Few people still remember the demand for new regulations for the financial markets, but after a long debate on the subject, some new rules were approved.
Since the collapse of Lehman Brothers and a long period of severe economic recession, the economy is finally recovering in the UK and in the US, but it is still stagnating in the Eurozone. An important issue within this broad topic is that of proper trading. Proper trading is the activity of trading with the bank’s money thus with depositors’ money. This practice is under special observation because of some famous cases of abuse in terms of moral hazard and for a more general moral persuasion that sees it as a dangerous practice. Even if a bank can build a security system and reduce its exposure, there still is a certain amount of risk for the bank to collapse and for the depositors to suffer some important losses.
Barings Bank is a well-known case of how risky proper trading can be. As a reminder about the Barings Bank episode we can say that it was one of the oldest banks in Europe and was brought close to bankruptcy by a single broker that, by forcing the company policy, took an overexposure on the derivative market, losing £827 million in a few days. This isn’t the only case. In 2008 Société Générale faced a 4,9€ billion cause of some unauthorized operation conducted by a trader. In this case the volume of the trade generated by a single person was near to 49 billon€, more than all the bank assets. So only for a matter of luck Société Générale was able to absorb such a loss.
Proper trading has been limited in the US and reduced in the world since the approval of the Dodd Frank Act, a law strongly supported by Paul Volker, the former chief of the Federal Reserve. This law sets strict parameters for proprietary trading abolishing it for derivatives and for other financial products. The European commission is in track to approve an anti-speculation law that is going to abolish proper trading from 2018. The interruption of this practice concerns systemic banks, those with more than 30 billion assets, while for smaller banks the local authority can extend the rule. The problem is distinguishing proper trading from the market maker activity, which is the activity of setting a price to sell and to buy a certain financial product on the market in order to gain from the spread between the two prices. Sometimes it is even more difficult to distinguish proper trading from the execution of a private order execution, which is a service the bank provides to a client that explicitly orders a transaction. This last distinction could be very hard to verify without consuming a lot of time.
Several other regulations have been imposed in the US to prevent a new financial crisis: for example the creation of the Consumer Financial Protection Bureau that prevents predatory mortgage lending by improving the clarity of mortgage documentation for consumers and reducing incentives for mortgage brokers to push buyers into more expensive loans. Even the shadow banking system needs more regulations especially in regards to the emission of Credit Default Swaps, which still allow investors to bet on someone else’s default. Such a product can be useful when purchased for covering a risk, but can be dangerous when used for speculation purposes.
All these security regulations are not fully effective if the economy does not achieve a more balanced equilibrium, but this is, of course, primarily a political matter rather than a financial one.