Market makers and vampire squid: regulating securities markets after the financial meltdown.

• Author: Thompson, Robert B.

"The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

--Rolling Stone, July 2009. (1)

Senator Collins: [W]hen you were working at Goldman, did you consider yourself to have a duty to act in the best interests of your clients?

Mr. Sparks: Senator, I had a duty to act in a very straightforward way, in a very open way with my clients. Technically, with respect to investment advice, we were a market maker in that regard. But with respect to being a prudent and a responsible participant in the market, we do have a duty to do that.

Senator Collins: OK. You are not really answering my question. I understand the difference between suitability standards, which you did have to follow, versus a fiduciary obligation to act in the best interests of your clients. I understand that you do not have a legal fiduciary obligation, but did the firm expect you to act in the best interests of your clients as opposed to acting in the best interests of the firm?

Mr. Sparks: Well, when I was at Goldman Sachs, clients are very important and were very important, and so--

Senator Collins: Could I--I am starting to share the Chairman's frustration already, and I am only 30 seconds into my time. Could you give me a yes or no to whether you considered yourself to have a duty to act in the best interest of your clients?

Mr. Sparks: I believe we have a duty to serve our clients well.

--Senate Hearing, April 27, 2010. (2)

1. INTRODUCTION

   The meltdown of America's investment banking industry in 2008 (disappearing into commercial banks via government-induced mergers or morphing into bank holding companies with access to the Federal Reserve's credit window) precipitated the federal bailout that created such angst in the American populace through the 2010 elections and beyond. (3) Senate hearings in April 2010 painted a picture of investment banks "funneling" for cash in ways that appeared to create fundamental conflicts with customers. Senator Carl Levin, for example, berated Goldman Sachs bankers for continuing to sell to customers securities that Goldman Sachs employees had vividly disparaged with barnyard epithets. (4)

   In tone and impact the 2010 hearings echoed the Pecora hearings of 1933 that crystallized for Main Street a similar disconnect between bankers on Wall Street and their customers. The denouement of those hearings occurred in the final ten days of the Hoover administration and the dying days of a lame duck Congress. (5) Ferdinand Pecora, having been appointed as Chief Counsel to the Senate Committee on Banking and Currency only weeks before those hearings, (6) focused on a leading Wall Street icon, National City Bank, and its chief executive officer, Charles Mitchell. (7) The hearings revealed a degree of executive compensation previously unknown to the American public, illusory stock transactions seemingly used to avoid income taxes on Mitchell's million dollar salary, and National City's securities arm selling securities to investors that the company itself was dumping. (8)

   The Pecora hearings, like their 2010 counterpart, gave the final boost to financial reform legislation that passed the Senate within weeks and was on the President's desk within a hundred days. (9) The Securities Act of (1933) regulated the issuance of securities and cabined the influence investment banks previously had in that process. (10) The Glass-Steagall Act, passed in the same month, fenced off investment banks and their speculative activities from commercial banks. (11) In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (12) ("Dodd-Frank") banned banks from the proprietary trading that seemed to have caused the worrisome activities discussed in the Senate hearings, set in motion a process to expand a broker-dealer's fiduciary duties to retail customers, shifted much of the troublesome derivatives trading onto exchanges and clearing houses, and provided for new capital regulation and resolution authority for the country's largest financial institutions. (13)

   The defense of the investment bankers in the 2010 hearings was that they were simply making markets for buyers and sellers who could take care of themselves, so that conflict didn't really matter in that setting. (14) Fabrice Tourre, one such banker who gained a measure of notoriety during the hearings, described this function as

   connecting clients who wished to take a long exposure to an asset-- meaning they anticipated the value of the asset would rise--with clients who wished to take a short exposure to an asset--meaning they anticipated the value of the asset would fall. I was an intermediary between highly sophisticated professional investors-- all of which were institutions. (15) While the argument failed to deter Congress from including the Volcker Rule banning proprietary trading in the 2010 legislation, market making and conflicts between securities intermediaries and investors remain core issues at the heart of understanding and framing financial reform of the securities industry. (16)

   Why did the Goldman Sachs executives cling to the mantle of market makers and continue to answer in ways that so frustrated Senator Collins as reflected in the excerpt at the beginning of this Article? (17) These men knew that the services the firm provides to investors come in two flavors. Sometimes clients come to them for advisory services (e.g., services relating to takeovers, raising money for the company, or portfolio investing). At other times, investors look to them as market makers, intermediaries with an inventory of securities that can be bought or sold in which the investment banker is on the opposite side of the transaction from the investor.

   The executives also would have known that there is a core regulatory difference between the two relationships. In the first, there is an agency relationship--the intermediary is bound by law to be loyal to the client, putting the client's interests first. (18) In the second, the law has deferred to the marketplace and to the incentives and monitoring that goes with that; the law's contribution is little more than mumbling the ancient Latin admonition caveat emptor. (19) After the recent meltdown one recurring explanation was the desire (and the ability) of financial firms to pick their regulators. (20) Here we have an illustration of the bankers trying to put more of their interaction with investors within the market regulation category and less in the legal regulation space.

   The third thing these Goldman Sachs executives would have known is that the overwhelming majority of the firm's profits had come from trading for its own account as principal as opposed to providing advisory services or acting as an agent for its customers' securities transactions (traditionally the backbone of investment banking activities). (21) The securitization wave of the new finance swept in an increasingly wider array of products for which markets could be made (and principals could trade). (22) The explosion of derivatives spawned what seemed at times an infinite ability in the new financial world to create synthetic bundles of rights, barely linked to (or bounded by) the underlying activity of the real economy. (23)

   Goldman Sachs knew that this trading-based paradigm provided increased areas of conflict with clients. Recent biographies of the firm trace a key theme visible through the leadership of Robert Rubin, Henry Paulson, and Lloyd Blankfein: a shared belief that the firm could manage this conflict and reap the benefits of this proprietary-based mode and, indeed, that it needed to do so to survive. (24) They were not alone; the rest of the investment banking industry was interested in the same thing. (25) Congress was not so sure. The Abacus transaction and similar deals that were the focus of the 2010 Senate hearings illustrated the particular concern that investment banks were betting against their clients, taking positions that would pay off if the housing market worsened while at the same time selling securities to clients who thought the housing market would continue its upward trajectory. (26)

   Dodd-Frank reveals a conscious legislative effort to move more of the conduct of securities intermediaries from market-regulated space to law-regulated space. Under the Volcker Rule, banks (a group that now includes all of the largest American firms performing the traditional functions of investment banks (27)) are banned from proprietary trading in which they engage in transactions opposite their customers. (28) More broker-dealer interactions with investors are to be governed by fiduciary duty. (29) Yet both of these core principles need large asterisks next to them. The enhanced fiduciary duty will only attach once a lengthy study (30) and rulemaking occur (31) and even then will likely only apply to retail customers. (32) The ban on proprietary trading has two large exceptions that could easily encompass the same behavior that was a focus at the 2010 hearings (or at least how the investment banks described their behavior at the hearings). (33) The Federal Stability Oversight Council's initial study on proprietary trading describes the core challenge: the activities permitted by the two exceptions "evidence outwardly similar characteristics" to the banned category of "proprietary trading." (34)

   This Article unpacks the various activities of the key intermediaries in securities markets and market makers in particular. The goal is a better understanding of the distinction between those intermediary behaviors that can be left to market incentives and constraints and those for which governmental regulation might be sought. Some intermediary behaviors should be regulated the same, even though they possess different core legal characteristics (e.g., brokers who buy stocks for retail clients as agents and receive a...