Listed vs. OTC: Why the NYSE is not the Problem

At the heart of the 2008 crash were a number of opaque, complex products with three-letter acronyms: MBS, CDO, and CDS. These products that have devastated our economy all have one very important thing in common: they were all traded over-the-counter (OTC).

One defines an OTC product by what it is not: if it is not traded on any financial exchange, it’s an OTC product. Since it is not traded on a public exchange, an OTC product is nothing more than a handshake between two people and a legal document outlining the terms of the trade.

You can think of an OTC trade as a bespoke suit. Instead of going to a department store and buying something off the rack, in a set size that may not fit you, you visit a tailor, who makes a custom suit tailored just to you. Because it’s tailor-made, you’re going to have to pay more for it.

But the bespoke aspect of OTC trades is only one reason Wall Street’s large institutional clients found them appealing. The other appeal of OTC trades is that no one, except the person on the other side of the trade, knows it’s happening. That’s appealing because when you trade on an exchange, the trade’s volume is made public. If you want to trade 10 million shares of Apple, and you start selling, everyone else watching the market may say, “Whoa, someone just sold one million shares of Apple stock in the last few minutes. What do they know that I don’t know? I better sell, too.” And then everyone piles on and starts selling too, and before you’ve finished selling what you want to sell, the price has plummeted. Now you’re stuck selling at a much lower price than when you began selling.

Wall Street loves OTC trades because anything custom-tailored costs a pretty penny more than a boring old listed product anyone could get off an exchange. But there were two things far more dangerous about these OTC products than the fact that they have allowed Wall Street to price gouge their clients. What is was most dangerous about OTC products are the following:

1. There is no way of knowing how many OTC products are out there.
2. These products are largely unregulated

Why are OTC products largely unregulated? In 2000, after heavy lobbying by the finance industry and by Enron, Congress passed the Commodity Futures Modernization Act. This act deregulated Over-the-Counter derivatives. It didn’t happen without a fight. Under the leadership of Brooksley Born, the Commodity Futures Trading Commission, which oversees derivatives trading, requested that there be “functional regulation” of this Over-the-Counter derivatives market. Their request was denied. The CFMA was introduced to Congress on the last day before the 2000 Christmas recess. It was not debated in the House or in the Senate. Worst of all, it contained a specific loophole for Enron that exempted portions of their energy trading from regulation. (To learn more, read Barry Ritholtz’s book Bailout Nation, p.139).

The main argument in favor of the CFMA was that OTC trades happen between sophisticated parties, and thus did not require oversight by the regulators. Unfortunately, we all now know where these sophisticated trades by sophisticated parties took us.

This is all in sharp contrast to the stocks traded on the New York Stock Exchange, or NYSE for short. While a hallowed and important symbol of Wall Street greed historically, the NYSE in recent years has been a fairly benign actor in the crisis. The kind of trading that happens on the NYSE has been regulated since the 1930s, when the Securities Act of 1933 and the Securities Exchange Act of 1934 were passed to regulate the stock market and improve transparency.

The NYSE trades stocks of companies like Whole Foods (WFM). They open at 9:30am and end trading at 4:00pm. Every single minute that trading occurs, you can see the volume of shares that have changed hands. You don’t know who traded, but you know how many and at what price.

The NYSE has a list of companies they trade. There is a certain application process a company must go through to be eligible for trading on the NYSE. Any company that successfully applies is then “listed” on the NYSE. A Listed Product is any product, be it a stock or a derivative, that is listed on an exchange. There are many exchanges other than the NYSE. To name just two, there is the Nasdaq, which trades many tech stocks and smaller companies, and the Chicago Board Options Exchange (CBOE), which trades options.

But what, you might ask, is an exchange? Exchanges are public marketplaces where buyers and sellers come together, and the volume of all trades are made publicly available.

There are other factors that make listed products more transparent than OTC products. They have set expiration dates, and have standardized contracts. Data regarding trading volumes and prices is made public for all listed products. Finally, listed trades all go through clearing houses.

A clearing house ensures that the trades made are actually executed. If I promised to pay the farmer $30,000 for 5,000 bushels of corn on November 2nd, and I didn’t pay, the clearing house would pay the farmer for me. How can the clearing house afford to make that promise? Several ways: they can require that participants post collateral, they can monitor how credit-worthy the participants are, and finally, they charge all members fees that go into guarantee funds for use when needed.

In the world of finance, what happens on the NYSE and on exchanges is considered transparent, simple, and even a bit quaint. The sexy stuff, the profitable stuff, and the extraordinarily dangerous stuff is all OTC. OTC trades that are opaque and custom-tailored are more valuable to Wall Street’s institutional clients, and thus more profitable to Wall Street. Until, of course, they aren’t.

Part of what made the crash so severe was that the warning signs were somewhat shrouded in fog. Because many of the riskiest products were traded over-the-counter, no one realized just how many of these Wall Street was creating and stockpiling. Further, no one realized how reliant on each other some of these companies had become. Goldman Sachs, for example, had a vested interest in AIG not failing because Goldman held thousands of CDS trades with AIG that Goldman wanted to be paid for. Perhaps if the public, or the regulators had known that there were so many outstanding CDOs at the six big banks, someone would have sounded the alarm before everything crashed and burned.

Examples of OTC Products

Mortgage-Backed Security (MBS) – An MBS is a large number of mortgages (e.g. 1000) pooled together and turned into financial products (i.e., securitized). Think of it as taking 1000 mortgages, putting it in a box, and selling that box to someone.

Instead of a commercial bank having to keep all the mortgage loans on their books, it can sell them off via an MBS. The buyer of an MBS receives a rate based on what home-owners are paying to the bank. The risk for the MBS buyer is that either the underlying mortgage will be pre-paid (via refinancing or pre-payment), or that the mortgage will default.

Collateralized Debt Obligation (CDO) – A CDO involved taking hundreds of MBSes and structuring them into tranches. Again, think of a CDO as hundreds of MBS boxes put into an even larger box, and then sold off. Except this box is divided up into sections: the tranches.

The tranches are varying levels of risk, based on the credit-worthiness of the mortgage holder. A tranche full of subprime loans would receive a higher interest rate payment, but has a higher risk of the underlying mortgages defaulting, which would result in the CDO tranche becoming worthless.

Credit Default Swap (CDS) – You can think of a CDS as an insurance policy that protects against the default of a company. If you want protection against the possible default of a company, you could buy a Credit Default Swap on that company. You will pay a quarterly fee for this protection (much as you may pay an insurance company a premium for insurance on your car or apartment).

With real insurance, there are laws preventing someone who doesn’t live in a house from taking out fire insurance on that house, because that creates perverse incentives. Because CDSes are not legally considered insurance, there are no laws against holding CDSes on companies you have no reason to need insurance on. So there is a perverse incentive for a CDS holder to do what they can to make the company they hold a CDS on fail, and fail hard.

What is the CFTC?

The Commodity Futures Trading Commission (CFTC) is an independent government agency tasked with regulating commodity futures and option markets in the United States. The CFTC was created in 1974, by an amendment made to the Commodity Exchange Act.

The CFTC’s mission is to protect market users and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open, competitive, and financially sound markets.

The CFTC and the “Commodity Futures Modernization Act”

In 2000, the Commodity Futures Modernization Act (CFMA) deregulated Over-the-Counter derivatives. These are the products that would eventually be core to the 2008 crash.

The CFTC clarified the law so that most over-the-counter (OTC) derivatives transactions between “sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act of 1936 (CEA) or as “securities” under the federal securities laws. Instead, the major dealers of those products (banks and securities firms) would continue to have their dealings in OTC derivatives supervised by their federal regulators under general “safety and soundness” standards.

The Commodity Futures Trading Commission had opposed deregulation, requesting instead that there be “functional regulation” of this Over-the-Counter derivatives market. Their request was denied by lawmakers with the passage of the CFMA.

Read more:

The CFTC and the Volcker Rule

The CFTC has released their own version of the Volcker Rule, that is nearly-identical to the initial rule that the SEC, Fed, OCC and FDIC jointly prepared. You can find the CFTC’s version of the rule at: The deadline for public comment on the CFTC rule is April 16th, 2012.

Notable CFTC Employees

The current chairman of the CFTC is Gary Gensler.

What was Glass-Steagall?

The Glass-Steagall Act, the official name of which was “The Banking Act of 1933,” forced banks to separate Commercial Banking from Investment Banking. The intent was to “limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. The [law banned] commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage).”

Glass-Steagall was also responsible for adding deposit insurance, creating the FDIC: Federal Deposit Insurance Corporation. In 1934, deposits of up to $2,500 would be guaranteed by the Federal Government, should the bank that was holding deposits fail. These limits were raised over time, and now you are now insured by the FDIC for up to $250,000 invested in a single bank.

Broadening of Glass-Steagall: Separating Banking from Insurance Underwriting

In 1956, Glass-Steagall was broadened by a regulation called The Bank Holding Company Act. This act “further separated financial activities by creating a wall between insurance and banking. Even though banks could, and can still can, sell insurance and insurance products, underwriting insurance was forbidden.”

The Beginning of the End for Glass-Steagall

Even before Glass-Steagall was officially repealed, its rules enforcing the separation of insurance companies, commercial banks and investment banks began to crumble.

Merger: Citigroup, The Largest Corporate Combo Ever

In 1998, Travelers Insurance and Citicorp merged to form the behemoth Citigroup, with $700 billion in assets. The merging of an insurance company and a bank violated the 1956 Bank Holding Company Act. So why was it allowed to proceed?

From the NYTimes in 1998:

Sanford Weill, the Travelers chairman, said he expected the Fed to quickly approve his company’s application to become a bank holding company and added: “I don’t think we have to spin anything off to make this happen.”

Current law, he said, allows at least two and as many as five years for prohibited assets to be divested. “We are hopeful that over that time the legislation will change,” he added.

Deregulation: “The Financial Services Modernization Act of 1999” (The Death of Glass-Steagall)

Glass-Steagall was repealed by the “Financial Services Modernization Act” in 1999, also known as the Gramm-Leach-Bliley Act. This Act allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate. And consolidate they did.

Further Deregulation: “Commodity Futures Modernization Act”

In 2000, the Commodity Futures Modernization Act deregulated Over-the-Counter derivatives. These are the products that would be core to the 2008 crash.

It clarified the law so that most over-the-counter (OTC) derivatives transactions between “sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act of 1936 (CEA) or as “securities” under the federal securities laws. Instead, the major dealers of those products (banks and securities firms) would continue to have their dealings in OTC derivatives supervised by their federal regulators under general “safety and soundness” standards. (see:

The Commodity Futures Trading Commission requested that there be “functional regulation” of this Over-the-Counter derivatives market. Their request was denied by lawmakers.

After this Act, “neither the Securities and Exchange Commission (SEC) nor the Federal Reserve, nor any state insurance regulators had the ability to supervise or regulate the writing of credit default swaps by hedge funds, investment banks or insurance companies.” (Barry Ritholtz, Bailout Nation p. 131)

Even More Deregulation: Five Investment Banks are allowed Unlimited Leverage… by the SEC

In April 2004, five members of the SEC met to discuss a change that was being asked for by the five largest investment banks (Goldman Sachs, Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers). The requested change was to allow them to take on far more debt than was originally allowed under the net capital rule. Hank Paulson, who at the time was the CEO of Goldman Sachs, “led the charge.” The SEC’s members unanimously voted to grant this except to the five largest investment banks.

The old net capital rule had “limited investment bank leverage (defined as the ratio of debt to equity) to 12 to 1.” However, under this new exception, the big investment banks quickly increased their leverage by borrowing more money, leveraging up to 20-1, 30-1 and even as high as 40-1 leverage. This means that they had 40 times more (borrowed) money invested in various financial products than they actually had as equity (easy to sell assets).

These deregulatory forces paved the way for the global financial meltdown of 2008.

What is the SEC?

The Securities and Exchange Commission (SEC) is a federal agency responsible for regulating the securities industry and for enforcing federal securities law. It is meant to protect the public against fraudulent and manipulative practices in the securities markets. While this is a simplification, you can think of them as the group that polices (or is supposed to police) Wall Street.

The SEC was created by the Securities Exchange Act of 1934 to regulate the securities industry. This law was passed in the wake of the 1929 crash, which led to the Great Depression. As Investopedia writes, in the time before the crash, “commercial banks were accused of being too speculative in the pre-Depression era…. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks.“ The spirit of the Exchange Act was to address the abuses of the past.

The authority this Exchange Act gives the SEC includes “the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation’s securities self regulatory organizations (SROs).”  The SEC does not have criminal authority, and primarily enforces its rules through the imposition of fines. It can refer cases to the Department of Justice for criminal investigation.

What are the maximum fines the SEC can charge for violations?

Fines against individuals are capped at $150,000 per violation. Penalties for firms are capped at $725,000 per violation.

At the end of November, SEC Chairman Mary Schapiro requested that these caps be raised to $1 million per violation for individuals, and $10 million per violation for firms, but these requests have not yet been addressed by Congress.

How is the SEC funded?

The SEC is funded each year by Congress.

You might think the SEC could be self-funded, given that “in some years, the agency has taken in almost twice the regulatory fees as Congress has provided it in funding.” But the SEC is not allowed to keep the fees and fines it receives through settlements or through the courts. Instead, any fees in surplus of their expenses go to the Treasury.

What are the laws the SEC enforces?

Read more at:

How many people work at the SEC?

The SEC has approximately 3,500 employees and 11 regional offices in the United States.# For context, the NYPD employs 34,500.

Criticisms of SEC’s Effectiveness

Many argue that the SEC is under-staffed and under-funded, leaving them unable to adequately police the US financial system. Bartlett Naylor of Public Citizen, a consumer rights advocacy group, pointed out back in March 2011 that:

”The SEC also deals with a more basic asymmetry in the cat-and-mouse game against market fraudsters: Veteran staff enforcement attorneys at the SEC may earn $125,000, whereas first-year attorneys at elite private firms begin at $160,000. The lure of such huge compensation adds an additional challenges for the SEC as astronomical paychecks siphon many talented people into the business of perpetuating frauds and fomenting financial crises.”

Prior to Dodd-Frank’s Wall Street reform law, the SEC oversaw some 6,400 public companies.
 The Dodd-Frank Wall Street reform law adds to the SEC’s responsibilities, requiring it to oversee an additional 30,000 institutions.

For additional comparison purposes, here are the total number of employees at just five of the 6,400 U.S. companies the SEC oversees:

New Powers Under Dodd-Frank

Section 922 of the Dodd-Frank Act includes a new whisteblower program, which intends to “reward individuals who act early to expose violations and who provide significant evidence that helps the SEC bring successful cases.”

This whistleblower program includes a bounty:

“The Commission is authorized by Congress to provide monetary awards to eligible individuals who come forward with high-quality original information that leads to a Commission enforcement action in which over $1,000,000 in sanctions is ordered. The range for awards is between 10% and 30% of the money collected.”

Settling vs Going to Court

The SEC has been criticized for routinely settling out of court with the banks that violate securities law. These settlements are often presented to judges for their approval.

Judge Rakoff’s Rejection of the November 2011 SEC/Citigroup Settlement

At the end of November, Judge Jed S. Rakoff of United States District Court in Manhattan threw out a proposed settlement between the SEC and Citigroup for $285 Million.

The settlement was over a case where Citi allegedly bundled up low-grade mortgage-backed securities, sold them off to investors, and then simultaneously shorted (i.e. bet against) the same securities. Citi made $160 million off the deal, and investors lost $700 million.

Settling would have allowed Citigroup to avoid admitting any guilt at all. All the SEC charged them with was “negligence.” The SEC did NOT charge Citigroup with outright fraud. This is despite the SEC having referred to Citigroup in a memo as a recidivist (a habitual criminal). Judge Rakoff states in the ruling: “By the S.E.C.’s own account, Citigroup is a recidivist.”

Settling also would have allowed Citi to avoid going to court, where the case would be argued out in public and put before a jury. Had Citi lost in court, it would have been subject to FAR more in fines than the $285 million that it settled for.

Judge Rakoff threw out the settlement, insisting that the case must go to trial.

As Adam Sorensen noted in Time:

“Monday’s decision could have implications beyond Citibank. Settling out of court with no admission of wrongdoing has frequently been the SEC’s modus operandi in cases like this. If political momentum built in the wake of Rakoff’s ruling and other judges picked up his banner, Wall Street could face a level of scrutiny it has so far avoided.”

Notable SEC Employees

The current chairman of the SEC is Mary Schapiro. She was a Commisioner at the SEC from 1988-1994, and has worked at another regulatory agency, the CFTC, as well as FINRA, which is one of the self-regulatory organizations that oversee the banks. Schaprio worked at FINRA (then named NASD) from 1996-2008.

Schaprio, during her time at FINRA, was an example of a regulator who made nearly as much as a Wall Street execuitve. In her final year at FINRA, “Schapiro earned a regular compensation package of $3.3 million; on departure from FINRA, she received additional lump sum retirement benefit payments that brought her total package in 2008 to $8,985,334 (about the same as Goldman Sachs CEO Lloyd Blankfein made in that year).”

Robert Khuzami is the current Director of Enforcement at the SEC. Prior to working at the SEC, Khuzami worked at Deutsche Bank as the global head of litigation from 2002-2004, and as the General Counsel to the Americas from 2004-2009. His history as General Counsel at Deutsche Bank makes him a controversial figure at the SEC, as Deutsche Bank was a major issuer of CDOs, a type of mortgage derivative central to the 2008 crisis. As noted by the Wall Street Journal, “Deutsche Bank has faced allegations of inadequate disclosure over its creation of CDOs.

Richard Bookstaber is a senior policy advisor at the SEC’s Division of Risk, Strategy, and Financial Innovation. Bookstaber had a long career on Wall Street before joining the SEC, including serving as the head of firm-wide risk management at Salomon Brothers and as the first market risk manager at Morgan Stanley. Bookstaber is the author of Name Your Link

What is the Volcker Rule?

What is popularly referred to as “The Volcker Rule” is actually Section 619 of the Dodd-Frank Act, which was passed in 2010 and aims to regulate Wall Street. Its official title is “Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds.”The Volcker Rule bans proprietary trading (i.e. speculation) and investments in hedge funds at government backstopped banks.

The concern behind the Volcker Rule is that banks have used depositors’ funds from FDIC-insured checking and savings accounts, as well as access to virtually free money from the Federal Reserve, in order to take extremely risky bets in the financial markets.  When these bets fail, they leave bank depositors and the American taxpayer holding the bag.

Similar concerns arose during the Great Depression of the 1930’s, leading to the passage of the Glass-Steagall Act, which required retail banks to be separate from investment banks.  Unfortunately, in the 1990’s, federal regulators and Congress buckled under pressure from the banking lobby and gradually repealed Glass-Steagall.  The final death-knell of Glass-Steagall came in the form of the Gramm-Leach-Bliley Act.  The proposed Volcker Rule attempts to approximate the restrictions of Glass-Steagall. However, there are a large number of exceptions to the rule in the current draft, which we believe has the potential to be abused by the banks.

Why is it called “The Volcker Rule”?

The Volcker Rule is named after Paul Volcker, who served as the Chairman of the Federal Reserve from 1979-1987. Following the financial crisis of 2008, Volcker wrote a three-page memo to President Obama where he argued that to avoid a similar crisis in the future, one approach would be to eliminate proprietary trading at and ownership of hedge funds by the big banks.

Is the Volcker Rule in effect now?

The Volcker Rule is not currently in effect. That is because Section 619 passed the task of writing the actual implementation of this new rule on to the regulators (the SEC, the Federal Reserve, and others). The regulators released their draft in October 2011, and the public has until January 13th, 2012 to submit comments on this draft. All comments become a part of the public record, and can be viewed online. After the comment period, the regulators will create the final rule, taking into account the comments received. The final rule is scheduled to go into effect on July 21st, 2012.

What does the Draft Volcker Rule Say?

The Draft of the Volcker Rule that the SEC and the banking regulators have prepared does ban proprietary trading at banks, and prevents them from owning hedge funds, but it makes many exceptions to these broad bans. Here are just a few:

  • Banks are still allowed to perform underwriting and market-making.
  • They are allowed to have up to a 3% ownership interest in a hedge fund.
  • In the first year of a hedge fund, that 3% limit does not apply.
  • The trading of repurchase agreements (called repos for short) is given a blanket exemption.

These exceptions, in their current form, are so broad that they have the capacity to essentially nullify the Volcker Rule’s main restrictions.