Perverse Incentives

I'll admit to being a bit of a fan of Hayek, the Austrian and Chicago schools of thought, and free, unfettered markets.  That includes for labor.

So when I read that the government wants to manage their investment in bailed-out banks by restricting bonuses, I worry.  How will the government recoup its investment if people who do good work don't get paid the market rate for their work?  Maybe those employees should be paid more for adding to the bottom line at a bailout bank: those banks need money dearly and provide more difficult environments for making money.

Worse, this gets back to the same troubles: We are taxing profitable banks -- banks which had better risk management and incentive structures -- to support banks which were not profitable largely because they failed at managing risk and incentives.  Then we constrain the pay of anybody at those supported banks who makes the bank a pile of money.  This encourages the best employees to leave for unsupported banks where their pay will not be capped.

In a way, that is good because it returns some reward to the profitable banks.  However, it is bad because it effectively traps bailout banks in amber: not going broke, but losing good employees.  Why would we bail banks out only to push them into mediocrity?  It seems to be a poor use of taxpayer money.

Now I agree pay should have clawbacks and be risk-adjusted; I've been a fan of such ideas for years.  But capping salaries is not the way to achieve this.  If anything, caps treat pay so simply that they make it much harder to argue for risk-adjusted, sustainability-driven pay.

What are we doing?  We need to be working to understand the subtleties of what went wrong (and what went right) -- not reducing the issues to simple morality plays or black-and-white cartoons.  At a time when banks should be working smarter, many are being forced to take dumb actions.

Dark Pools Drained

Yesterday, the SEC decided to rein in dark pools.  The basic idea: changing how much volume a dark pool can transact before it must "illuminate" (start broadcasting trades and quotes) or shut down for the day.  That level was 5% of volume, now it is 0.25%.  (except for large, block orders)

I'm not a big fan of dark pools.  They can function like bucket shops (remove order from larger market, get filled when to your disadvantage) in that they are hotbeds of adverse selection.  However, the market largely realizes this -- which is why dark pools have collectively stayed at around 10% of total volume for years.  (One can think of the adverse selection like bucketing as in Ready (1999).)

What I dislike is the (false) implication that "dark pools" are a new innovation designed to take advantage of customers.  They're not.  For example, ITG's POSIT is a dark pool and has existed since 1987.  Further, if dark pools can attract some fraction of volume despite their well-publicized issues, I have to believe they are meeting some need in the markets.  Mary Shapiro deserves credit for acknowledging some of this: "Although dark liquidity always has existed in one form or another in the equity markets, the commission must assure that the public markets and non-public trading venues operate within a balanced regulatory framework."  I read that as "this is neither new nor serious, but it is a PR problem."

Why are dark pools a PR problem if they are not new?  I suspect because the term "dark pool" is new.  If ever a financial term were created to sound scary, this is it.  Dark pool, sharks, piranha, sharp rocks, danger, what is down there?  The word associations sound like a B-horror movie.  Frankly, I'm surprised the industry tolerated such a loaded term.

I've stated before my view that many regulators and economists in the government have no idea how modern markets work and to what extent competition has forced these markets to evolve.  I still believe that, but I am heartened the administration acted with restraint in not banning dark pools.  There is hope for our capitalist world yet.