Tag Archives: dodd-frank

Exchange Trading of Corporate Bonds Must Wait

Entrepreneurs seeking structural change in the corporate bond market should focus first on creating alternatives to corporate bond mutual funds.

I first learned of a supposed, Dodd-Frank-induced liquidity problem in the corporate bond market about two years ago. A friend from an inter-dealer-brokerage firm who knew of my prior work to bring an exchange to the U.S. Treasury market called to encourage me to train my sights on corporate bonds. I was skeptical, not least because one of my customers dealt in corporate bonds and seemed to have a good business doing so, but decided to at least follow the market more closely. 

Since, Tabb Group and a number of other analysts and market observers have written about the need for alternative execution venues for corporate bonds. They report that because of Dodd-Frank and other regulatory initiatives, dealers have become less willing to commit capital to the corporate bond market. Several of the electronic routing venues do decent volume in odd lots, but according to these reports, the so-called buy side is frustrated and wants someone to come forward with a more general solution. Accounts of what the buy side supposedly wants vary from a peer-to-peer market to a full-fledged exchange. 

This clamor for new corporate-bond-trading systems arises at an unusual time. The primary market is strong and has been for several years. Companies are taking advantage of low interest rates to issue bonds in large volumes. Logically, a healthy secondary market should ensue, and dealers should be more than willing to support their syndicate operations with capital for secondary trading. Issuers once expected such support from their underwriters. 

If the reports of meager capital commitments from dealers are indeed accurate, promoters of new venues should be wary, not encouraged. Dealers are money-motivated. If their capital allocations to corporate bonds are falling relative to their allocations to other endeavors, one possibility is that something other than regulation may be too blame. While I loathe government regulation as much or more than anyone, other markets may simply be more attractive to these dealers than the corporate market is at present. 

Dealers are reluctant to let any customer trades flow elsewhere. The risk is too great that new venues will expand into new markets. All dealers of any substance attempt to estimate what share of a customer’s total available business they receive. As a tactical matter, dealers will even lose money to win greater shares of such business. So I put little stock in the notion that dealers are ready to concede anything in the corporate bond market. 

But let us consider the customer side of the ledger. Are large asset managers so frustrated with dealer commitments to corporate bonds that they would lead a stampede to alternative venues? 

I doubt it. Large asset managers are beholden to large dealers. Almost twenty years into the Internet revolution, I have yet to see one of these large asset management firms step out of line and challenge the prevailing market structure. I have heard several of them say, “Yes, we would love an alternative and would use it.” But when push comes to shove, timidity prevails. The market is littered with the bones of entrepreneurial ventures that relied on promises of large asset managers. Venture capital firms have invested and lost hundreds of millions of dollars on failed corporate bond platforms. Even the largest custody bank that accounts for almost a third of institutional assets has tried and failed to win support for a credible, functional, well-capitalized, alternative platform for corporate bond trading. When time came for its customers to put up, they shut up. 

All markets evolve. The corporate bond market has yet to reach a final state where no further change is desirable or feasible. But large asset managers who are supposedly unhappy with their dealers will not supply the motive force for a new market structure. In fact, these asset managers are the problem, and entrepreneurs should focus their efforts on providing alternatives to them, not to dealers. 

Outside of a handful of names for a brief period of time after issuance, corporate bonds are not (yet) suitable for exchange trading. They trade over the counter because they should trade over the counter. They lack the price continuity that is a prerequisite for exchange trading. If it is ever to develop, this continuity must develop naturally. It cannot be forced or fomented by the sudden appearance of an exchange. 

The juiciest targets for entrepreneurial efforts in the corporate bond market are not the dealers, who actually provide a useful economic function, but the large asset managers, who for the most part do not. The most vulnerable among these are the investment companies operating as corporate bond mutual funds. These funds are demonstrably among the most inefficient investment vehicles ever devised. 

Bringing forward alternatives that will spare consumers and companies the inefficiencies of corporate bond funds will lead in due course to a better secondary market for corporate bonds. Reliance on complaints from large asset managers about the quotes they receive from their dealers is a fool’s errand.

TabbForum first published this essay, under the same heading, on November 6, 2013.

The Exchange Act rests on a false premise

The U.S. Congress contrived a fraudulent device in order to usurp the rights of the people to conduct their own affairs in the trading of securities. The U.S. Supreme Court abetted this unlawful act and served as accessory, both before and after the fact. Through their wrongdoing, these supposed public servants harmed our market relations and effectively destroyed the free enterprise system.

This device was a congressional declaration that what amounts to a supernatural being – a national public interest – affects securities transactions. The Supreme Court instructed Congress in the creation of this device and preordained its constitutionality so as to prevent the parties it injured from obtaining relief in courts of law. Through these coordinated steps the federal government seized total power and control over securities transactions, firms, and markets.

Congress premised the legal necessity and propriety of the Exchange Act on its assertion that “transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest” (original Exchange Act [PDF], Title 1, Sec. 2). It derived this language from the Supreme Court’s majority opinion in Board of Trade of City of Chicago v. Olsen, 262 U.S. 1 (1923).

Prior to Olsen, multiple congressional attempts to wrest control of exchange regulation from private exchange governors and the states failed to survive legal challenges on constitutional grounds. But then an activist Supreme Court, determined to break free of the chains of common law and logic and to engage instead in the making of social and economic policy, intervened.

In Hill v. Wallace, 259 U.S. 44 (1922), a case testing the constitutionality of the Future Trading Act of 1921, the court reluctantly overturned the act as a violation of Congress’s tax powers. But the court spelled out a procedure Congress could follow and a new theory it could use so that comparable, future acts would survive legal challenge.

Two weeks later, Congress followed the court’s guidance in Wallace. It made cosmetic modifications to the Future Trading Act and rebranded it as the Grain Futures Act. This nearly identical act would also find its way to the highest court, but this time the outcome would be different.

In Olsen, the Supreme Court for the first time upheld Congress’s taking of regulatory authority over exchanges and dealer markets from private parties and the states. The majority held in doing so that “The Chicago Board of Trade is engaged in a business affected by a public national interest, and subject to national regulation as such.”

This conjuring by the highest court of a “public national interest” was odd, even for a court bored with traditional jurisprudence. Even stranger was the court’s assertion that this anthropomorphic creature it dubbed a national interest affected the business of a local exchange. But for the court to subject the object of the creature’s actions to federal control was despotic.

The court’s imaginative rulings in Wallace and Olsen freed Congress to extend its sphere of control from a grain market in Chicago to all exchanges. Congress exercised its newfound freedoms with abandon in creating the Exchange Act.

By that act, the mythic, national public interest came to lurk behind every securities transaction in the United States, distorting markets and limiting innovation, raising prices and barriers to entry, and creating haves and have-nots, among other ill effects.

If we restate the Exchange Act’s premise in active voice for clarity – a national public interest affects transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets – its absurdity becomes obvious. But as imagined by its storytellers, this “national public interest” creature thinks and acts autonomously, though millions of individuals with disparate interests comprise it. And a chosen few – chiefly lawmakers, judges, and bureaucrats who serve as a priesthood of sorts – know the creature’s will and do its bidding faithfully.

In reality, the set of factors that may affect or influence transactions in securities is numerous, ranging from fear to greed, from the size of a trading floor to the processing power of a matching engine, from Regulation ATS to Regulation T, from the rate of capital gains taxes to clearing fees to preferences for other goods. So large is this set that a complete enumeration of its members is impossible.

But the set includes only real factors of production, objectives, preferences, and constraints, whether owned or felt by actual individuals or firms, even if irrationally. And even though we cannot list all of its members, the set most definitely excludes Santa Claus, the Easter Bunny, and the national public interest totem, no matter how fervently the priesthood protests otherwise.

Seventy-six years after the Exchange Act’s passage, the Dodd-Frank Wall Street Reform and Consumer Protection Act [PDF] (“Dodd-Frank”) amended the Exchange Act’s original premise by striking the word “affected” and inserting “effected” in its place (Dodd-Frank, Title IX, Sec. 985(b)(1)). The words affected and effected are homophones but not synonyms – that is, they sound alike but have different meanings. By substituting one for the other, the government changed the Exchange Act’s legal premise.

To appreciate the significance of this change, observe that only twice in history has Congress amended Sec. 2 of the Exchange Act. The Securities Acts Amendments of 1975 [PDF] made the first such amendment, creating the national market system controversy that rages to this day. More than three decades later, on July 21, 2010, came the second, Dodd-Frank.

In a November 1975 speech [PDF] to the Joint Securities Conference in Boston, Commissioner Phillip A. Loomis, Jr., of the Securities and Exchange Commission (“SEC” or “Commission”) referred to Sec. 2 of the Exchange Act as “the traditional standard for Commission actions, the public interest and the protection of investors.”

Given the importance of Sec. 2 and the continuing controversy attending the first amendment to it in 1975, what are we to make of the deafening silence surrounding the second amendment under Dodd-Frank in 2010? The government ordered the substitution of effected for affected in the “Technical corrections to Federal securities laws” section of Dodd-Frank. The report of the conference committee that produced the final version of Dodd-Frank contains no discussion of the matter. Google appears to contain no index of legal analysis or newspaper coverage of this amendment. And in signing Dodd-Frank into law, President Barack Obama made no comment on the change.

If the Exchange Act’s original premise was merely absurd, the new premise was positively stupefying. Stated in active voice, Congress now demanded that we accept this proposition as justification for federal regulation of securities markets:

A national public interest effects transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets.

Yes, the priesthood would now have us believe, the imaginary being national public interest actually trades. Its powers are not merely influential, inspirational, or motivational, but kinetic. Just as God parted the Red Sea, the national public interest matches buy and sell orders and pronounces them “Done!”

Let us set aside for now that in substituting “effected” for “affected,” Congress deviated from the exquisitely fallacious formula the Supreme Court devised in Wallace and then ratified in Olsen for testing the constitutionality of federal exchange regulation (see part 1 <LINK>). As I will describe in my next essay, even with a Supreme Court acting as nursemaid for its usurpations, Congress struggled to craft the original Exchange Act in a way that would survive court challenge.

What is inexcusable is that we allow this officious priesthood to utter such claptrap, that we listen to it and take it seriously, and then act as if the nonsense made sense.

A desire for profit may affect transactions in securities markets, and the New York Stock Exchange may effect transactions undertaken for such motive, but the national public interest neither affects nor effects anything: it doesn’t exist, except as a deceptive construct conjured by activist judges and then aped by legislators in defiance of common sense and law.

Responsible adults do not knowingly harbor or act on false premises; they reject them and correct their ways accordingly. They do not acquiesce in bad laws, but repeal them. Repeal of the Exchange Act is long overdue. The sooner we get after the business of doing so, the sooner our markets will heal and the benefits of vigorous competition under a system of free enterprise be restored.

TabbForum recently published a version of this essay in two parts, with only modest differences in content and formatting, under the headings “The Exchange Act Destroyed Our Markets, Part 1: A False Premise” and “The Exchange Act Destroyed Our Markets, Part 2: Justice Demands Repeal (free registration required).