Regulatory Arbitrage

Published: Thu 27 April 2023
Updated: Mon 01 May 2023
By steve

In Markets.

Thursday 27, April 2023

Matt Levine talks about his own job

Matt Levine is not a person. He is like Zero Hedge’s Tyler Durden: a whole team of individuals who are chained to their computers churning out insightful articles ever day of the year (nearly).

Anyway, ‘he’ wrote the following:

I used to be a corporate equity derivatives investment banker, which means that I’d go to companies and try to convince them to buy or sell options on their own stock. If you read a finance textbook, you will get the impression that derivatives are mostly about risk management, about hedging and speculation: People who own stock buy put options to protect themselves agains price declines, or sell call options to transform some of their potential upside into cash now; people who don’t own stock buy calls to take some cheap stock-price risk, etc.

This describes almost none of what I was selling to these companies. What I was selling, much of the time, was tax deductions: We could build you a derivative that, sure, had the economic properties of some call options, but that took advantage of technical tax rules to get you extra deductions.[2] Other times I was selling accounting treatment: We could do a thing that had the economic properties of buying back stock, but that took advantage of technical accounting rules to juice your earnings per share a bit more.[3] Or I might be selling something like securities-law compliance: If you had some legal restriction on your ability to buy or sell stock, you could buy a derivative from us that was economically like buying or selling stock, but that avoided those restrictions.[4]

In my line of work, derivatives were essentially about regulatory arbitrage: There were some complicated rules, created by legislators or regulators or accounting standards-setters, and those rules had the effect of rewarding some things and penalizing other things. And our job was to find a way to take something that the rules penalized and turn it into something that the rules rewarded, without changing its economic substance too much.

A famous example. The US tax code discourages short-term trading and encourages long-term investing. If you borrow a lot of money to rapidly trade stocks, you will be penalized, paying short-term capital gains rates. If you buy a long-term call option on a variable basket of stocks that you have management rights over, you will be rewarded, paying long-term capital gains rates. If you notice that those two things are the same, you can have a lucrative career as a derivatives structurer. (And get in trouble: This is the Renaissance Technologies tax trade, and it ended up not working.)

The lesson that I learned from my career as a derivatives structurer is that much of finance is about this sort of regulatory arbitrage. Economic life is socially constructed, society has rules, and you can make use of the rules to make money.

Sometimes the rules change and particular businesses get harder. But there is a sort of conservation law at work; the rules for complex systems have to be somewhat complex, and if you have mastered the current complexities you can probably figure out how to make money off new and different complexities. Tax trades sometimes get shut down by new tax rules, but that doesn’t put tax structurers out of work; they’re the ones who are best positioned to figure out the new tax trades enabled by the new rules.

Sometimes some whole new area of economic life gets brought into the domain of rules, and a new industry springs up to game it. In my lifetime, environmental, social and governance investing went from an academic idea to a huge business with all sorts of competing and economically important regulatory and accounting regimes, and so there are lots of people in the financial industry working on ESG arbitrage.[5] “ESG Consultant But Evil,” I sometimes call this job, and we talked last week about how companies whose business is cutting down trees can get environmental credit for the trees they don’t cut down. That is the purest form of financial engineering: Some accounting regime exists that rewards you for not cutting down trees, you are in the business of cutting down trees, and you find a way to make cutting down trees look, for the relevant accounting purposes, like not cutting down trees.

More rarely, some set of rules will go away or be simplified in a way that really does demolish someone’s business niche. For instance, there is, in the US, a rule saying that bank accounts are insured by the Federal Deposit Insurance Corp. up to $250,000. FDIC insurance is valuable, but you cannot pay the FDIC directly for the amount of insurance that you want: If you have $250,000 in your bank account, it is all insured without you doing anything; if you have $2,500,000, it mostly isn’t, and that’s just that. But of course you can open 10 accounts at 10 banks and put $250,000 in each of them; then they will all be insured. If you have $25,000,000, you can open 100 accounts at 100 banks, but that is pretty annoying. But someone else can open 100 accounts for you at 100 banks, and put $250,000 in each of them, and charge you a fee. That intermediary is selling you FDIC insurance, and charging you a fee for it, because it has found a (fairly straightforward) way to structure around this one FDIC rule.

And that really exists and is a business (“brokered deposits”). And if the FDIC tinkered with its rules in some way — if it changed the rules so that all of a household’s bank accounts at one bank counted together toward the limit, or so that checking and savings accounts at the same bank counted separately, or whatever — then probably the intermediaries who currently sell this product would be best positioned to sell a revised product to comply with the new rules; they are the experts at FDIC insurance cap structuring.

But if the FDIC did away with the limit entirely they’d be out of business. David Dayen reports:

Legislation has been proposed to uncap deposit insurance. And that has prompted the private equity–owned company that is one of the main beneficiaries of the cap to spring into action.

A company called IntraFi offers two products that allow large depositors to spread their money among a network of hundreds of banks, each with accounts that don’t exceed the cap and are therefore effectively covered in full by deposit insurance. The company takes a fee for facilitating these “brokered deposits.” If deposit insurance were uncapped, their business model would be worthless.

The prospect of uncapping has the extremely well-connected officials at IntraFi scrambling. In the first quarter of 2023, when Silicon Valley Bank was shuttered, IntraFi tripled its lobbying expenses and hired a firm known for its access to senior congressional leadership. The new lobbyists who registered to work for IntraFi have experience with senior members of Congress, as well as the Trump and Obama White Houses. It’s a full-court press to maintain a lucrative status quo. …

Brokered deposits have been heavily criticized by former FDIC chair Sheila Bair, who described them as “just gaming the FDIC rules. The FDIC takes all the credit risk, and Promontory [IntraFi’s predecessor] gets the profit.”

Sure, yes, I don’t disagree, I’d just point out that “[product] is just gaming the [government agency] rules; the government takes all the credit risk and [company] gets the profit” describes a surprisingly large portion of finance!

It’s a wonderful read, but the basic point is that there is a sort of arms race in which one set of smart people create rules to prevent things happening, and another set of smart people craft clever (but possibly complicated) ways of doing something which is economically equivalent anyway. It just seems to me that if enough of this sort of thing is going on, no wonder our productivity growth is so weak. Finance is a big part of the UK economy (according to this, about 8.3% of the economy, and surely responsible for employing more than that proportion of the best brains in the country). Given that ‘finance’ is just about routing savings (income which is not consumed) into investment (physical or intellectual capital), this is a lot of friction. I suppose that those who argue that finance is doing “God’s work” would say that bankers ensure that savings are put to their best use. Well, I leave you to decided on that!

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