Wednesday, 3 February 2010

The [Permissible] Boundaries of Bank Regulation

If you have been following current events, you are familiar with President Obama’s plan to “take on” banks. His plan, inspired by Paul Volker, calls for, among other things, the banning of proprietary trading by banks.

If you have been following this blog, you know that proprietary or prop trading is arbitrage trading – taking simultaneous long and short positions in two “equivalent” trades. That is the modus operandi of speculative capital which still, two years into a protracted crisis, dominates the markets.

The Theory of Speculative Capital posits that speculative capital would not, short of being forcefully subdued, accept any restraints or limitations on itself. From Vol. 1:
Speculative capital abhors regulation. Regulations interfere with the cross-market arbitrage that is its lifeline. If speculative capital cannot freely operate, it cannot generate profits and must cease to exist. The opposition of speculative capital to regulation is thus not a matter of some technical or tactical disagreement but a question of life and death.
So if my Theory of Speculative Capital is correct, then the President’s bank regulation plans, at least the part that deals with prop trading, should be dead on arrival, no matter what. From today’s New York Times:
The chairman of the Senate Banking Committee warned on Tuesday that the Obama administration’s new proposals to rein in Wall Street firms ran the risk of derailing months of delicate negotiations over overhauling financial regulations.“It’s not a movable feast,” the chairman, Christopher J. Dodd, told Paul A. Volcker, … who has become an influential outside adviser to President Obama, [adding] that the administration was “getting precariously close” to excessive ambition for the legislation.
There you have it.

Not to underestimate Congress’s ability to neuter any legislative proposal on cue no matter how ironclad the theory behind it, but the administration’s proposal, what President Obama called “Volker rule”, has a theoretical Achilles’ heel that makes it vulnerable to attack. The problem is the definition of prop trading. According to the Times, in answer to criticism that his rule was too vague, Volker said:
”Every banker I speak with knows very well what proprietary trading means and implies.” For example, he said, a pattern of exceptionally large gains and losses over time in a Wall Street firm’s trading book should “raise an examiner’s eyebrows.”
Sorry Mr. Volker, but large gains and losses or the intuitive recognition of bankers cannot be the basis of regulation; it must be made of sterner stuff.

Volker’s problem is theory. He cannot define prop trading because prop trading is arbitrage trading. And speculative and potentially ruinous arbitrage is, after the trade is made, indistinguishable from the “legitimate and conservative” hedging. That was my discovery in Vol. 1 that led to the Theory of Speculative Capital:
The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it. What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.
If you know Volker’s address, send him a copy of Vol. 1.