Ethics in finance

The Ethics in Finance Robin Cosgrov Prize was delivered a week ago in Geneva. Organized Prof. Dembinski and the Observatoire de la Finance, the prize is given to young people strenghening the case for a more ethical finance. Any formal regulation will never be truly effective without a change of "culture" across financial sectors.

Among others, the prize this year went to Prabhay Joshi, who analyzed how the different actors of the LIBOR manipulation interacted. Normally competing banks and individuals, bound by a culture of reciprocity, were cooperating to submit lower or higher rate. This is the dark side of social capital and one of the factors hindering the modernization of market economies in transitions countries, most notably in Russia. Complex financial sectors underpinned by dubious practices (clearly at the expense of the rest of the economy) does not always mean progress.

The death of traditional stock markets

Economists usualy tend to divide financial systems in two: market-based and bank-based financial system. Critics argue that this view is getting outdated as banking has evolved away from its traditional activities of lending and facilitating payments. But it is often overlooked that today's stock market have nothing to do with the one of our fathers. It is fragmented in sub-markets, dark pools and other Alternative Trading Sytems (ATS) and Multilateral Trading Facilities (MTF) in Europe.

Trading of shares in these dark pool of liquidity has risen 45% in the past six months. It accounts for 8% of stock trading in Europe (it is twice as much in the U.S.) and 98% of institutional investors choose to execute their trades in these venues.

The graph above illustrates the volume of equity traded in dark pool in Europe main financial centers. So the European Commission decided to regulate these alternative trading venues, proposing a trading cap for any one stock of 4% per venues or 8% on a European market wide basis. The EU commission is also concerned with the effects of dark liquidity (these plateforms do not publicly display orders) on the price discovery of publicly lit markets.  Hence the insistance on pre-trade and post-trade transparency. 

Reading "Broken Markets" by Arnuk and Saluzzi, one learns that the problems lies also in the presence of High Frequency Trading algorythms, preying on institutional investors order flows. Some dark pool also sell information to HFT firms, some brokerage firms sell off-the-shelf- algorythms to their institutional clients, so that they can predict their clients trading patterns. Arnuk and Saluzzi's account of the "industry" rapid change suggests there are deeper forces at play (p.74):

Demutualization changed the ownership of the exchanges from a member-owned, nonprofut organization to a shareholder-owned, for-profit corporation. What was once thought of as a quasi-government utility-type organization would now be a bottom-line driven publicy traded, shareholder-focused company. The old method of having members vote on proposals and rule changes would be abolished. Exchanges would now make decisions by executives who reported to the board of directors who served the shareholders. Unfortunately, as we have seen all too often, shareholder interests and investor interests are not always the same.

Global inequality spurring global excess demand for securities

Excess demand for high yields is the main culprit of the financial crisis. This very interesting perspective is proposed by Ph. Lysandrou here. While lots of attention was devoted to the supply side of the problem, less attention was directed at the factors pushing Western financial industries to come up with new financial products and high yield securities. Lysandrou's starting point is that governments and corporations are not viewed anymore as organisations who require external funding to carry on a certain function. Instead these organisations are now viewed by investors as containers of wealth. This new nature of corporation and governments depends on their capacity to issue securities. 

These past decades, the demand has been coming from four groups of investors: 1. large institutional investors 2. commercial banks 3. sovereign wealth fund 4. High net worth individuals. The pressure these groups created was exacerbated by some constraining factors such as standardisation (necessary to the commodisation of securities) and slow regional market development (EME's supplied only 15% of the global stock of securities). 

Banks and intermediaries thus responded to this pressure by getting creative and finding ways of supplying more standardized securities by making tranches out of packages of subprime mortgages. Lysandrou's paper is particularily interesting in that it isolate a particular group: high net worth individuals, 

who in 2006 numbered 9.5 million (a figure that represents just over 0.01% of the world's population of 6.8 billion) and who had combined wealth of $37 trillion, more than half of which, $19 trillion was in securities ( a figure that represents just under 10% if the total financial claims on the world's governments and large corporations. 

HNWI were the most important supplier of finance of hedge funds, who were the main buyers of CDO. Financialisation might have increased income inequality, but income inequality might also have caused financial innovation, triggering the last crisis. 

Financialisation, Economy, Society and Sustainable Development

FESSUD is a EU financed research project to understand how finance can better work for the economy and society at large. I went to its annual conference (a month ago...) but I am not ashamed to to say (a month later) that it was very interesting. Some posts to follow on the papers presented there,  hopefully during the course of this week (or this month). Some papers on European financial systems here.