Innovation/Global Crisis

 If You Liked CDS’s, You’ll LOVE ETF’s:

 Wall St.’s New WMD

 By Shlomo Maital

 

   

 

 

 The invention of “credit default swaps” (CDS) was a major cause of the 2007-9 global crisis.  CDS’s name itself is a lie.  It is not a swap at all; it was simply called that, in order to avoid any and all regulation.  A financial innovation, like a human, born in a lie, cannot bode well for the world.  And it did not – it nearly destroyed a great insurance company AIG.

    Many of us have been waiting to see the next ‘innovation’ Wall St. comes up with, to fatten its wallets and its bellies.  We didn’t have to wait long. It is called ETF – exchange traded funds.   These funds are ‘baskets’ of securities, traded on stock exchanges, mostly meant to track an index, like the S&P 500 or Dow-Jones 30 Industrials.   According to Andrew Ross Sorkin,  Reuters columnist, quoting a Wall St. veteran, named Douglas A. Kass,  ETF’s are “the new weapon of mass destruction”, echoing Warren Buffett’s description of CDS’s.  “They have turned the market into a casino on steroids”, Kass says, “They accentuate the moves in every direction – the upside and the downside”.   Sorkin quotes a study by Kauffman Foundation scholars Harold Bradley and Robert Litan, demanding that the Securities Exchange Commission pay “more attention” to the proliferation of ETF’s.   

    Why are ETF’s bad?  They generate huge volatility, which tends to keep legitimate investors on the sidelines, and which tends to create profits for insiders and losses for outsiders.  They make it possible for scoundrels like UBS’s Kweku Adoboli to take huge risky positions (ETF’s are supposed to be ‘rebalanced’ at the end of every trading day, so the basket really does match the index it is tracking – but it is tempting NOT to rebalance, because with the risk goes potential profit (sometimes) ).  They encourage leveraged trading (borrowing half the money, thus doubling the return, and of course doubling the risk).  They permit computer-driven trading, through ‘algorithms’, to create major feedback loops that can drive asset prices down for no reason. (What if all the algorithms are more or less the same, and they all decide, for the same reason, to issue ‘sell’ orders? Remember the one-day 20% drop in stocks on Oct. 19, 1987?).   

    What can be learned from ETF’s?  Regulators, give up.  You are always going to be sailing in the wake of the financial ‘innovators’.  By the time you get control of ETF’s, they will have come up with something new.   Somehow we need to change the DNA of the financial services industry.  How? Very simple.  

      For every financial innovation it invents, that hypercharges profits, make them ask one question:  Does this innovation create redeeming social value, by doing what financial services should do,  bringing those who have money together with those who need it, in a manner that builds businesses, jobs, and long-term growth and stability?   Prove it! 

  Do Exchange Traded Funds have redeeming social value?  Do they fulfill the core function of the financial services industry?  If so, let them thrive.  But the patently obvious answer is,  we have just traded one horrendous acronym, CDS, for another, ETF,  and both are WMD, weapons of mass destruction.

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