Get Derivatives Out of the Dark

 | Aug 14, 2013 | 3:21 PM EDT
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Will the financial world change because district attorney Preet Bharara has charged a couple of key employees at JPMorgan Chase (JPM) with fraud and a conspiracy to hide losses? I am a huge believer that every single prosecution of financial fraud is a deterrent. Anything that makes potential fraudsters think twice about falsifying numbers is a win for you, me, for everyone. It's terrific that the government is pursuing this kind of activity which, frankly, really isn't any different from a division within a company keeping two sets of books.

Now, it is very easy to suggest that the whole enterprise must be corrupt. It is true that JPMorgan totally screwed up here. Mistakes, misjudgments and terrible decisions were made throughout the organization. I do think, however, that this is important to point out: When JPMorgan found out about the second set of books, it did go to the authorities and said, "Please investigate this issue." A corrupt organization does not do that. The actions of JPMorgan itself and its top executives wasn't criminal. It was just stupid, and you can't prosecute people for stupidity.

Nor can you game fraud. There will always be people who will try to get over on the system in order to hide losses, to make more money, to steal and to conspire, especially when the money's as big as it is in this situation, in which billions and billions are lost. These alleged crooks stole billions in market capitalization from the institution, which was ill-equipped to discover the second set of books and was way too trusting.

Still, this kind of behavior will happen again and again and again. It's human nature, and no prosecution is going to stop human nature. All prosecutions can do, besides punish individuals after the crimes are committed, is to make it so that other potential crooks fear being caught and brought down, too. Anything that puts people behind bars is a for-real preventative. Nobody wants to go to jail, and if you increase the odds that they will, which is what this prosecution does, fewer frauds will be committed. That's a win.

But this case also brings out a systemic problem -- one that it won't solve. The amazing thing about this case is that it shows lots of smart people couldn't even detect that something was wrong, even though billions of dollars were at stake. That's because the market in which these alleged crooks played was and still is totally opaque.

As someone who has traded the kinds of instruments that are involved in this case, I can tell you that there's way too much guesswork about what they are really worth. You could get away with having two sets of books, because nobody really knows what the right and wrong set are. The markets aren't on display anywhere. There are no checks to the markets. It is impossible on a daily basis to even figure out what they are worth. That's why it was so easy to commit this kind of fraud.

That's why I want all derivatives traded publicly, on an exchange, for all to see -- or they shouldn't be traded at all.

The banks all fight my position. They love the opaque nature of these derivatives, because they can charge more for the product and create a market that's very advantageous for the firm, not just for the client -- or sometimes, even, to the exclusion of the client. In other words, you can rip people off in the dark; you can't rip them off in the sunlight.

You want to prevent this kind of individual fraud? Yes, you prosecute. But if you want to correct the systemic problem, you have to shine a light on all of this stuff, posting the bids and offers for all to see. Without that sunlight as a disinfectant, to paraphrase late Supreme Court Justice Louis Brandeis, you can't police this nonsense. The industry should use this sobering lesson to shine some light on derivatives, if not put up huge lanterns on them. Otherwise even the top dogs, as smart as they are, won't even be able to spot criminal enterprises within their own four walls.

You want change? Force firms to post derivatives. You want more crimes? Keep the derivatives in the dark -- and I promise you that, even if the prosecutors get their men, there will be dozens more right behind them, ready to commit the same fraud. Without a spotlight on the market, it's just too easy and too tempting not to do so.

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