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The Trouble With Transparency
By Paul Nathan

Everyone is for transparency. I am for transparency. How can we not be. But as they say sometimes too much of a good thing can be bad for you. Transparency is fine until it crosses the line of privacy and violates certain personal liberties.

For example, it is said that certain parts of the derivatives market is "dark". It is hidden from view and should be brought "into the light of day" so we can all know exactly what we are dealing with. There are about 600 trillion dollars in derivatives around the world. Would someone explain to me how you make 600 trillion dollars of differing securities products in every corner of the world transparent? Who would inspect them and how? The only way I know how to do that is for the individual buyers of such products to do the due diligence required to know what they are buying. In other words,"buyer beware".

There is nothing wrong with derivatives in and of themselves. They are simply products that take positions long and short and attempt to hedge against risk. Some insure against failure like credit default swaps, CDS's and others package a variety of different mortgages from various regions to spread investment risk like collateralized debt obligations, CDO's. Nothing wrong with that -- unless the content, the collateral, is fraudulent. There are lots of different custom derivatives that are created to fill the need to handle risk. Most are perfectly legitimate. The derivative market, in fact, is one of the few markets that survived and grew during the credit meltdown.

It is argued that if derivatives were required to trade on exchanges, settle and clear, that would provide transparency and therefore prevent fraud and lead to greater stability of the financial system. If that were true, how do you explain the dot com stocks which were both transparent and regulated and traded on exchanges daily, yet melted down to virtually no value what-so-ever. Enron and WorldCom and their securities (which are derivatives) were as transparent and regulated as any company could be. Yet, they went the same way as Lehman Bros. and Bernie Madoff.

So, why should derivatives be any different if they are traded? It is fraud that is the problem and needs to be controlled, not markets. You have to wonder why trading something makes it transparent. CDO's, traded to the extent they were packaged sold and bought, but nobody knew or cared what was in them. Dot com stocks selling at 100 times hoped-for earnings, and tulip bulbs trading for the price of houses, were all transparent. It takes a buyer with open eyes that cares about value, content, and is rational and competent to prevent fraud or "irrational exuberance". The buyer is always the first line of defense. Regulation and transparency will not guarantee that a meltdown of markets "will never occur again", as claimed. It never has.

To further complicate things, while some derivatives such as exchange traded funds, ETF's, are public and must disclose exactly what they contain, others like credit default swaps, CDS's, are privatecontracts written between a buyer and seller to insure against loss. They are custom derivatives that insure against specific risks and are developed between the buyer and provider that structure the contracts. There are many different kinds of private and custom derivatives the vast majority were as represented, but some were fraudulent --- which leads us to the question, does the government have the right, "in the public interest", to disclose the existence and contents of private contracts? The answer should be "yes', if they can prove fraudulent activities, and "no", if they can not.

For example, Swiss bank accounts that were sacrosanct and protected for centuries have been recently opened to government scrutiny. Does the government really have the right to expose individual private accounts to "the light of day"? Are these "dark" areas of the market really the business of government? In the name of preventing fraud, government has decided the individual, whether innocent or guilty, must at times yield his right of privacy to the "greater good" to provide transparency and protect the system.

Consider: we know there is a difference between public stock in a company and private stock issued to private parties. While the public stock trades on exchanges and is completely transparent, private shares in private companies issued to private citizens are not and have no reason to expose their personal business to the government or the public at large. And they don't. Would mandating that all derivatives trade on exchanges force private companies to go public? Would these "dark" areas be "exposed to the light of day?" Would transparency lead to public scrutiny of any and all private transactions?

Further, does the government have the right to know how much cash you hold at any one time? How many gold coins you own? How much in collectibles? How often you trade them? What contracts you have made with others and the exact details? After all, we want transparency, don't we? This knowledge could help the government prevent fraud. If government can open up Swiss accounts to search for criminal activities, why not all accounts? Does anyone detect a slippery slope, here?

If it is now law (with the urging and cooperation of the United States) in Switzerland to inspect private accounts, how far fetched is it to expect strict regulation of the buying, selling, and storing of gold and other commodities? After all, there are a lot of fly-by-night gold companies that have sprung up lately that might be taking advantage of unsuspecting clients and might "need regulating". Most of them I would never do business with. But then, I do my due diligence. Where though, should government intervention end?

The new catch phrase that really worries me is that we should outlaw certain transactions that have "no redeeming social value." By that standard we should ban the act of burying gold in the backyard? After all, individuals holding gold contribute nothing to society. They are only interested in their "self-interest".

The bill on financial reform will probably be voted on and passed soon with a bi-partisan majority. What's in it? What is it's position on derivatives? Where will transparency start and end? What will be regulated and to what degree? I'm afraid we will, once again, be subject to the "Polosi rule": We won't know until we pass it. I am for financial reform. And I am for regulations that provide standards and rules of the road. But government regulation has the power to control individuals and in doing so can damage markets, the economy, and the financial system rather than helping them. No one has to make the case that bad or over-regulation hurts business let alone has the power to violate individual liberty. History is full of the evidence of this fact. So the exact wording of the final bill, which is still being debated, becomes crucial.

The proper function of government is to protect individuals against force and fraud. But does that mean the government can force an individual to provide private information for the "good of the country"? In pursuing financial reform, we need to protect such things as individual rights and property rights lest we end up trading freedom for security. In such trades, a nation usually ends up with neither. I'm for transparency. But the goal of transparency must end at the doorstep of a free people. Transparency and regulations should never violate individual rights.

We must not allow catch phrases such as "regulation" and "transparency" to cross or blur the lines of proper government power. Power is a dangerous thing and needs to be thoroughly monitored at all times. The government needs to have the power to protect us but not the power to control us. A free people need the right to take actions and the freedom of choice to explore, innovate, produce, and exchange with one another. The job of government is to create an environment where all actions are possible yet prevent and prosecute the initiation of force and fraud wherever and whenever it can.

As of this writing there is no wording in the reform bill defining how regulating derivatives would be accomplished and to what extent. The Dodd bill is 1300 pages, which tends to hide rather than reveal, and must be voted on after amendments and compromises are made. Democrats and Republicans have not been able to resolve the exact wording. Why not? It is an important enough issue that President Obama said last week he'd veto any reform bill that did not include derivatives regulation. Why? Why place so great an emphasis on this one point? And why not spell out what's in the bill and allow ample time for debate? Are we going to be given 72 hours to study the bill before it comes up for a final vote as was the case with the health bill? What's the big hurry? President Obama has appointed a commission to study and report on the causes of the financial and credit crisis and report its findings in November. Why call for a vote now, before the report is completed?

My worry is that, at the last minute, wording might be snuck in and voted on that would be much more intrusive than anyone expects. This could open the door to aggressive control and regulation of the private market. It could allow the governments to force individuals to disclose personal property and transactions. I hope not. Standardizing trading in derivatives by making them subject to settlement and clearing like other similar trading vehicles is, according to Obama essential. In fact it has been occurring more and more voluntarily on exchanges because it's in the interest of both buyers and traders of derivative products to have transparency. But if it amounts to a mandate requiring non-publicly traded derivatives to become subject to government scrutiny, this opens up the constitutionality of what would become the legal invasion of privacy by government. This kind of transparency we don't need.

The use of the term "transparency" is like the use of the term "force". I am for the use of force by the government through armies and the police to defend individuals and their property against the initiation of force and fraud by others. This is a proper function of government together with establishing courts to settle disputes and prosecute crimes. For the government itself to use force against its citizens violates all that a free society is supposed to be. Force in defense is a good thing. However, the initiation of force by government, when used against individuals who have done nothing wrong, is intolerable.

I am for regulations that protect life and property. I am against regulations that attempt to control peaceful human behavior. And I am for transparency as long as it does not violate the rights of individuals. I am against any attempt at using transparency to pry into the private affairs of others unless their use of force or fraud can be demonstrated. I do not consider looking into someone's safety deposit box, an act of transparency.

Having said all this, from what I can see so far, the Dodd bill on financial reform looks pretty good. Unfortunately it is not yet completely?transparent. It addresses several issues like how to break up failing institutions in an orderly way; how to prevent institutions that are "too big to fail"; the function of a bank of last resort to prevent structural damage. It raises capital requirements which, without that one provision -which will reduce leverage - would render anything else done with regard to regulation unimportant. And it puts teeth into laws that already exist that proclaim to be against fraud but have been impotent. It is ultimately the prevention of crime that we all seek. However, it also potentially imposes 27 new regulations on banks and small businesses which are of debatable use. And it could strip derivative trading from banks altogether. We will not know the full contents of the bill until it is finalized. Hopefully, the governments' bill will be as transparent as it demands the private sector to be.

No government and no society will ever totally prevent crime, but all should try to prosecute crime if and when it occurs. That's what laws are for. Regulations are fine when they are consistent with freedom and the protection of rights. But if and when they become a power grab by government to control and regulate individuals who have done nothing wrong, it is then that we must draw the line. We are searching for that line today. Let's hope we have the wisdom to know it when we see it.

 



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