I've often compared the stock market to the Wild Wild West - you had a sheriff in some of these western towns, but many times outnumbered or on the take himself. You have to fend for yourself and not count on any regulatory body to help you - both then and now in the stock market. Put another way, the foxes guard the hen house. If our regulatory bodies were not politically captured (which it appears clear they have been) by those they regulate (ahem), they'd still have to deal with the issue that we have a bunch of lawyer types chasing against the most highly compensated, mathematically and scientifically talented folk in the world. It would be like putting a junior law firm up to monitor the team from the Manhattan Project. Sure they can sit and make sure the i's are dotted and t's crossed but would they have any clue about the science? And that's not a rip on attorneys - it is simply a complete mismatch of skill sets.

Harry Markopolos, who tried to hand over Bernie Madoff to the SEC multiple times said as much in his 60 Minutes piece [Mar 1, 2009: 60 Minutes - Harry Markopolos - The Man who Figured Out Bernie Madoff]... basically the SEC is layered with attorney or administrative types. As any good political body should be. In fact the SEC should be loaded to the gills with former insiders of the financial world (takes one to know one theory), and some of the most talented statisticians. But with the pay differential between the 2 worlds, other than from good heartedness I could not see a regulatory body attracting that level of talent.

I am not even making the claim that most of what goes on is illegal... I am sure just as in corporate American accounting and high income tax evasion... err tax planning.... the LETTER of the laws are followed, while the SPIRIT of the laws are trashed. Having people self regulate and/or follow the SPIRIT of the law is something that only works in some idealistic setting (perhaps Wonderland) or in an academic textbook. It only works in the real world when both the buyer and seller are equally financially sophisticated... that's not our reality.

I'll use the example I proposed a few weeks ago - effectively what is going on in increasingly technology laden financial markets is parallel to doping in sports. Whatever the regulator is figuring out now, was created 4-5-6 years ago and already served its purposes. By the time said regulator figures it out, and fixes it (if they can work around the lobbying interest that is) the athlete / financier is most likely 2 generations forward onto the next innovation. There is so much money involved in both (sports, high finance) and such tawdry penalties in most cases that it pays to cheat (worst case) or press the envelope and smash the spirit of the law (best case). That's if you are one of the slow antelopes who is so behind the times as to get caught. I'm sure some of what is going on, will simply be lost in the dark pools and never figured out.

I realize that is a cynical view but simply think about what you see and read about these markets everyday, and assume that is just the part of the iceberg you can see. We can only imagine what goes on that never is recognized. Or best case will be stumbled upon 5 years after the fact. My belief is the predominance of technology and the lack of sophistication watching over it, will create another Black Swan even for the stock market sometime in the coming decade. I think August 2007 when all the quant funds went into a tizzy at the same time was just a minor preview of what could happen in 2013 or 15 or 17 when so much more of the market will be programmed. And we'll ask again how could we miss this? The answer is quite clear - the same ways we constantly miss everything; the actors at the center of the drama control the (purse) strings. Those who watch over them have become national hood ornaments.

p.s. one request for the SEC; could you put a team of lawyers in charge doing just 1 thing. When a massive amount of puts are bought just ahead of bad news, or a massive amount of calls ahead of a buyout - could you have SOMEONE ask a few questions. Thank you for your service.

The Wall Street Journal has a pretty good article on the challenges the SEC faces.

  • The Securities and Exchange Commission says it is taking a close look at flash quotes, high-frequency trading and other dark corners of the stock markets. But by many accounts, the agency is outmatched by the traders and market venues with technology that is remaking the trading world.
  • The agency lacks its own traders with knowledge about cutting-edge strategies and how the markets operate. (now that's encouraging)
  • It long ago ceded the daily surveillance of trading to self-regulatory organizations, like NYSE Regulation and the Financial Industry Regulatory Authority.

  • And it takes a lawyerly approach to regulation and rule making that rarely employs deep analyses of real trading data.

Should I even bother going further? I mean that alone should make you realize what David is up against versus financial Goliath. And Goliath has friends all over D.C. to make sure David never really upgrades his sling. But it is convenient to keep David around to assure the 401k contributors and Main Street = Wall Street crowd that someone is watching their back.

  • Jonathan Katz, who left the SEC in 2006 after 20 years as secretary, says the complexity of modern markets poses a stern test for the agency. You need the quantitative, analytical capacity that the agency has never had, Mr. Katz says.
  • You need to start looking at these issues not only as legal compliance issues, but you need to look at them also as questions of national economic policy: How do the markets truly function?

Well at least they admit they are David.

  • In recent statements, commission officials have admitted they lack the tools to do the same kind of data-intensive surveillance as the self regulators.

On the docket...

  • The SEC is expected as soon as next month to issue a rule-making proposal on flash orders, which give equities and options traders on some exchanges an early look at orders before they are routed to other markets. Critics say flash trading can hurt market transparency and can give a leg up to certain traders.
  • The staff also is considering rules to root out unfair advantages to traders in dark pools, automated trading venues in which orders are matched without displaying all quotes publicly.

Now once a rule is proposed it goes to public comment, just like the accounting governing body (FASB). It's at this time the lobbyists for said firms can see the rules, and work on Congress to water them down. Err, I'm sorry - I meant to say this is when the public can comment on the rules and offer helpful suggestions to make the rules work even better.

  • In proposing the rule, the SEC is expected to solicit comments and meet with proponents and opponents of flash orders and dark pools. But the agency hasn't collected market data that would allow it to follow a trail of flash quotes and analyze their true impact on share prices and trade executions, according to people familiar with the agency's progress.
  • Although the SEC receives many filings of different sorts, it does very little to collect significant data, analyze it, and then disseminate it to other government agencies and the marketplace, said Harvey Pitt, a former SEC chairman, in an email to The Wall Street Journal.

A walk through memory lane shall we?

  • The agency toyed with its own surveillance in 1980 when it deployed the Market Oversight Surveillance System, a computer program that plugged the SEC into mounds of trading data being generated by newly electronic markets.

Sounds great!

  • The exchanges, which had policed themselves, complained bitterly that MOSS usurped their authority, according to media accounts.

Ah, self regulation - foxes and hen houses. Seems to work wonders. Even better when the hen house implodes, and then the taxpayer builds a new one, and says to the fox all yours... again. Foxes have a great life. If you are a self regulation is best type, and I am sure some readers are - I'll meet you half way. The next time the hen house implodes through foxes greed, and the foxes run to government asking for help, say to the foxes: die. Even if it means pain for the everyone else - because only THEN will everyone else care about what the foxes are doing. Let the system cleanse itself - that would let the next generation of foxes know that there is not an implicit backstop to their hen feasting. And then the future foxes might actually give a damn about self regulating - rather than lip service combined with superficial actions. But since, dear self regulation preferred reader, we know in the United States of Financial Oligarchy there will never be a time the connected are allowed to fail, that example of let the fox die is simply an idealistic wish. But I digress.

  • The SEC ultimately extracted promises that the exchanges would beef up their ability to police trades across markets and discontinued its own surveillance system in fiscal year 1985, according to SEC documents.
  • Today the SEC still requires the exchanges to conduct their own market surveillance

That investment to fight off the SEC in the early 80s has had a long tail of benefits... a good 25 years of fox domination.So where are we at today? Ah, about the same... if the SEC presses TOO hard, the exchanges tend to get upset and withhold information. Yes you heard me - the regulator can't even get information from those they are trying to regulate ... which calls into the question why they are titled a regulator. It is laughable on the surface but really in a country where we run a bank stress test that the banks themselves can negotiate guidelines, [May 9, 2009: WSJ - Banks Won Concessions on Stress Tests] are we really surprised?

  • ....changes don't do much to assuage critics who think the SEC leads first with enforcement and then with analysis.
  • Industry representatives and former SEC officials say the conflict has at times chilled frank conversations between firms and the regulator, inhibiting the SEC's ability to obtain real-time information.

If it's anything like post Enron, Worldcom - we'll have some mild changes done... everyone will be assured we fixed everything and change is here. Then as we lose interest the lobbyists get to work over the ensuing years pulling thread after thread out of the patch, and 4-5 years out all the threads are unraveled. It's the exact same pattern across the entire political & regulatory system: captured... money talks. Just like any good banana republic.