Excerpts from THE PAYOFF: WHY WALL STREET ALWAYS WINS, By Jeff Connaughton
In January 2009, Ted Kaufman was sworn in as a U.S. Senator, filling Joe Biden’s seat and saying immediately he wouldn’t run two years later in the special election. Kaufman never had to raise money to become a Senator or to stay there longer. For two years, he fought for average investors. THE PAYOFF: Why Wall Street Always Wins, written by Jeff Connaughton (Kaufman's chief of staff), tells how Kaufman and he took on Wall Street in Washington and had to fight “The Blob.”
The Blob (it’s really called that) refers to the government entities that regulate the finance industry—like the Banking Committee, Treasury Department, and SEC—and the army of Wall Street representatives and lobbyists that continuously surrounds and permeates them. The Blob moves together. Its members are in constant contact by e-mail and phone. They dine, drink, and take vacations together. Not surprisingly, they frequently intermarry.
Indeed, a good way to maximize your family income in DC is to specialize in financial issues and marry someone in The Blob. Ideally, you and your spouse take turns: One of you works for a bank, insurance company, or lobbying firm while the other works for a government entity that regulates, or enacts legislation for, the financial industry. Every few years, you reverse roles: “Sally Striver, staffer on the Senate Banking Committee,” so might read a typical notice in Roll Call, “today announced her departure to work for the Financial Services Roundtable”; inevitably, she’s replaced with someone from the financial industry because, so runs the justification, the committee needs people familiar with the issues. What you and your spouse do all the time is share information. After all, no lobbying restrictions yet promulgated can prevent pillow talk between Blob spouses.
Actually, marrying The Blob isn’t even necessary. A Blob member can simply take his or her non-Blob spouse to Blob parties—convivial gatherings of lobbyists and Wall street emissaries, SEC and Treasury Department officials—to help gather and disseminate intelligence. It’s a weekly, and sometimes nightly, occurrence in Washington. Ted and I quickly learned that, when you take on Wall Street in Washington, you take on The Blob.
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In August 2009, then Senator Kaufman wrote SEC Chairman Mary Schapiro to urge her to study how dramatic changes in our stock markets in only a few years time had led to an explosive growth in computerized trading.
Ted's letter to Chairman Schapiro helped draw the media's attention to dark pools and HFT, which began to receive extensive (and concerned) coverage in the financial press. The letter also transformed Ted from a virtually unknown Senate newcomer into a brightly flashing blip on Wall Street's radar screen. In response, Wall Street scrambled an entire air wing of bankers and lobbyists to buzz Capitol Hill. Soon, squadrons were swooping into our office, anxious to thwart new regulations following the financial crisis and, particularly, to prevent a crackdown on HFT. They were numerous (we typically met with five high-level Wall Street executives at a time) and unanimous. Whether a megabank, broker-dealer, or a hedge fund, they all said they believed that the stock market had never functioned better. "Competition has driven down the costs of trading," said one. "The spread between a stock's asking price and offer price has never been so narrow," said another. "There's always enough liquidity -- even during times of market stress -- to ensure that trades will almost certainly be executed," said a third. The refrain "mom-and-pop investors have never had it so good" was intoned by nearly all of them. As a former lobbyist, I almost had to admire the way they unswervingly stayed on message. And the message was that the status quo was good for everyone and that Ted and I were wasting our time exploring whether market changes might call for statutory and regulatory changes.
It would've been easy, and quite understandable, for us to be convinced by Wall Street's unanimous message. But we'd been educating ourselves about these issues and we were convinced that there were, to use Donald Rumsfeld's locution, too many unknown unknowns for us to stop burrowing for answers and prodding the SEC. Our chief burrower was Josh Goldstein, a twenty-two-year-old college graduate who'd deferred entry to Yale Law School for a year to come work for Ted. Josh is brainy, curious, and tireless. He spent all day, every day, immersing himself in the arcana of HFT, stock market structure, and regulation. He soon became so knowledgeable that his questions in meetings would elicit who-the-hell-is-this-kid looks from Wall Street lobbyists. We also had help from a few industry insiders (who worked with us on the condition that we never mention their names publicly), which suggested there was less unanimity than Wall Street wanted us to believe.
We learned about a range of trading strategies, some of which are beneficial to the average investor, but some of which are predatory and harmful. One HFT strategy is called pinging. It involves attempting to "uncover how much an investor is willing to pay -- or sell for -- by sending out a stream of probing quotes that are swiftly cancelled until they elicit a response. The traders then buy or short the targeted stock ahead of the investor, offering it to them a fraction of a second later for a tidy profit" (the Economist). Another HFT strategy is called quote-stuffing. It involves purposefully sending millions of orders to one trading venue to slow it down imperceptibly so that the trader can take advantage of time and price disparities at other trading venues. There are also momentum strategies (in which traders take a position in a stock and then use HFT to generate market momentum that would benefit their position) and liquidity-detection strategies (in which traders use HFT to front-run -- that is, buy or sell microseconds ahead of -- incoming orders from pension and mutual funds). An SEC staffer stated that in some instances these strategies "could be manipulation" and "would concern us."
The Tabb Group estimated in 2009 that HFT generates $8 billion in profits annually. The question is: How much of this profit is from legitimate practices that benefits all investors, and how much of it is effectively an illicit toll extorted from average investors without their knowledge?
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Our top priority was to get the SEC to identify (or, to use the industry term: tag) high-frequency traders and collect data about their trades. Under current rules, such data weren’t collected. So it’s impossible to track an order as it wends its way—if “wend” can apply to a journey that takes a microsecond—through the electronic trading labyrinth and is executed. In fact, the entire reporting system for the execution of trades is antiquated. The SEC doesn’t even monitor brokers to ensure they execute trades fairly. Oversight in this area has been outsourced to the Financial Industry Regulatory Authority (FINRA), of which Schapiro was the chairman and CEO from 2006 to 2008. A self-regulatory organization for broker-dealers, FINRA has often been criticized for being lax in policing the industry and generous in compensating its executives (Schapiro’s regular compensation for 2008 was $3.5 million).
We met repeatedly with FINRA to learn what, if anything, it was doing to detect manipulation in today’s microsecond trading environment. FINRA admitted to me that its computer programs only allowed it to monitor the market in multi-second increments. They were, in effect, engaged in the hopeless endeavor of using a Brownie camera to capture an image of a bullet train. “Guys,” I said, “there’s an entire multibillion dollar industry of high-frequency traders operating within your margin of error.” As it stood, no one could look for, or detect, stock manipulation at the current high speeds. FINRA didn’t dispute this. For our part, we were determined to prove that a workable monitoring solution was possible. So we threw ourselves into composing another letter to the SEC. Attached was a five-page memorandum that detailed the obsolescence of the current reporting requirements and offered specific suggestions, gleaned from some of the top experts in the field, on how to update them.
Meanwhile, the pushback from Wall Street was intense and multi-pronged. The Blob oozed through the halls of government, seeking, through its glutinous embrace, to immobilize the legislative and regulatory apparatus, thereby preserving the status quo. The executive jets of the Wall Street air force flew sortie after sortie, transporting high-ranking emissaries from new York to Washington to meet with the SEC, [Senator Chris] Dodd and [Senator Richard] Shelby staff, and the staff of other senators on the Banking Committee. Some of the executives, no doubt less enthusiastically, even met with Josh and me. The research companies and market experts Wall Street employs also raised their voices against us. At times it got ugly. Ted was called a crackpot and dangerously uninformed. He was accused of “politicizing” market regulation (a strange notion considering he wasn’t running for election). It seemed as if Wall Street, which wasn’t used to someone on Capitol Hill asking in-depth questions about arcane issues, wished to silence or marginalize its critics. Industry people would always ask me, “What got Kaufman so interested in this stuff?” Used to politicians whose top priorities were to please their home-state business interests and raise money, they had trouble fathoming that Ted was so interested because it was the right thing to do. He believed in fair markets. And because he was genuinely concerned about emerging issues that threatened the stock market, where half of all Americans keep a sizable portion of their retirement savings.
Ted Kaufman Meets With SEC Chairman Schapiro
In October 2009, then Senator Ted Kaufman asked to meet with SEC Chairman Mary Schapiro to discuss how dramatic changes in our stock markets had in only a few years time led to an explosive growth in computerized trading.
When she walked into Ted’s office, my first reaction was that I thought she looked exhausted, which made me feel some sympathy toward her. Ted had been spitting bullets at the SEC for months, but even his manner seemed to soften from meeting her and sensing her fatigue. After they exchanged pleasantries, Ted launched into a brief summation of his views, which he’d been using effectively with his fellow senators:
Just like with derivatives, which blew up and nearly sank the country, we’ve got the same formula with HFT. I call it the Kaufman Formula. Whenever you’ve got a lot of change, a lot of money, no transparency, and therefore no effective regulation—watch out. Because the next thing you could hear is “boom.” There’s been a lot of change. The stock markets have transformed dramatically in only a few years time. There’s a lot of money. The daily market volume by high-frequency traders is now over 60 percent. And they’re making billions of dollars a year. There’s no transparency. The SEC has admitted you’re not collecting any data and you have almost no baseline understanding of HFT. And therefore we have a rapidly expanding market that’s operating completely in the dark, with no effective regulation. I’m very worried that this is a prescription for another disaster.
Schapiro took it all in. She responded by reiterating her pledge, which she’d made publicly in response to Ted’s letter, that the SEC would conduct a comprehensive review of market-structure issues and HFT. She added that she had many other issues on her plate. And indeed she had. America had just been through the biggest financial disaster in sixty years; Bernie Madoff’s Ponzi scheme had gone undetected by the SEC for years despite repeated warnings from whistleblowers; investors were rattled and worried that the SEC was toothless. Nevertheless, it was obvious to me that she only had one choice if history was to judge her well: she had to do something.
Ted must have been thinking the same thing. Near the end of the meeting he told Schapiro, “I don’t believe you’re going to do anything about high-frequency trading.” Looking him straight in the eye, she replied, “You just watch.” We watched for nearly three years. It wasn’t until July 2011 and June 2012 that the SEC approved minimalist rules that would force market participants to collect the data that would enable the SEC to begin—begin—the process of understanding HFT’s impact on markets. In effect, Ted and I and America are still watching and waiting for the SEC to take meaningful action.
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Newton’s first law of motion states that “every object continues in its state of rest, or of uniform motion in a straight line, unless compelled to change that state by external forces acted upon it.” If he’d replaced “object” with “organ of government” he’d have written the first law of organizational inertia. Ted and I knew all about that law, because we felt its immobilizing force every day on Capitol Hill. So we knew how difficult it was for an organization like the SEC to think, and move, in new ways (particularly with the weight of The Blob serving as a constant check against motion). We tried to be a helpful, not hectoring, external force, to prod with useful ideas, not jab with invective. As the Reverend Jesse Jackson might have said: we tried to engage, not enrage.
During his term in office, Ted went to the floor every week to praise a federal employee. One week, he picked an SEC employee, an attorney in the Enforcement Division who’d recently won an insider-trading case involving U.S. Treasury bonds. The speech was an opportunity to reassure SEC employees that one of their toughest critics was nonetheless sympathetic to their situation. “As the SEC embarks on its next chapter, I want all of its employees to know when they walk out of that lobby each day and see the Capitol Dome, they should feel confident that those of us who work under it are their partners. . . . The era of looking the other way is now behind us. The time has come to look forward.” It was, in keeping with Ted’s character, a noble sentiment and heartfelt (as trite and corny as they may sound, I believe those modifiers aptly capture Ted’s intent).
On the other hand, we were well aware of the three main impediments to the SEC taking meaningful action. First, nearly all the data, evidence, and analysis the SEC uses to monitor the financial industry come from the industry itself, creating a temptation for the industry to spin the data in its favor (as we’d seen with the naked-short-selling data provided by Goldman Sachs). Second, The Blob oozes endlessly in and out of the revolving door of public service. According to the Project on Government Oversight, 219 former SEC staff members filed 789 “post employment statements indicating their intent to represent an outside client before the commission” between 2006 and 2010. In other words, 219 former government officials were representing Wall street clients on matters before the SEC. Third, because the SEC has been so slow to start collecting data about HFT, it’s still years away from being able to propose HFT regulatory rules that it can empirically justify based on hard data (as the federal courts will require it to do).
Attached to our final letter to Chairman Schapiro, dated August 5, 2010, were eight pages of proposals for addressing the above-mentioned (and other) shortcomings: the need to bring light to dark pools, to eliminate conflicts of interest, to ensure that regulators have the data they need to prevent manipulation and accurately assess whether small investors are being ripped off. The letter pointed out that how the SEC responds to our proposals is “a test of whether [it] is just a ‘regulator by consensus,’ which only moves forward when it finds solutions favored by large constituencies on Wall Street, or if it indeed exists to serve a broader mission.”
As part of our effort to engage, not enrage, we didn’t drop the letter through the SEC’s transom like a hand grenade and run away. Prior to August 5, I met with the director of the SEC’s Division of Trading and Markets and provided him and his deputy with an hour-long briefing on everything we’d learned and what the letter would propose. As a joke and gesture of good will, I’d taken along a Senate calendar with the prior days X’d off and a big red circle around Ted’s last day in office to indicate that we suspected they were counting the days. Ted had signed it and added “keep up the good work!” After I finished my presentation, one of the director’s responses was, “Wow, it’s great to hear from someone who isn’t from the industry.” When I got back to my office, I called a friend who’d been a top staffer for former SEC Chairman Bill Donaldson, and he told me, “Jeff, it’s true. The only people who walk through the SEC’s door are Wall Street people bitching about SEC proposals."
To read more and buy the book, visit jeffconnaughton.com