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Q&A with Georgetown Finance Professor James Angel

Georgetown finance professor James Angel explains how the financial world has evolved over the past two years, touching on everything from the explosion of displayed liquidity to why thirst for risky speculative practices remains unquenched.

The global financial crisis of 2008 was a cataclysmic event that wiped out billions in retirement savings, left millions jobless and led to the biggest restructuring of the regulations governing Wall Street since the Great Depression. And, according to Georgetown finance professor James Angel, the market crash also led to deleveraging at the last two large investment banks left standing: Goldman Sachs and Morgan Stanley. In an exclusive interview with Advanced Trading associate editor Justin Grant, Angel explains how the financial world has evolved over the past two years, touching on everything from the explosion of displayed liquidity to why thirst for risky speculative practices remains unquenched.

What are some of the biggest changes in how business is done on Wall Street following the collapse of Lehman Brothers?

Angel: Well, the biggest change is that the old classification of investment banks has disappeared. And their leverage has decreased. I think the biggest real change that we've seen is the decrease in leverage. And this is a good thing because leverage is what puts risk into the financial system. And leverage is always a two-edged sword: When you're making money, leverage amplifies your profit. But when you're losing money, leverage amplifies your losses as well.

And we discovered after the fact there was way too much leverage in the system, both at the investment banks and in many of the hedge funds. So I think the deleveraging is the biggest change the industry is going through right now.

The other big change is that the regulatory landscape is changing. … Unfortunately we haven't had fundamental reform. One of the biggest problems of our regulatory structure is not too much or too little regulation, but too many different agencies. We literally have hundreds of regulatory agencies at the federal level. And yet nothing's really been done to rationalize the regulatory regime.

There's an old saying that insanity is doing the same thing over and over again and expecting different results. Well, if we continue to have the same regulatory structure, we're going to continue to have a system in which the regulators miss very important details.

What really has struck me is not how much has changed, but how little has changed. The software in our brains has not been reprogrammed. People's desire to get rich quick, people's thirst for speculation - those don't go away. And we actually have a generation that got burned and now is a little bit more careful. But it's amazing how quickly people forget. And they will be back to the same old games fairly soon.

Derivatives were seen as one of the root causes of the crisis. Will the effort to move them onto exchanges and have them cleared by central clearing parties (CCPs) be an effective enough measure?

Angel: I think derivatives really had a bit part in the whole drama. Their only blame stems from the fact that they amplified the exposure to subprime-backed securities. So when people look at the total number of subprime mortgages they didn't realize the exposure was that much higher.

That being said, one of the things we learned when Lehman went down was just how messy the clearing of derivatives was. And I think the move to push the generic product onto clearinghouses is a good thing. I think that's one of the reforms that probably would have happened sooner or later, but the crisis basically forced us to speed that up.

However, it's not as simple as it sounds. It's one thing to say, "Let's put it in the clearinghouse" - to protect the clearinghouse, you have to have margin. And when you do that, you end up adding risk to the user of that product. Let's suppose you're a corporation and you enter into an interest rate swap to turn your credit rate exposure into a fixed rate exposure. So now you've gotten rid of your interest rate risk, or so you think.

You've done a swap - now, if you put that swap onto a clearinghouse, they're going to require margin. So now you have margin risk in place of interest rate risk.

So there goes the utility of your swap. So it sounds great from the politician's point of view: "Let's just put everything in a clearinghouse." But then you have to ask yourself, what is this doing for the usability of this product?

Is there a danger in concentrating risk within CCPs?

Angel: And that's one of the issues. We've had a pretty good track record with CCPs because people know that the people running the clearinghouses realize that for them to be useful they need to be bulletproof.

As for plain, generic products, it's easy to make it bulletproof because you get two levels of protection, actually three levels: You've got the margins the customers put up; you've got the clearing broker, who is backing the customer; and then you have the guaranteed support by other members of the clearinghouse. So as long as the margins are done right, that's a bulletproof arrangement.

However, in an extreme dislocation, you can theoretically cross the clearinghouse. It's one thing if you've got generic commodities that are traditional. But if you have a number of custom products that are not commoditized financial instruments, then you have a real issue as to how you are going to set the margin on a product when you don't even know the price for that product. That's the issue with putting everything onto a central clearinghouse.

It's one thing when they have a financial product that is regularly traded and where you can get good pricing. But for a complex custom product where the price may not be very visible, or people may disagree on the price, you can run into a lot of issues as to what margins need to be set up. And indeed, this is one of the issues when AIG was going down - there were big disputes between AIG and its counterparties about how much margin needed to be put up for those instruments.

It's one thing for commoditized financial products where everyone knows what the price is and if a party goes bad you can liquidate the position easily. However, if it was a custom product where you may not agree on what the price is, and if one party goes bad, how do you liquidate their position? That's not easy to do from a CCP.

Why has high-frequency trading grown in prominence since September 2008?

Angel: It's the evolution of the technology as computers get better, as the exchanges get faster and as more people have discovered that using computers is a lot more efficient for trading than using people. So what we've seen is, if you look at the equities markets after 2008, the amount of displayed liquidity in our market has just exploded, and that is really good for the market, good for consumers, good for the institutions. …

There's a long tradition of "blame the intermediaries" for all your problems. And if you talked to buy-side traders 20 years ago they'd be mumbling about the specialists and how they were ripping them off, or the Nasdaq market makers. But now those market makers have been replaced by computers for the most part. The bid/ask spread has fallen from eighths and quarters all the way down to pennies.

The amount of displayed liquidity is skyrocketing, and the execution time is vanishing. So by all measurable means, our markets are a lot better than they were before. Now it doesn't mean they're perfect; it doesn't mean you won't have occasional disruptions that overwhelm the market mechanism. We saw that in the crash of '62, we saw that in the crash of '87 and we saw it in the Flash Crash where the volume of activity goes but the market mechanisms start to jam. As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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