Thursday, January 31, 2013

Why Investors Need New Markets

Can investors trust the financial markets, notably the public equity, options, futures and debt/credit markets? The short answer is: No. Why? Here are just a few salient reasons, in no particular order:

  • Rumors for Profit. With daily rumors running amok in the financial media and elsewhere, many investors are left vulnerable by this mill, controlled by those who have the power and perch to create and disseminate false or misleading information, and a conflict of interest, in that they can profit from the trade.
  • Government Intervention. With the Federal Reserve buying $1Trillion+ of Treasury and Agency/MBS debt in 2013, not to mention an open-ended mandate to increase that figure or buy up other outstanding debt, markets are manipulated, become dependent, and do not adequately factor risks from such dependencies. Moral hazard has taught the Main Street investor that those who take inordinate risks from the flow of cheap money at the top and lose will be bailed out, at Main Street’s expense. With U.S. net leverage at a 6-yr high, these inordinate risks are a red flag.
  • Dishonest Money/Asset Management. The Main Street investor is repeatedly told to put money into the public markets, even at cyclical/secular tops, on the pretense that not to do so will result in a lost opportunity. The latest cheerleading comes from such Wall Street investment banking and asset management characters as Lloyd Blankfein of Goldman Sachs and Larry Fink of Blackrock, two recipients of the bailouts in 2008/9.
  • Understated Counterparty Risks. In public financial markets, investors are exposed to counterparty risks whether they want that exposure or not. These risks range from undercapitalized market makers to highly leveraged speculation to overdependence of Ponzi Finance. Counterparty risks such as these were largely responsible for the failures in the financial system in the 2008 credit/housing market crises (for excellent references, see HERE, HERE and HERE). Underpriced risk on credit/debt instruments due to misstated ratings by market sanctioned rating agencies was, and still is, a factor.
  • Inefficient Price Discovery. When there is less transparency in a market, prices will not have absorbed hidden or less known information and become more unpredictable. Transparency includes knowing who is on the bid/offer and who makes the buy/sell. Less liquid markets will also show wide price spreads, as the market makers seek to pad the uncertainty in those markets with risk premiums. In the worst cases, prices do not adjust to reflect information that has become known to the market: this can happen in the options market, where pricing of the option becomes decoupled from the pricing of the underlying instrument.
  • Manipulative Trading. Not all speculative trading is manipulative, and there are positives in markets from the presence and participation of speculative traders, especially if they enable liquidity. However, manipulation can occur from insider trading, as well as large block trading meant to corner markets, affecting price discovery. Eliminating market corners has been as effective as eliminating insider trading. Banning speculative trading has clear negatives for existing electronic financial markets, yet some investors would rather not be in a market with such counterparties and activity, regardless of the positives or negatives, as they (correctly) perceive this activity as gambling in a casino. I will state that I believe that the casino nature of our traded financial markets has existed for well over a century, so this is nothing new.

So how can investors looking for a place to put cash/capital to work avoid these perceived market negatives? My answer: we need new markets. Innovation in new markets and investment opportunities will go a long way toward fending off the negatives that “entrenched” markets have come to acquire. Some will say that new markets will just become entrenched too, so why bother. This defeatist attitude did not hinder those in the past who pushed ahead in the face of adversities to realize new markets that go on to thrive and grow competitively. Here are just a few short ideas, all consistent with the concept of “free markets:”

  • Markets that create disincentives for moral hazard, where failures drive out bad counterparties.
  • Markets that work around the SEC “Accredited Investor” rule, which shuts out many Main Street investors on lucrative return on investment (ROI) opportunities, all in the name of “consumer protection.”
  • Markets that incentivize longer-term investments [most venture capital and private equity investors are relatively long-term, and as “insiders” can obtain higher potential ROIs].
  • Markets that build in fault tolerances that are not a result of over-regulation but of design/construction consistent with free markets.
  • Markets that spread out risks [note we have to be careful that this does not lead to moral hazard: that the large risk taken by one actor is not borne by all the others, but is proportionally absorbed by that actor].
  • Markets that maximize transparency and disclosure of information, and that optimize price discovery.

Critics may reiterate that any new markets will adopt the same market factors as I listed at the top, making it difficult to realize significantly different outcomes. Some critics may state that what I call negative entrenchments are fundamental to any market, and that investors need to learn how to cope with them, investing their money in the available choices and environments. Nonsense. Once again, if we don’t try to innovate and create, and instead adapt to entrenchment, then sure, investors will be served with the same range of outcomes. Limiting choices is what causes entrenched negatives, and only by increasing choices and competition can investors realize a broader range of outcomes, and enable investing in markets that more closely align with investor “value systems:” in short, become value propositions that cause money to shift from one market (the old) to another (the new). Absent new markets and more competition, we face further market entrenchment and stagnation, and even failures from instabilities, such as increased investor disenfranchisement and alienation. It is not impossible to imagine a run on markets that become too hostile to investors. Yet the establishment (read: the mainstream financial media, money/asset management, government regulators) will consistently claim, as they do now, that investors need to get with the program and put their money into existing financial markets, for they have few other choices to earn yield on their money. As I have written previously, this form of financial repression and coercion will backfire, as it always has, historically. Only by increasing choices in markets, and freer choices at that, providing genuine value propositions, can investors demanding trust and other value factors be invigorated. The monopoly to oligopoly financial world we live in is not a fait accompli.

Readers should note that a basic definition for a market is one where participants disagree on value, but agree on price. If investors are limited by what they perceive as value, and refuse to participate in those limited choices, then existing markets may deteriorate unless they have enough participants willing to engage in this basic process. Disappointed participants will simply walk away and hoard cash, or go to any market (even underground markets) that will serve them the process they are looking for: exchange of value at an agreed price. Financial repression and coercion via entrenched market interventions and manipulation are destabilizers. Investors have come to expect and demand more, or they should.

My suggestions for new markets contain many generalities, and need to be focused to allow for specific implementation, particularly in an environment of increasing central planning and regulation. These challenges can be overcome, and I intend on addressing these issues in future articles. I invite readers to add to the suggestions, and to provide specifics on implementation, or simply to provide links to efforts out there that look like they have a chance of success. Only by sharing and proliferating ideas can we start to see a renaissance in our markets.