Putting the Walls Back on Wall Street

As the story behind the great financial meltdown unfolds, we can also see evidence of deep changes in the culture and practice of Wall Street firms. Greater risks were routinely taken in the pursuit of what had become expected huge returns. Firms drastically increased their trading for their own accounts, often using their regular customers as counter-parties to take the other side of a big trade.

Inevitably, this high rolling broke down some of  the written and unwritten rules of Wall Street that has been widely recognized and respected.  One of them was a sharp separation between proprietary trading and the buying and selling done for customer accounts.  The proverbial Chinese Wall between those two activities was meant to ensure that a firm’s proprietary traders didn’t take advantage of its customers, either by knowing their positions when they might be caught short or when they were about to make large purchases that would move the market. There are a host of such activities from which conflicts of interest could all too easily emerge.

Now, surveying the wreckage left behind by the meltdown from 2007 to 2009, it appears that, as proprietary trading expanded, those rules softened and the Walls became permeable. To understand why this might happen, one has to consider about how power is accumulated within an investment banking firm. Think of dollars earned as votes; he who accumulates the big bucks gets a big say in how the firm is run. Although that’s an imprecise way of describing how people rise in an investment bank, it captures the basic fact that you become influential by making a lot of money. And the way people made a lot of money during the boom years was trading for proprietary accounts. The profits from those activities were so large, particularly relative to the staffing and resources committed, that it seems that they swamped the influence of other, more customer-oriented components of the firm. It’s odd that in the avalanche of news articles, hearings and other dissections of what went on during the period leading up to the great crash, there’s very little discussion of whether information was properly segregated so that proprietary traders had no knowledge or special advantage over customers.

One didn’t need to have official rules by the government to create and maintain these walls in the first place; the assumption was that market forces would support them.  In other words, customers would not deal with a firm that would take advantage of inside knowledge provided by the customer.  But as these banks became bigger and more important than their customers, that foundation for sustaining the walls crumbled.

In any event, the erosion of barriers between proprietary and customer trading needs a good deal more scrutiny than it seems to have received so far. It may even be that a government rule is needed to ensure that fences, or walls in this case, make good neighbors. 

Wall Street is nothing if not innovative and for good reason: new products almost always have the largest profit margins. Continuing to stay ahead of the curve on developing such instruments can assure a steady stream of bonuses and successes for a firm that is creative and well run.  In fact, when anything turns into a “commodity,” in which one firm’s product is indistinguishable from another’s, the margins inevitably come down, as they should. The best and the brightest then go looking off in new directions to create another novel financial instrument that will support a hefty margin, at least until the other firms on the Street catch up.