Without Stronger Transparency, More Financial Crises Loom
By Michael J. Casey
The social forces that can encourage euphoria among investors and then suddenly flip them into mass panic are not unlike those that generate crowd disasters such as the stampedes that have killed more than 2,500 pilgrims at Mecca since 1990.
Sharp swings in the stock market have led to questions about who stands to benefit from high-frequency trading. (AP/Richard Drew)
In such moments of herd-like behavior, the common element is a profound lack of information. If neither the individuals in an enthusiastic crowd nor those charged with policing it have a grasp on how it is behaving as a whole, the mob can grow too big for its surroundings. Equally, if those people are ill-informed about the extent of the risks they face when they discover something is wrong, they will assume the worst and rush for the exits, increasing the danger to all. This describes numerous crowd disasters. It also illustrates the financial crisis of 2008.
The recent crisis is a story of mass ignorance. It deserves to be treated as a powerful lesson on the importance of information transparency in a market economy and, by extension, on the crucial role to be played by a free press. We learned the hard way that without transparency, markets not only fail to fulfill their primary function in allocating capital efficiently but also can become agents of destruction.
Unfortunately, in the five years since, it is not at all clear we have removed such risks. Despite reams of new regulations and information technology aimed at opening up the financial markets to more scrutiny, financial firms are finding new and creative ways to retain and control information and thus are undermining the functioning of markets. Many governments, meanwhile, are limiting disclosure about their economies. And this is happening as newsrooms in developed countries continue to shrink, making rigorous, independent investigative reporting into banking practices and markets all the more difficult just when it is needed most.
From former U.S. Federal Reserve Chairman Alan Greenspan down, financial policymakers in the late 1990s and the first seven years of this century believed that technological innovation was making markets more efficient, open, and fair. It was widely contended that the advent of electronic trading had created a more transparent marketplace and had eaten into the power of Wall Street's bond and stock traders. By some measures this was true. The broadcasting of asset prices across networks such as Bloomberg's meant that banks were less able to exploit investor ignorance when buying and selling securities; it became more difficult for them to buy stocks, bonds, or other financial assets at a steep discount and sell them at a much higher price.
But technology can also make markets less transparent. The expansion of computing power, coupled with a soft regulatory environment, allowed Wall Street banks and other powerful institutions to add opacity back into the financial system and to put themselves in the middle of a new, phenomenally complex investment business. Leveraging their unmatchable capacity to pay high salaries, the banks lured math and physics experts into their fold. These "quants" were put to work engineering an alphabet soup of highly complicated financial instruments that were snapped up by an investor community hungry for new ways to turn their cash into profits.
The more complex these newfangled products became, the further detached they were from the underlying risk in their component assets--which in many cases came down to the prospect of an American homeowner falling behind on monthly mortgage payments. This made it harder for an outsider to figure out how to price them. What's more, thanks to special exemptions from regulatory oversight, most of them traded not on traditional exchanges such as the London Stock Exchange or the Chicago Board of Trade but in over-the-counter markets where prices, volumes, and other transaction details are unavailable to outsiders. This meant that neither the investing public nor regulators had an accurate sense of the huge buildup of risks being taken by the biggest players.
"We live in a world where there is so much information, and where technology has flattened the information hierarchy. So, in theory, everybody has easy access to everything and yet you still have" enormous secrecy in markets, said Alan Murray, president of the Pew Research Center and a former deputy managing editor of The Wall Street Journal. "What you saw in the crisis was ... that people may have had access to information, but if we can't access it in a way that anybody understands then it doesn't make a difference."
Wall Street banks were greatly empowered before the crisis, aided by their role in developing the complex new financial instruments that fueled the credit bubble, which gave them exclusive access to the complicated formulas on which those instruments were priced. This enterprise was spectacularly successful in restoring the banks' monopoly over information, helping them overcome the challenges to profitability posed by electronic trading and allowing top bankers to claim annual compensation deals that in some cases ran higher than $100 million.
To be fair, those on the losing side of Wall Street's profit-driven pre-crisis trade mostly failed to exploit new opportunities to expose the risks associated with it. In this era of "big data," where high-tech analytical techniques can produce abundant, quantifiable information, we should all have been empowered to uncover the truth. But in reality, for the average investor, journalist, or even regulator, this new trove of data has been mostly out of reach and unintelligible.
It should now be the duty of journalists to unlock it. And to do so, they need to harness the same tools that financial institutions and corporations use to sift, interpret and make sense of mass digital information. The value of human sources providing information on market players' activities hasn't gone away--think of the lasting impact of The Wall Street Journal's "London Whale" scoop on JPMorgan Chase's risky trading bets last year, a story that led to news that the bank had racked up $6 billion in losses and, later, $1 billion in regulatory fines. But those stories must now be complemented with computer-enhanced analysis and interpretation. To get at the truth will require crunching the numbers--billions of them.
"The question is: How do you take the proliferation of data and extract something intelligent out of it?" said the Pew Center's Murray. "I think data analysis is going to become a much more important part of journalism."
If journalists are to investigate and interpret the complex systems of data management with which financial institutions create information monopolies, they need resources. Yet in the developed countries in which these complex new financial markets are thriving, the dominant trend in the penny-pinching media industry is for cutbacks, not investment, as traditional news outlets adjust to a highly competitive environment for online advertising. According to the Pew Center's annual State of the Media report, in 2012 the total U.S. newsroom workforce dipped below 40,000 for the first time since 1978, a 30 percent decline since 2000. Similar challenges exist in Europe, where the same patterns of declining newspaper revenue and media fragmentation were evident in a seminal 10-year study by the Reuters Institute in 2012.
Such statistics are depressing enough, but they take on new relevance when positioned against another one: the total number of public relations managers and specialists in the U.S. stood at 320,000 in 2010 and was projected to grow by 21 percent in 2020, according to the U.S. Bureau of Labor Statistics. That's well above the projected growth rate of the overall national workforce. In other words, there's a growing and well-funded demand for those who deliver spin in the interest of corporate entities and a declining demand for those whose job is to independently report and analyze those entities' activities without bias.
Hard data on the number of journalists becoming public relations agents is difficult to come by. But anyone in the financial press--where the prospects of being lured to a corporate communications job are greatest--will recognize a trend. They know that the often higher salaries offered on what journalists call the "dark side" are enticing struggling reporters and editors away from journalism. Some even compare it to Washington's revolving-door problem, where politicians and their aides are increasingly hired as lobbyists at the end of their public service careers, creating a conflicted relationship that tightens corporate money's stranglehold on politics. The comparable concern is that the possibility of future job opportunities compromises business journalists' ability to keep an arms-length relationship with their sources.
"The world of journalism is losing a lot of brainpower and experience that is going over to work for corporate America. To me that it is troublesome," said Chris Roush, a journalism professor at the University of North Carolina at Chapel Hill and the founder of the Talking Biz News blog, a clearinghouse of news about staff movements and other developments in financial journalism.
Here's another complicating factor: in the post-crisis era, governments around the world have become far bigger players in world markets and economies, a direct outcome of the financial rescue missions many had to undertake. The problem is they are not being forthcoming with information--certainly not to the press.
The U.S. Federal Reserve, whose policies of boosting the supply of money to stimulate the economy and whose accumulated stockpile of $3.6 trillion in purchased bonds have left global investors singularly absorbed by its policy deliberations, launched some effective pro-transparency initiatives throughout this period. For one, Chairman Ben Bernanke now gives news conferences after the Federal Reserve's regular meetings to set monetary policy. But it hasn't been entirely transparent, either. The Federal Reserve fought hard against Freedom of Information Act requests from Fox Business and Bloomberg that sought the names of the institutions that received $3.3 trillion in emergency central bank funding in the fall of 2008. Even after the Supreme Court ruled that the Fed must release the data, it delivered it in a rudimentary and hard-to-interpret format.
The other behemoth in world finance is the Chinese government. With $3.7 trillion in foreign currency reserves, the country's central bank, the People's Bank of China, has an almost unmatched capacity to move markets whenever it tweaks the mix of foreign bonds it holds. The problem is that beyond reporting an estimate of total holdings, China reveals virtually nothing about what it does with those funds. Beijing refuses even to comply with a program run by the International Monetary Fund that reports a simple breakdown of different national reserve managers' currency allocations, even though a lengthy delay in that report's release means the information is hardly sensitive. There are also serious doubts about the quality of economic data in China, the second-largest economy in the world. That is exacerbating fear of a future economic crisis brought on by excessive debt. Chinese banks and foreign investors are owed hundreds of billions of dollars by local and provincial governments that partook in a decade-long construction binge.
It has been a better story in most other emerging markets, where waves of reforms since the Cold War and the adoption of websites for publishing official statistics have generally encouraged a more open approach to economic information. But the crisis-like environment since 2008 has put those changes at risk, as volatile flows of speculative money in and out of these smaller economies have left some questioning the value of playing by the international community's transparency rules. Some have already crossed that line. Argentina's government, for example, has significantly understated inflation statistics over the past six years--based on numerous independent studies, including by the IMF. It has fined economists who have produced more accurate measures of price trends and has implicitly threatened news organizations that reproduced those independent estimates. In a move that opposition politicians likened to the intimidation tactics of Argentina's Dirty War, a judge presiding over the government's case against the economists ordered newspapers to divulge personal information about journalists who covered inflation.
This is to say nothing of how entrenched corrupt practices and conflicts of interest undermine financial journalism in many countries, with blame found on both sides of the business-media relationship. In Indonesia, for example, some local news organizations have turned a blind eye to the biases encouraged by “envelope journalism,” as their reporters often supplement their meager incomes with the envelopes of cash that are stuffed into public-relations packets at corporate news conferences. And in various places where journalists do strive for hard-hitting, independent reporting about powerful business elites, they can run the risk of legal harassment, violence, or even murder. For example, in 2012, Cambodian journalist Hang Serei Odom was found murdered with ax wounds to his head after having reported on military involvement in illegal logging. All of this diminishes the quality of information available to the public about the state of the local economy and financial system, which in turn breeds inefficiencies and crises.
Press freedom and information transparency are arguably even more urgently needed now in the world of business than before the crisis. That's because the same kinds of institutions that created the conditions for the 2008 meltdown are up to their old tricks. Continuing a decades-long pattern of counter-responding to regulation and technological change with its own innovations, Wall Street will protect its profit base. Some argue that if the financial markets hadn't done so over the years, society's natural demand for an open, transparent marketplace would by now have rendered banking an unsexy, low-margin business.
"The search for non-transparent markets was more of a reflection of the weakness of the banks' business models. They could only make money in the dark," said Terry Connelly, dean emeritus of Golden Gate University, who worked at Salomon Smith Barney in the 1980s, a time when that bank's bond traders established a reputation for trail-blazing financial engineering.
Algorithmic, high-frequency trading is one new area of concern. With this technology, Wall Street banks and hedge funds exploit what Connelly calls "the opaqueness of time." These ultra-fast trading operations employ computerized trading systems that process information and execute multiple buy-and-sell trades within milliseconds. All this happens within a time frame that a human brain is incapable of even contemplating, let alone monitoring. Once again, innovation has edged out transparency.
High-frequency trading has thrived off the expansion and digitalization of financial information--the stock prices, economic statistics and corporate earnings reports that are entered into the algorithms. Enabled by the ever-widening information base, high-frequency trading systems grew so large that by 2010 they accounted for 56 percent of all U.S. stock trading volume and 77 percent of the U.K. market, according to estimates from the Tabb Group, a consulting group.
Its proponents tout high-speed trading as a driver of market efficiency, but that has been brought into question by a string of sudden market breakdowns, including the "flash crash" of 2010, when an avalanche of self-perpetuating sell orders for U.S. stocks turned a relatively stable market into a scene of chaos in which $1 trillion in market value was temporarily wiped out. A common view now is that high-frequency trading is at best beneficial only to investors with the most powerful computer systems and is at worst a destabilizing force capable of unleashing a scary form of automated herd behavior.
Meanwhile, alternative electronic trading platforms and quasi-exchanges have created new venues for big investors to execute trades in secret. Trading services known as "dark pools" invite large institutions to place and execute orders anonymously and outside the purview of regulated financial exchanges. Again, the advantages accrue to the biggest and most well-financed firms, all at the expense of individuals and of pension funds, whose charters require them to invest transparently on traditional exchanges.
Regulators are trying to curb these abuses. But the complex set of rules developed under the 2010 Dodd-Frank Act--2,300 pages of initial legislation, which in turn gave rise to 155 new rules contained in 14,000 pages of regulations--is not an elegant solution. Historically, a basic principle behind market regulation in the U.S. was that rule-making should prioritize the enforcement of transparency so that more draconian constraints on investment activity aren't needed. Freedom of information, it was thought, would facilitate free markets. One could argue, then, that the Dodd-Frank Act, with its unseemly mix of excessive bureaucracy and negotiated loopholes, reflects a failure of those past efforts to achieve financial transparency. A truly open and free market in which information is widely available to all participants would not give rise to the abuses that prompt such heavy-handed intervention. Yale Law Professor Jonathan Macey even contends that the regulations can undermine transparency and honesty in the financial sector because banking firms cease to worry about bad press. With the government now promising to protect Wall Street's clients, "an industry that was built on reputation now could (not) care less about its reputation," he told The Wall Street Journal.
One area in which Dodd-Frank does free up information is in its regulation of so-called swaps, financial instruments that give investors the opportunity to transfer the risks attached to certain securities to other investors. One version, the credit-default swap, was a key contributor to the financial crisis. That's because the over-the-counter market on which they traded provided too little information about the interconnected risks of default in the financial system. It meant no one could perceive the domino effect that would arise once a large institution like Lehman Brothers failed to make payments--a development that led each market participant to respond with an excess of caution, dumping bonds, demanding repayments from their borrowers, and charging more for insurance against default, until credit completely dried up. To mitigate the threat of such mass panic attacks, Dodd-Frank rules now force many of these instruments to trade in more public forums known as swap execution facilities. With the prices, volumes, and terms of the swaps contracts more transparently presented, the hope is that investors and regulators have a clearer picture of the overall market and its potential for a 2008-style "systemic" meltdown. Ultimately, the goal is to make a "crowd disaster" less likely.
It will take the next debt crisis--and whether it generates a wider threat to the financial system--to determine whether these changes have removed systemic risk from the swaps market. But what is known is that Wall Street lobbyists successfully fought to water down some of these new regulations. For one, most currency swaps, a growing portion of the $4 trillion-a-day global foreign exchange market, were exempted from trading on the more transparent swap execution facilities. Meanwhile, U.S. banks aligned themselves with European governments to convince U.S. regulators that overseas transactions could continue to occur in over-the-counter markets. The banks argued that without these adjustments, the uncertainty imposed on markets could have fueled another credit crunch and that businesses needed the customizable strategies for hedging risk available in over-the-counter markets. Nonetheless, the upshot is that much of the global derivatives market still operates outside the new open trading rules. The opaque system survives.
Given these failings, more regulation could be on its way. The authorities in the U.S. are increasingly concerned, for example, that owners of high-speed trading systems can access and act upon sensitive market-moving information-- including closely guarded government data--ahead of human traders. Any effort to address this imbalance should not, however, infringe upon the right of the press to freely report that information. It is in society's interest that the guiding principle again be one where regulation works to enhance transparency instead of discouraging risk-taking.
Perhaps the biggest challenges lie within our industry. We journalists must lead the struggle for more transparency in finance. But to do that effectively, we'll need to reverse the decline in news organizations' resources. The fundamental challenge in developed economies is to make financial news sufficiently profitable for serious media groups to attract reporters and editors of integrity and talent and to invest in technology that empowers them. Meanwhile, as emerging economies develop more sophisticated financial markets, it's important that journalists are granted the freedom and technology to report on them.
As a starting point to addressing these challenges it's worth acknowledging the central theme here: that in a market economy, information is extremely valuable. Investors need fast, reliable information from a trustworthy source whose interests are not conflicted. Why wouldn't they pay for that?
Media companies feel trapped by Internet competition that's strengthening the bargaining power of their advertising clients and reducing spot news to a commodity. But given the market's insatiable demand for reliable information, there is intrinsic value in their newsrooms' output. Unlocking it is a noble task, one that would align many interests: those of investors who seek to profit from knowledge; those of society, for which transparent, efficient markets are vital to prosperity; and those of journalists, who deserve to be fairly rewarded for a valuable service.
Michael J. Casey is a senior columnist covering economics and global financial markets at The Wall Street Journal. He has worked as a journalist in Australia, Thailand, Indonesia, Argentina, and the United States. He is the author of two books, The Unfair Trade and Che's Afterlife. This commentary reflects his opinions and not necessarily the opinions of Dow Jones or The Wall Street Journal.