1、Global MarketsInstituteEffective Regulation: Part 4 Turning Good Ideas Into Good OutcomesOctober 2009Steve Strongin1(212)357-4706 Goldman, Sachs the importance of full participation in the price-discovery process; and the most effective role for clearing houses. In looking at each, we consider how
2、the whole financial system can be strengthened without inadvertently sowing the seeds of the next crisis or significantly diminishing market efficiency. October 20, 2009 Global Markets Institute Goldman Sachs Global Investment Research 2 Table of contents Introduction: the complex financial eco-syst
3、em 3Financial reforms: some key conclusions 4Mismatched markets: why simple is not always better 6Illustrating the mismatch: a study of commodities markets 6The benefits of well-functioning commodities markets 8Illustrating the mismatch: examples in other markets 9Sellers create buyers: the value of
4、 full participation 10Credit default swaps can lower corporate funding costs 11Short sellers aid the price discovery process 13Improved market structures: “dark pools” and clearing 15Alternative trading platforms and their effect on liquidity 15Enhancing comfort with innovation 16Clearing houses: wh
5、ere they do and dont reduce systemic risk 17Conclusions 19Acknowledgements 20Appendix A 21Appendix B 22Appendix C 23Appendix D 24Disclosures 29October 20, 2009 Global Markets Institute Goldman Sachs Global Investment Research 3 Introduction: the complex financial eco-system Consider the honey bee. P
6、erhaps an odd start to a paper on financial-market regulation, but it is an appropriate one. Financial systems, like complex eco-systems, are interconnected in ways that can be opaque to the casual observer and sometimes to the informed observer as well. Reforms to financial regulation are undoubted
7、ly necessary, and we support them wholeheartedly. But they should take into account the necessarily complex nature of the global financial system if they are to make it both safer and more efficient. Efforts to address a single flaw in isolation have often had unexpected and unwanted consequences as
8、 they ripple throughout the entire financial system. By singling out individual behaviors, current efforts to reform flaws in todays system run the same risk of causing detrimental unintended consequences. That is not to say that significant improvements are undesirable or impossible. It is only to
9、argue that as much effort should be dedicated to understanding financial interconnectedness as is dedicated to reviewing individual practices. Ultimately, reform should not only make the system safer, but also improve its ability to perform its two critical roles: to allocate capital to areas where
10、it will be utilized best; and to provide individuals with the opportunity to participate in markets in an equitable fashion. If we set out to cleanse the financial system of every practice that does not immediately appear “useful” or “good”, or that could be subject to abuse, we may find that we hav
11、e accidently destroyed the ability of markets to provide essential services. Eco-systems require many parts. Although most of us would prefer not to deal with them, the world would be worse off without bees, bats or fungi. Similarly, the role played by each part of the financial system must be consi
12、dered in a broader context if reforms are to improve the functioning of the system as a whole. Understanding the role played by each part of the market requires an appreciation for how markets really work, and how different pieces interconnect. In our view, the core driver of complexity in financial
13、 markets is that markets tend not to be naturally balanced between buyers and sellers. Different market participants have different interests, needs, time horizons and liquidity requirements. Market makers and similar entities create balance in markets by bridging the gaps between what investors wan
14、t to supply, and what companies, individuals and governments want to use. Filling the gap between the capital that investors want to supply and the capital that companies and others need is the core function of modern markets. The success of innovations such as the repackaging of risk into derivativ
15、es and the increasingly complex nature of market-making have allowed capital to be raised in larger quantities for more companies, and to be allocated more efficiently than in the past. This has, in turn, fuelled economic growth and the ensuing benefits of such growth job creation, innovation and gr
16、eater tax revenues. That is not to say that complexity in and of itself is positive. The recent past is filled with examples of complexity getting the better of markets and of individual firms in many cases because complexity appeared to be an attractive end unto itself. On the other hand, complexit
17、y that is the byproduct of markets serving the needs of their users and the economy should not be eradicated just because complexity sometimes fails. Simple is not always best. Our goal in this paper is to help better focus the debate on financial reform beyond individual issues and to look instead
18、at how the whole system can be altered to reduce systemic risk and improve overall economic performance. This is likely to become a question of how to take some of the very good ideas that will drive the reform October 20, 2009 Global Markets Institute Goldman Sachs Global Investment Research 4 proc
19、ess such as the standardization of financial products and the increased use of clearing houses and better understand how and when they will be clear positives for the system, and when the opposite might well be true. Crises like the one we have recently experienced tend to drive their own momentum f
20、or change, but there is no idea that is so good it cannot be misapplied. The most recent example of this is securitization. In response to earlier crises, financial markets and regulators embraced securitization as a powerful means of mitigating risk at individual banks. And it worked up to a point
21、local banking problems became fewer and more easily managed. But this good idea turned bad when it was applied to low-quality assets like sub-prime mortgages. It turned worse when it was used by financial firms to reduce the capital they held against low-quality loan portfolios or to hide risk in af
22、filiates. Ultimately, securitization helped create the current crisis.1As legislators, regulators and market participants alike implement various reforms, the goal must be to increase systemic stability, rather than to inadvertently sow the seeds of tomorrows crisis. In the next section of this pape
23、r, we summarize the key conclusions of our analysis, and then follow with a more detailed look at several major market reforms currently being considered. Financial reforms: some key conclusions Form should be allowed to follow function Standardization of financial products solves many problems, and
24、 in the high-volume parts of the markets, standardization is a true positive. But, as we will discuss, the high-volume parts of the markets are not the only economically important parts. Non-standardized products that trade over-the-counter (OTC) are critically important to financial markets. They a
25、llow companies to raise capital at lower costs, to manage risk more effectively and to engage in transactions that improve their structural efficiency. These non-standard transactions are often the kinds of transactions that drive the largest economic benefits including job creation, investments in
26、physical assets and the development of new technologies. The high-volume parts of the markets in addition to performing their most critical function of setting prices are in fact what allow these low-volume, high value-added transactions to occur. As we will show, this is because market makers must
27、execute many high-volume transactions to hedge the risks associated with a single non-standardized one. Thus, as we seek to standardize more financial products, we must take care that we do not accidentally inhibit the ability of markets to create economic value. Markets should continue to offer a b
28、road array of products that can be used by capital providers and capital consumers. Market makers must be able to manage the risks that ensue from these products. The connections between custom and standardized parts of the markets need to be understood and maintained, rather than hindered or elimin
29、ated. For example, hedge exemptions can be critical to allowing market makers to offset risk from providing corporate clients with specific risk-management services that are impractical for corporations to manage for themselves. Incentives to use standard products are highly 1We discussed the role o
30、f securitization in fueling the current financial crisis in the first paper in our Effective Regulation series: Avoiding Another Meltdown, March 2009. October 20, 2009 Global Markets Institute Goldman Sachs Global Investment Research 5 appropriate, but prohibitions on non-standard products can serio
31、usly interfere with the ability of the market to help corporations raise capital and manage risk. Restrictions on participation are almost certain to hurt the functioning of markets Many commentators argue that price volatility benefits only traders, while hurting the rest of the economy. While it i
32、s true that the price-discovery process in financial markets can be very messy, price discovery is undoubtedly one of the most important functions of markets. Price discovery yields good prices, which benefit everyone. This is because weak companies with inflated stock prices or an inappropriately l
33、ow cost of debt waste valuable capital. Allocating capital instead to strong companies will help them fund expansion, and that expansion can, in turn, fuel economic growth. This is the key to long-term prosperity, a point we will demonstrate in detail later in this paper by looking at a few case stu
34、dies involving oil companies. Short sellers and the buyers of credit default swaps (CDS) have come under particular criticism over the past year, with some observers arguing that they generate little economic benefit. Yet they bring valuable information to markets: contrarian views in the case of sh
35、ort sellers, and more accurate pricing information in the case of CDS buyers. As a result, they give market participants greater faith in prices and increase their willingness to provide funding. As we show later in this paper, companies with CDS are able to raise debt capital at lower rates because
36、 CDS allow buyers to more easily manage their risk. This lowers funding costs for the companies and improves their ability to invest. Full participation is essential to an efficient price-discovery process. This is true even, and sometimes especially, when we dont like or agree with all of the answe
37、rs markets provide. Liquidity should be a key goal of regulation, and transparency should be seen as a tool to create liquidity, not a goal in itself It is important to understand the interplay of liquidity and transparency. Liquidity is the key attribute of well-functioning markets, ones that reduc
38、e systemic risk and serve the real economy. Transparency is a key attribute of liquid markets, as investors will not supply significant capital if they cannot understand the true value of an entity. However, it is important to distinguish between price transparency and transactional transparency. Pr
39、ice transparency allows investors to know the price at which a security has been sold or bought. This, in turn, allows investors to accurately assess the value of their investments. This kind of transparency makes investors more willing to commit capital, aids liquidity and promotes systemic soundne
40、ss. An alternative notion of transparency transactional transparency that allows all participants to see all trades on a real-time basis can actually inhibit liquidity. This is because participants who invest large pools of money such as pension funds and the mutual funds through which small investo
41、rs allocate most of their capital can be severely disadvantaged if all of their transactions are visible in real time. Having their positions visible to everyone else forces them to act much more defensively in their trading. This, in turn, significantly reduces the liquidity available to other larg
42、e investors and corporations. While real-time reporting may seem like a simple positive, in the world of real markets, there are substantial trade-offs to consider. Many of the positive innovations in trading platforms over the last decade have allowed large investors to provide liquidity without ha
43、ving their orders broadly seen until after their transactions are completed (this is called “non-displayed liquidity”). These innovations have essentially transferred liquidity from hard-to-access slips of paper sitting on the trading desks of large mutual and pension funds, to easier-to-access elec
44、tronic systems. Greater liquidity has, in turn, lowered trading costs by reducing bid-ask spreads, and has allowed companies to execute larger capital October 20, 2009 Global Markets Institute Goldman Sachs Global Investment Research 6 raisings and risk-management transactions. If liquidity provided
45、 by large investors goes from being non-displayed to virtually non-existent, everyone loses. Although clearing houses may be the most effective way to reduce systemic risk in derivatives markets, they are not appropriate for every market or every user Clearing houses are really only effective when a
46、pplied to highly liquid, high-volume markets, and only for major participants. This issue is quite simple: well-capitalized clearing houses that clear high trading volume and accurately priced products can massively reduce counter-party risk but they do this at the cost of concentrating that risk at
47、 the clearing house itself. In high-volume markets operating through tightly regulated clearing houses with stringent membership requirements, this trade-off is very positive. Yet in lower-volume products with less liquidity and weaker members, the reduction in counter-party risk is naturally much s
48、maller and the risk accumulated at the clearing house is much greater. In these cases, clearing houses can actually increase and concentrate systemic risk. Thus, we believe that low-volume products should remain outside of the clearing process, though not outside of the position and trade reporting
49、processes. For regulators and other participants, there is another important lesson from securitization to be drawn. Altering a system to implicitly or explicitly promote a particular market structure or product such as securitization or clearing houses increases the risk that this structure or product will be used in ways that are unintended or inappropriate. If regulators and investors rely too much on this explicit or implicit promotion, they may overlook signs of strains in the market. Although securitization was originally
