Merkley-Levin Amendment

We have reached endgame. We know the rough contours, at least, of the financial-regulatory reform that will become law this year. See the particulars here.

Among the tweaks pending, there is an amendment on offer from Sens. Carl Levin, D-Mich., and Jeff Merkley, D-Ore., that would re-work the “Volcker Rule,” Paul Volcker's brainstorm re keeping banks from using their deposits for nasty speculative purposes. This is the rule that would prohibit banks from sponsoring hedge funds or from running their own proprietary trading operations.

The Volcker Rule is section 619 in the Dodd bill, S. 3217. The key point is that the only way to ban prop trading is to distinguish between prop trading on the one hand and market making on the other. The Dodd bill simply took it as a given that legislation can't do this effectively, and left that detailed distinction to the regulators. Subject to "such restrictions as the Federal banking agencies may determine," the buying or selling of securities "as part of market making activities, or otherwise in connection with or in facilitation of customer relationships," is not proprietary trading and thus is not banned. Those Federal banking agencies will presumably "know it when they see it" as a Supreme Court Justice once said in another context.

Levin and Merkley aren't satisfied with this, and their language would attempt to take some discretion away from the federal banking agencies. They, too, have a generic "market maker" exception, which they word so as to exclude from prop trading "the purchase, sale, acquisition, or disposition of securities and other instruments ... in connection with underwriting, market making, or in facilitation of customer relationships, to the extent that any such activities permitted by this subparagraph are designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties."

Which means ... what? For an argument to the effect that this is a loosening of Dodd's version of the rule posing as a toughening-up thereof see The Economics of Contempt, an excellent blog in general and a worthy posting on this subject in particular.

Payment for order flow

There is an intermittent controversy among those whom manage stock exchanges, brokerage houses and related institutions -- and among those who regulate them -- about a practice known as "payment for order flow."

Back in January 2003, for example, the then-chairman of the Securities and Exchange Commission, Harvey Pitt, wrote to the heads of each of the five US exchanges where stock OPTIONS are listed, just to give them what one might call a heads up.

"Hey guys, we're looking at this issue down here in DC. I'm not saying nothing, I'm just sayin'." [Not his exact words].

The idea was that an exchange would pay a brokerage firm for routing an order to them rather than elsewhere -- the payment might be a penny per share.

The controversy arises because your broker is suppsoed to be working for you, the investor, trying to get you the best deal. If he can get you a better deal for certain options on exchange A than on exchange B, shouldn't he rout your order through exchange B? If a payment from exchange B persuades him to do otherwise, aren't they cheating you?

The same might well be asked also if you're trying to buy the underlying stocks, though Pitt's January 2003 letter involved options for reasons I won't get into today.

Likewise, the same questions might be asked when it is a market maker, rather than an exchange, that is paying to keep orders on some form of security or other flowing. From whomever the money is coming, the broker who receives that money may be putting itself into a conflicted situation vis-a-vis its client.

I'm thinking about such matters today because an investment manager named Bernard Madoff is all over the news this weekend, even putting the continuing controversy over the auto bail-out in the shade for the moment.

Prosecutors claim that Madoff told senior employees at his firm, a market maker, that his operations were "all just one big lie," and "a giant Ponzi scheme."

If there is anything to the charges, the ongoing scandal may further discredit the whole idea of anyone -- exchange or market maker -- paying for any kind of market flow. Because Madoff had been closely associated with the practice, and was in fact a public voice in its defense.

He once told a reporter from CNN who interviewed him on the subject (May 2000): "If your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated."

The analogy is borderline absurd. The stocking manufacturer isn't in a relationship of contractual privity with the shopper, so such issues don't normally arise.

Here's some further reading for the curious.

Anyway, when this is all sorted out we may think of the whole idea of payment for order flow as an important warning sign. For the mark of a pyramid schemer is an increasingly desperate desire to keep increasing order flow.