“Systemic Risk Laundering” -- Financial Crisis Root Causes -- Part II

How could American taxpayers get stuck with a multi-trillion dollar tab that they weren’t even aware that they were running up? How could that huge tab still be allowed to run up unchecked today? For the Financial Crisis Inquiry Commission, the sad answer is one of the biggest root causes of last fall’s devastating financial crisis and one of the biggest continuing systemic risks to the financial system and the economic recovery.  

A decade ago, in what may prove to be the most expensive bipartisan legislative mistake in U.S. history, a bipartisan policy became law that effectively ensured that no Federal regulator had oversight or enforcement jurisdiction over derivative financial instruments. The Commodity Futures Modernization Act of 2000 (CFMA) created “legal certainty for excluded derivative transactions.” That law allowed a shadow derivative overlay system to be built literally on top of the public financial system, with none of the inherent accountability of the underlying financial system.  In other words, a deliberate bipartisan U.S. government policy change a decade ago unwittingly created an unaccountable “black hole” market that sucked enormous value out of public markets, (Bear Stearns, Lehman, AIG, Fannie, Freddie, securitized sub-prime mortgages, etc.) while laundering the risk to the U.S. taxpayer.

Simply, in fostering an unaccountable marketplace that derived all its real value from public markets, the Government fostered systemic risk laundering from the unaccountable to the accountable, which ultimately left the U.S. taxpayer holding the bag. More specifically, with no accountability to fairly represent or disclose risk, too many did not. Too many figured out that they could launder huge financial risk with impunity, because most public investors assumed someone somewhere was ensuring that these derivative instruments were fairly represented, disclosed, and accountable. Oops!

The origin of this monumental bipartisan blunder was a shockingly poor understanding of what free markets fundamentally require to work efficiently, i.e. confidence in: the enforceability of property rights and contracts; the competent policing against fraud and bad actors; and the free flow of necessary market information. For all practical purposes, the offending CFMA provision perversely redefined the word “free” in free-market to mean “unaccountable.” More specifically, the provision also systematically abandoned the implicit social contract that underlies the American free market system -- “with freedom comes responsibility” -- and re-interpreted “free” to mean freedom from accountability. Freedom from accountability is heaven on earth for fraudsters and bad actors. A decade of widespread freedom from accountability disgorged the totally dysfunctional marketplace of last year, which in turn required the Government to flood the market with trillions in capital, bailouts and guarantees to mop up this historic mess of systemically laundered risk.

Unaccountability fosters corruption, fraud, and unlimited liability, because there is no third-party check and balance of oversight, supervision, enforcement, legal liability, research, measurement, audit, due diligence, or internal controls. An unaccountable system is a system out of control, just like the system that ended up in the financial ditch last fall.     

The sanctioned unaccountability in this CFMA law also neutered the free market by ensuring little free flow of necessary market information. The provision basically allows two parties to secretly agree on the value and risk transfer of derivative transactions without sharing any market information with public markets or the owners of the public assets the derivatives are based upon. If parties can secretly create and extract value from unaccountable derivative transactions on the backs of public assets, they easily can launder risk to the unaware owner of the underlying public asset. A light bulb should be turning on about how so many public investors and the American taxpayer systematically could be left obligated to pay trillions of dollars for a tab they didn’t even know was being run up. Another light bulb should be turning on about how this enormous systemic problem is still going on today – largely unchecked. Ignorance is indeed bliss. 

Why do you think industry insiders refer to these derivative transactions as “dark pools?” It is because there is no transparency or light shed on this critical market information. This is also why I refer to the shadow derivative overlay system as an unaccountable “black hole” market from which no light can emerge to enable markets to efficiently maintain price equilibrium.    

Let me be crystal clear, financial derivatives themselves are not the problem because derivatives can have many legitimate and valuable benefits. The problem is an unaccountable shadow derivative system, which fosters systemic risk laundering to public investors and the taxpayer, and which ensures there is no way to discern which derivatives, transactions or submarkets are trustworthy and which ones may be fraudulent. The problem is systemic risk laundering from the unaccountable to the accountable, which can create near unlimited liability for public investors and the United States Treasury – without their knowledge.

What is the definition of a bad derivative? Simply a bad derivative launders risk from the aware to the unaware. That’s fraud and unfortunately it is still happening systemically everyday because there is currently little to no risk of detection or prosecution.  The financial crisis exposed all to well the hundreds of billions of dollars of risk that effectively had been laundered to banking counterparties. What overseers have not yet figured out, and what the Financial Crisis Inquiry Commission will need to figure out, is how public investors and U.S. taxpayers still continue today to be the unwitting counterparties to systemic risk laundering by this derivative “black hole” market. 

The common defenses of systemic risk laundering are: “it is innovation;” “it improves transaction efficiency;” and “it increases liquidity.” The problem with these common defenses is that those who use them have grown confident that they work as “get out of jail free cards.”

• They know consumers and policymakers prize “innovation,” even if all innovation is not good, because crooks can innovate too. They know screaming innovation is like screaming fire at a fire-mans’ convention, everyone reflexively will rush to their aid no questions asked.
• They also know that consumers and policymakers love technology, and that they really don’t understand it very well, but assume its all good and efficiency enhancing. The big mistake policymakers have made here is that they have allowed arbitrageurs and flash traders to use technology advances to force a redefinition of market efficiency as transaction speed in milliseconds rather than what true market efficiency is -- clearing supply with demand based on a public market price. The two are related but NOT the same.
• They also deflect scrutiny by warning about threats to “liquidity.” While liquidity is exceptionally important as the financial crisis re-proved, it is not an absolute, nor should liquidity be used as cover to hide risk laundering or risk dumping without transparency to the public markets which are directly affected by the risk transfer.      

So what’s the solution? In a word, it is accountability.

• First, completely repeal the chaos and fraud fostering CFMA provisions that grant effective safe harbor from any accountability.
• Second, foster the free flow of market information between derivative and public markets by treating any effort to hide necessary derivative market information from the owners of the underlying assets to be a big enforcement red flag of fraudulent activity.
• Third, require all derivative financial instruments be screened for risk laundering using a Systemic Risk Prevention Framework and Derivative Accountability Checklist like the one included at the end of this piece.       

In conclusion, the Government’s bipartisan decision a decade ago to allow derivatives to be unaccountable is another major root cause behind the hyper-stress on the financial system and the unprecedented destabilization of the economy.  Imagine how much more stability, trust, confidence, investment and growth there could be if the all derivative financial instruments that affect the value and stability of publicly-traded assets were in fact accountable and not systematically laundering risk to the unaware public investor and taxpayer.  

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Note:

• Don’t miss the recommended “Systemic Risk Prevention Framework and Derivative Accountability Checklist” below.
• Don’t miss the first part of this research series: “Indexing into the Ditch – Financial Crisis Root Causes – Part I” Click here.

Scott Cleland is President of Precursor LLC, an industry research and consulting firm, and was the Founding Chairman of the Investorside Research Association. Click here for Cleland's Biography.

Systemic Risk Prevention Framework 

Derivative Accountability Checklist

All of the thousands of new derivative financial instruments and systemic practices that have emerged over the last decade since the CFMA created a safe harbor from accountability need to be audited and evaluated for unaccountable systemic risk and fraud.

1. What asset, instrument, or market is the derivative dependent or predicated upon?
2. Does the derivative’s second purpose conflict with, or undermine, the first purposes/value of the underlying public asset, instrument, or market that the derivative is derived from?
3. How is the derivative interconnected with other assets, instruments, markets or counterparties? And to what extent is that interconnectedness reasonably transparent and known by all the affected parties?
4. What are the side effects, externalities, and long-term/cumulative effects of the derivative?
5. Does the derivative enhance or detract from the underlying asset, instrument, or market?
6. Does the derivative undermine or break any linkage/relationship/balance between:
   
   1. Supply and demand?
   2. Risk and reward?
   3. Borrower and lender?
   4. Short and long term?
   5. Risk and insurance?
7. As the derivative scales in usage could it foster systemic:
   
   1. Market momentum?
   2. Market speculation?
   3. Misrepresentation?
   4. Front running?
   5. Destabilization?
8. Is the derivative’s effect prone to undermining or discouraging capital formation?
9. Is the derivative’s effect prone to undermining market efficiency in reaching price equilibrium?
10. How could the derivative be susceptible to fraud or manipulation?
11. Does the derivative transfer risk transparently and with fair representation?
12. Does the derivative have independent research coverage?
13. How is the derivative accountable and to what/whom?
14. What are the accountability measures, (audit, internal controls, etc.) for the derivatives algorithms or quant models?
15. What independent third party audits and creates accountability for ensuring integrity of the algorithms and computer code that undergird these virtual derivative exchanges/systems?