The Wild West of Finance

15 january 2013

Human beings, at heart, are wild animals in love with the thrill of the hunt. I can prove it merely by pointing to the existence of the exchange-traded fund FAZ, which one friend calls “day trader’s crack.” For most of us, the stock market has been moving far too much, far too quickly. For those who buy FAZ, though, that speed is not fast enough.

Known formally as the Direxion Russell 1000 Financials Bearish 3X ETF, FAZ follows the gyrations of some of the most twitchy stocks, like banks, insurance companies and real estate firms. As an exchange-traded fund, it takes a security made up of a bunch of underlying assets and makes it behave like a stock. Investors can buy and sell FAZ, moment by moment, to try to grab quick wins.

But FAZ is not a simple basket of financial stocks. It’s composed of odd derivatives and loans that are designed to reverse financial stocks — to go up when they go down and vice versa — and triple gains or losses. It is designed for gunslinger day trading, as investors try to profit by predicting how the market will act in short bursts.

However reckless FAZ may sound, there’s a reason to root for the sector of the financial world that created it. Day trading is part of the often demonized Wild West of investment. It’s a world of online brokers, boutique money-management firms, private-equity companies and others — a gold-rush universe where anybody can sell almost anything as long as you don’t (technically) tell any lies. It isn’t a glamorous life. Day traders, for instance, stare at computer screens all day buying shares, only to sell them seconds or minutes later. Their hope is that if they buy low and sell a tiny bit less low enough times in a day, they can add up some real profit. Surveys indicate that most lose money and give up fairly quickly.

Hedge funds, which allow rich people and institutions to outsource their financial gambling, are the major players in the Wild West. And, contrary to public belief, they are no more likely to succeed than independent day traders. The handful of firms that have made huge and consistent profits hide a remarkable secret: study after study shows that most hedge funds either lose money or make tepid returns. Many — and, some argue, most — actually shut down after a few years.

What’s to celebrate here? The Wild West represents something akin to a normal, thriving market. It is largely overseen by the S.E.C., which takes a forgiving approach to firms that sell products to active investors. The downsides to this lax regulation are well known, but it is not without its benefits. Entrepreneurs with nothing more than a good idea can enter the market relatively quickly and compete against established firms. If they can offer better products than their competitors, they’ll succeed; if not, they go bust (hopefully before they almost blow up the world). One major sales pitch for capitalism is that constant competition makes us all better off. If FAZ — or a hedge fund, for that matter — doesn’t appeal to enough people, it will eventually collapse. And there is nothing wrong with that. Failure is as important to healthy capitalism as success.

The nation’s handful of huge banks, however, are spared the indignity of failure. (Ignore Bear Stearns and Lehman — they were puny compared with the true giants.) Citi and Goldman Sachs both bet against the interests of some of their largest clients and created products designed to fail. It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

One of the biggest problems is that the big banks are regulated in a manner that, paradoxically, often works to their benefit and against ours. The S.E.C. watches over them but so do a host of other regulators. Every large institution can choose from among the Fed, the F.D.I.C., the Comptroller of the Currency and 50 state banking regulators, all of which compete with one another in turf battles. They also have countless agencies in other countries overseeing them. With so many different regulatory bodies, some things slip through the cracks. (A.I.G., for example, had around 400 different regulators throughout the world and conducted its sketchy financial activity in places where it did slip through.) Remember that the worst excesses of the housing bubble — especially the creation and distribution of those toxic assets — occurred within the highly regulated big banks, not the lightly overseen hedge funds.

When the banking rules are rewritten — as they are every few decades, usually after a crash — the banks also get the chance to play a big role in drafting them. Last year, Congress set broad new guidelines and tasked each regulator with writing specific rules. It was a nominally democratic process — all Americans are invited to express their views about banking regulation — but the main participants are the lawyers and lobbyists for the largest financial institutions. In one example, the S.E.C. held 34 meetings with groups proposing changes to the way the important Volcker Rule, which restricts banks from certain risky investments, is implemented. So far, almost all of these get-togethers have been with big banks and their representatives. Only one has been with a consumer-advocacy group.

The reality is that smaller banks or clever entrepreneurs who want to sell useful products to the general public simply cannot pay the price of admission. They can’t get much market share, because they don’t have the influence; and even more practically, they can’t afford the extraordinary number of lawyers and the lobbyists either. And being too big to fail generally makes the largest institutions fairly impervious to competition. There are nearly 8,000 banks in the United States, but the top 20 control more than 90 percent of the market. The top three alone control 44 percent. This is terrible for customers, who would be better served if banks competed entirely on the basis of serving us better.

Some economists say banking in the United States is a full-on oligopoly, while others say, well, it’s only oligopolesque. Regardless, we clearly need smarter, stronger regulation. But we also need banking upstarts — the Googles of finance — capable of competing with the big banks. Unfortunately, many ambitious newcomers mostly see opportunities in high-risk, high-loss products like FAZ and not in sensible things that the rest of us might want.