Market Mover

by Robert Greifeld

  He wasn’t the only one concerned about the issue. In fact, Cox was also getting pressure from the banks and politicians about it. Both New York Senators, Chuck Schumer and Hillary Clinton, were urging a short-selling ban. At one point, during the crisis, TV personality Jim Cramer went after Cox personally for not reining in short sellers, and then presidential candidate John McCain called for him to be fired. Personally, I found Cox to be hardworking, nonideological, and responsive—all good qualities for running the SEC. But justified or not, he was being held accountable for allowing short sellers, the bogeymen of the moment, to further destabilize markets.

  “Chris, I agree,” I told him, “but as you know better than anyone, the SEC is not an organization known for its adaptive agility. It isn’t designed to move fast on anything.” It was a simple fact. The SEC is required to meticulously follow sunshine laws requiring transparency. You can’t even have more than two Commissioners talking to each other at the same time; otherwise, these laws require a full public hearing of all five Commissioners. The public has to weigh in on new regulations. There is a comment period. It’s an orchestrated process. Indeed, I had come to realize an inconvenient truth—when it comes to government institutions, you can have transparency or you can have speed, but you can’t have both.

  “Dad, are you ready for dinner?” Katie’s voice rang out as she entered my office. My daughter and I had made plans to go out, and she was hungry. Normally, she would have looked irritated and urged me to hurry up and get off the phone, and like most teenagers shown little concern for her father’s business dealings. This time was different, however. As soon as she entered the room, she got very quiet and still. She suddenly looked concerned—for me. I was amazed at how the very atmosphere of the room and the gravity of the moment cut through all of her teenage self-absorption.

  Cox soon explained to me that he had a new plan. “Bob, since the SEC can’t self-propose this, I want Nasdaq and NYSE to join together and do it themselves. That could be approved quickly.”

  Cox’s plan was sound, and that was exactly what we did in the following days. The SEC passed a temporary ban on most short selling, which lasted several weeks, and ended in early October 2008. At the time, it felt good to have done something. But of course banning short selling doesn’t stop selling, or prevent the markets from falling. I’ve come to regard it as a cautionary tale about what can happen when one acts too quickly to fix a perceived problem and in the process interferes with natural market forces. Even at the time, the consensus was largely that the ban did little to help stabilize markets, and a number of careful studies afterward came to the same conclusion. If anything, it might have been counterproductive. Before he departed the SEC later that year, Cox also said that he regretted the decision. “Knowing what we know now,” he said, “I believe on balance the commission would not do it again.”1

  The Perils of Leverage

  “There are only three ways a smart person can go broke. Liquor, ladies, and leverage,” is a saying attributed to legendary investor Charlie Munger.2 There are a lot of smart people on Wall Street, and it’s true that the three Ls have taken down more than a few, but in 2008, one stood out far above the others—leverage. There was no single cause of the crisis; many events came together and conspired to set the system on fire. But the dangers of leverage were at the center of it all, and that stands out to me as a lesson that must be learned if we are to avoid repeat performances.

  Leverage is not all bad, of course. I went deep into debt to acquire some of the assets that were essential to the transformation of Nasdaq, like Instinet. In those days, we were temporarily nine times leveraged. That means, for example, that if our business declined for some reason, it could impair our ability to pay off the debt. We knew that Nasdaq was temporarily in a delicate position, but given the synergies of the deal, we also knew that we could quickly bring it under control. That was a unique circumstance. In general, I was careful to keep our debt well within reasonable limits. I also avoided acquisitions that I felt would have left Nasdaq too highly leveraged, as demonstrated when we walked away from the LSE bid.

  Perhaps my most relevant experience with leverage came as the new owner of OMX, which owned a clearinghouse in the Nordics. This was a business I was familiar with but had never overseen operationally, so I had to get up to speed fast. Any CEO worth his or her paycheck needs to understand any business he or she is overseeing and find the right comfort level in terms of the degree of oversight. It can be surprising how many CEOs, especially in large corporations, don’t truly know important details about their own businesses. So I had to learn the essential components of the clearinghouse business—one of which was managing the margin. In the context of clearing, that means knowing how exposed the positions of your member institutions are and how much capital is needed to account for that risk. We employed a number of high-IQ mathematicians to help us do exactly that.

  Soon after the acquisition, I met with the team managing risk. This was many months before Bear Stearns and Lehman Brothers made everyone rethink our risk models. This team was using sophisticated mathematical profiles to measure correlations among different assets, and the risks entailed in those relationships. So, for example, if a big institutional client had a $100 million portfolio that was cleared with us, we might demand a $7 million margin at the clearinghouse. However, in this meeting, our team was telling me their models showed that declines in certain assets weren’t historically correlated with declines in other assets. Since the model showed the risk profile was reduced in such cases, perhaps we should relax the margin requirements on those types of portfolios containing these noncorrelated assets.

  Thankfully, our team decided not to change our margin requirement based on those calculations. We stayed conservative. I had no idea then how grateful I would be for that decision. In retrospect, it looks prophetic. Now we know that too many such models proved disastrously inaccurate. In a real crisis, everything is correlated. But in those days, I didn’t know the storm that was coming. I decided not to ratchet up our risk, no matter what the smartest guys in the room suggested. A few months later, as we found ourselves closely monitoring our risk levels on a daily basis through the crisis, there were several cases when we were forced to make margin calls on our member firms.

  Here is where one of the most important leadership lessons applies: Don’t fool yourself. It’s a hard lesson to learn. There are always ways to convince yourself of things that don’t deserve your conviction. It’s always possible to talk yourself into a conclusion that owes more to the climate of the moment and the temporary incentives of the day than to any independent assessment of the situation. And leverage is one of those matters about which it’s all too easy to fool yourself, assuming that the future will look like the past.

  But the reality is that the future doesn’t always look like the past. That may sound obvious, but humans always like to interpret their current experience through the lens of what’s come before. Computers (programmed by humans) often do the same. Just because something has not happened doesn’t mean it won’t. We all learned that critical lesson in the financial crisis. Some models seemed rock-solid until the very day they failed completely. Don’t get caught fighting the last battle. Don’t fool yourself.

  “Beware of geeks bearing formulas” is another pearl of wisdom from Warren Buffett, urging investors to be skeptical of history-based models. It’s sound advice, although I might phrase it differently. After all, Nasdaq has built a multibillion-dollar business while relying on many geeks bearing useful formulas and models—likewise with many of our listed firms. But like any sophisticated tool, mathematics can become one more way to fool yourself—like the investment bankers on Wall Street before the financial crisis who somehow convinced themselves that a 30:1 leverage ratio was acceptable. In other words, they were putting up $3.33 in actual capital for every $100 invested, meaning that if their portfolio declined 4 percent or more, they would be insolvent! Yet CEOs armed with
formulas talked themselves into thinking such leverage was manageable. I have made plenty of mistakes in my career, but that was one I never would have made. I could not have slept soundly with that kind of risk hanging over my head.

  In an era in which the investment banks were still organized as partnerships and not as public corporations, I find it hard to imagine that such high-risk levels would have been employed. The incentives of the partnership—the skin in the game, so to speak—would surely have exerted greater discipline, and that would have mitigated some of the assumed risk. No crisis on the scale of 2008 has one or even two causes; inevitably, it’s a confluence of many events. But leverage, the failure of leadership, and the different organizational structure of Wall Street investment banks each played a significant role.

  What about the SEC? How much blame should they get? Regulatory failure also contributed to the crisis, and the SEC was obviously ground zero of that issue. But rather than point the finger at one person, or even the five-person committee, or home in on specific events leading up to the crisis, I think it is more instructive to examine the regulatory culture of the SEC.

  Culture may be destiny, as many have pointed out, but in this case, “charter” is also destiny. The SEC’s charter is explicitly focused on investor protection and maintaining fair and orderly markets. The stability and soundness of the institutions it oversees are not front and center. This mandate is right there in the founding charter, and arguably it worked fairly well for most of the century since it was set up—until it failed completely. Institutional inertia is a powerful force. The SEC was making sure everyone followed the rules, obsessing over every little change that Nasdaq and other institutions made to their business models—in the name of investor protection—while world-destroying amounts of leverage and risk were building up under their noses. Looking back, the lack of oversight would be laughable if it wasn’t so consequential. The SEC simply wasn’t designed to look in the right direction.

  During the crisis, the surviving investment banks converted to commercial banks, which gave some regulatory authority to the Federal Reserve, changing the dynamic completely. Nevertheless, the financial crisis signaled that it was time for a major update of our nation’s regulatory structure—which was exactly what happened after the smoke cleared and some stability returned to the markets.

  Dodd-Frank and a Big Bank

  “You f——k! You f——king ass! Who do you think you are? What do you think you’re doing!?”

  The stream of F bombs being hurled at me came as a shock. I had just picked up the phone and was unexpectedly greeted by this tirade before I could even say a couple of words. But it wasn’t just the torrent of invectives that was a surprise. It was the person behind them. It’s not every day you have Jamie Dimon—CEO of JPMorgan Chase and one of the individuals in the business I respect most highly—call up and curse at you like a drunken sailor.

  “Jamie, let me speak,” I broke in after about fifteen seconds. But this only seemed to reenergize his rant.

  “You don’t speak! You listen!” And this was followed by another thirty seconds of shouting and cursing.

  Admittedly, I knew exactly what he was upset about. I could even sympathize with his frustration. It was 2009, and we were in the middle of the discussion around the new legislation package that would come to be known as Dodd-Frank, which promised a full overhaul of our nation’s financial regulatory structure in response to the systemic breakdowns that had occurred. Dimon had just realized that Nasdaq was involved in a campaign to change the way that certain types of trading and clearing would be conducted—a change that would have significant consequences for the big banks.

  A few months earlier, Ed Knight, Nasdaq’s legal counsel, had proposed a series of steps we could take to influence the new regulatory structure that would be put in place postcrisis. Every major institution on Wall Street had a stake in it—though Nasdaq’s stake was less direct than others’.

  The financial crisis highlighted, for me, certain aspects of our model that had proven critical to our resiliency. Equity markets like Nasdaq function using what is sometimes called an “all-to-all” model, meaning that all buyers and sellers come together in an exchange with a central, independent clearinghouse that mutualizes risk. That latter part is key. A clearinghouse legally settles the trades that happen on the exchange. It provides a standard set of rules that governs those transactions. If a retail investor, John Q. Public, puts in a sell order using his retirement account on TD Ameritrade, he may get a confirmation right away, but that does not mean the trade is complete. The trade is not cleared until it is settled at the clearinghouse, and the contract is finalized and the money moves. In a sense, clearinghouses systematize and institutionalize trust. Every institution that is a participant in that market has to put up some collateral to the clearinghouse. In turn, the clearinghouse monitors the creditworthiness of member firms and provides a fund that can cover losses if those losses exceed any one member’s collateral. Today, the function of a clearinghouse in U.S. equity markets is performed by the DTCC (Depository Trust and Clearing Corporation).

  For years, I had been an advocate of open, transparent markets, with competing electronic exchanges and independent clearinghouses. Nasdaq operated that way, and we had pushed regulations that encouraged the evolution of markets in that direction. In the midst of the crisis, the markets that adhered to that model had performed the best, without the hidden risks that had built up in the bilateral, private credit markets. If ever there was a moment when that faith was vindicated, this seemed to be it.

  Bilateral, private markets have a tendency to fail; not because of nefarious behavior, but simply because trust is more delicate in those relationships. Without the firewall of a clearinghouse, they are only as strong as their weakest link, and contagion is more of a danger. The rumor mill has more power. A breakdown in trust can quickly infect the whole system. Indeed, failures of trust can more easily infect whole interconnected webs of bilateral relationships. That’s why many of those over-the-counter (OTC) trading venues ground to a halt in 2008. Clearinghouses provide an institutional firewall and help inoculate against exactly the type of contagion that attacked our system in the crisis.

  Ed’s proposal was that we initiate a grassroots campaign to lobby for the inclusion of our proposed changes in the Dodd-Frank rules that were currently being negotiated in Congress. We invested some money in that lobbying campaign, distributing it to civic-minded organizations that were aligned with our goals. We felt it was for a good cause, and we hoped to have a real influence on policy.

  During that campaign, one of the more memorable meetings we had was a conversation in the West Wing of the White House with Larry Summers, head of the National Economic Council under Obama. It was exciting to set foot in that iconic building, not as a tourist but on official business that would affect the nation. As we launched into our sermon on clearinghouses, Summers, who is one of the smartest individuals I’ve been privileged to know, leaned back in his chair and closed his eyes. My heart sank. Was he concentrating? Was he sleeping? I wasn’t sure, but I knew he had a reputation for working long hours. Perhaps they had caught up to him (a few days later, the press would actually circulate a photo of him sleeping in a meeting with the President). After a few moments, however, his eyes popped open and he exclaimed, “Clearinghouses, I get it! Basically, that’s the reason we invented money.”

  Puzzled by his statement, I thought, He must have been asleep. Then I realized he was right. It was a wonderful leap of logic. Money gives people the confidence to exchange goods and services independent of needing to personally trust each other’s creditworthiness. In the same way, a clearinghouse gives investors confidence to exchange securities independent of having to personally trust and verify the creditworthiness of the counterparty. Money may just be pieces of paper (or numbers in an account), but because we’re all invested in that medium of exchange and it is backed by the full faith of the federal government,
it becomes a way to clear hundreds of billions of transactions every day. A clearinghouse performs the same critical function in trading securities, as Summers quickly grasped during our conversation. No one else we’d spoken to had made this unique connection. It’s always interesting to see a great mind at work.

  In due course, on December 11, 2009, a bill passed the House of Representatives that would mandate the use of independent clearinghouses in many over-the-counter derivatives and take those functions out of the hands of the banks.

  When it passed the House, the banks woke up. Suddenly, they realized that there was a possibility they might lose the clearing and trading function in certain derivative markets given the proposed regulatory structure. That hit the bottom line directly, as they would potentially lose significant streams of revenue, like the billions of dollars in profit they earned from trading over-the-counter interest rate swaps for large companies and institutions. In 2008, Chase reportedly earned $5 billion in profit on this one business alone! It’s no accident that the internal nickname for the leader of this trading business for JPMorgan Chase was “Matt the Mint.”

  The House bill threatened to lower the boom on this type of trading and clearing and move it out of the private markets controlled by banks like Chase. When it passed, warning bells went off in executive suites all over Manhattan. In a tough banking environment, that revenue stream was critical. They started asking, “Who is pushing this legislation?” All of which led to that irate phone call from Dimon.

  For JPMorgan Chase, the issue was particularly relevant. With one of the biggest balance sheets on Wall Street, they could offer customers a security and certainty that few others could match. They could make trades on derivatives—interest rate swaps, for example—that few others could handle. Bilateral trading venues cleared by specialized, custom-made contracts tend to give an advantage to the person with the biggest balance sheet in the room. In contrast, a mutualized clearinghouse is all about the collective strength of the group, not the individual strength of a particular player. Everyone is treated roughly the same: no sweet deals, no special rates. Everyone puts up collateral. The rules are more transparent and standardized.