boom of securities markets. Capital managers are, primarily, banks, investment banks and hedge funds. Their success is due to the essential functions they perform in the markets: by distributing liquidity and information in the world financial system they earn good returns to their shareholders and make the securities markets work well.
The growth of capital managers has brought into focus some important imbalances in the relation between institutions and functions in financial markets. Functions are continually evolving in response to the people’s needs, as well as by the effects of progress in information and communication technologies. Institutions are meant to provide the appropriate regulatory, contractual and procedural frameworks to support given functions, and make the performance of such functions smoother and more effective. However, this comes at the cost of somehow crystallising the way functions are performed. Institutions by definition evolve slowly and discontinuously and as a result there may be situations where, within certain entities, functions are performed that are not those for which such entities were originally conceived. Below are some examples of potential inconsistencies between functions and institutions around the business of capital managers:
- the institutional framework of capital managers is far from uniform: commercial banks are subject to the rules of capital adequacy and supervision, designed to minimise bank runs, but ill-adapted for the liquidity crises of securities markets; investment banks have rules appropriate for the broker-dealer business (a very low risk business); hedge funds are, typically, corporations located in offshore centres (to avoid double taxation problems) and, unlike their management companies, they are outside the reach of regulators;
- both commercial banks and investment banks may have potentially serious conflicts between their client business and their capital management (also called proprietary trading) business, while hedge funds only perform capital management business;
- because of different regulatory constraints, capital constraints on hedge funds’ capital managers appear tighter than capital constraints on capital managers within banks or investment banks (to cite a few examples, hedge funds do not have access to the discount windows, they have arms-length relations with all of their counterparties, their capital availability is subject to market discipline, not managerial discretion).
Most of the recent experiences of market instabilities, including episodes where the fear of contagion – or systemic crises – has been palpable, originated in securities markets. A “crisis”, a situation where there is abnormal liquidation not justified by fundamental values, is a state of the market that can only be produced by the interaction of two essential ingredients: leverage and liquidity mismatches. Traditionally, leverage and balance sheets with liquid liabilities (short-term deposits) and illiquid assets (long-term loans) were managed only by commercial banks. Nowadays, capital managers have been at the centre of crises and their interconnection can fast spread crises to the whole financial system.
The institutional framework of capital managers is outdated and inadequate or, more precisely, it does not exist as such. This requires immediate involvement of authorities and market participants, with the objective to help such a fundamental function to be carried out smoothly and safely. Reform initiatives do not necessarily have to bring about more regulation: what is needed is better regulation. This regulation should, at a minimum, do four things:
1. Recognise that the same function is performed in very different institutional frameworks and, if necessary, provide a consistent framework for all entities involved in capital management;
2. Recognise that the presence of tight and effective capital constraints is the most reliable way for capital managers to avoid excessive risk taking;
3. Recognise that a sound financial system needs sound capital managers and devise tools to minimise systemic risks, which may require more disclosure to authorities by all capital managers;
4. Address the distortions caused by conflicts of interest arising from the coexistence of capital management and broker-dealer businesses.
Currently, regulation is too intent on entities’ “labels”, missing out on the functions they perform. We have banks and brokerages that in fact are hedge funds and we have a booming hedge fund industry that, as important as it has become, resides largely outside the main financial centres. These glaring manifestations of institutional sclerosis are a source of confusion in financial markets, and need correction. Many examples from near and far history show that the smart institutional reforms have been extraordinary boosts to markets and economic activity. Markets cannot do it alone, but governments need all the help they can get to act wisely.
The writer is chief executive officer of Unifortune, an independent asset manager based in Milan