“Finance can, and does, make things better,” says Maureen O’Hara, Samuel Curtis Johnson Graduate School of Management. “But many people don’t really understand finance, so they often assume that if something bad happens in the financial markets, it’s because banks or financial institutions are evil. They don’t realize that the financial system is complex, and that sometimes markets go up and sometimes they go down. How we design our markets, their structure, is extremely important. When markets become fragile, bad things happen.”
Prohibiting Speculative Bets
O’Hara looks at a variety of issues related to the design and regulation of asset markets and stock exchanges. Recently she investigated the effects of the Volcker Rule—which prohibits banks from making investments that do not benefit the customer—on the corporate bond market. A corporate bond is a type of debt security issued by a corporation and backed by the company’s ability to pay it off in the future, usually with projected profits. A concern by many in the market was that the Volcker Rule, a part of the Dodd-Frank Act, was negatively affecting corporate bonds.
O’Hara joined with Jack Bao and Xing Zhou, economists at the Board of Governors of the Federal Reserve System, to look at whether the rule caused banks to pull back from market making in the corporate bond markets. Did this result in markets that are less liquid and in corporate bonds that are less attractive to investors?
“Our work showed rather definitively that the Volcker Rule had dramatically affected corporate bond liquidity in a very negative way,” O’Hara says. “The rule restricted the amount of proprietary trading banks can do. A lot of the Dodd-Frank restrictions were needed to curb activities that exposed the financial system to excessive risk. But banks also act as market makers for corporate bonds. The Volcker Rule was never intended to affect corporate bond markets, but the way it was written, it definitely was viewed by banks as restricting their behavior.”
“Some firms seem to have forgotten that the point is to make markets better, to take care of their clients, and not just make money at all costs."
O’Hara and her co-authors’ paper was widely cited, and it was mentioned in the most recent treasury proposal to change capital markets. “From my perspective, it’s fun to do research like this,” O’Hara says. “Congress or the regulators make changes to the rules, and then what happens? It’s important that our corporate bond markets work well, and if we’ve inadvertently created rules that are impeding their ability to function, we want to fix that. Finance research can play a vital role in sorting this out.”
Preventing Flash Crashes
Recently O’Hara turned her attention to the effect on the markets of a relatively new financial development, Exchange Traded Funds (ETFs). ETFs hold assets, such as stocks, commodities, or bonds and are intended to trade at values close to the total worth of the assets within them. “ETFs are great in many ways,” O’Hara says. “They have very low fees, and they allow people to trade all day long as opposed to a mutual fund, which can only be bought or sold at the end of the day. But ETFs tend to be much more liquid than the underlying securities. There’s a big concern that the ETF can start moving the market, instead of the market moving the ETF.”
O’Hara collaborated with former graduate student Ayan Bhattacharya, PhD’16 (now at Baruch College) to investigate whether ETFs make the market more fragile—that is, more susceptible to market breakdown. “Our results suggest that ETFs can increase market fragility,” O’Hara says. “They can create intraday dynamics in asset prices that can result in some of the underlying securities not being priced accurately.”
Similar to the situation with the Volcker Rule and corporate bond markets, some of the problems with ETFs stem from reform rules—the Limit Up–Limit Down (LULD) rules—put in place to correct other problems, O’Hara explains. In this case, LULD was intended to prevent flash crashes, a very rapid, volatile fall in securities that takes place within a short time period. Flash crashes are partly the result of modern markets’ reliance on high frequency trading. LULD halts trading when a stock has moved so fast that an imbalance of buy and sell orders arises on the book, potentially resulting in enormous price increases for that stock. The rules allow orders to re-accumulate on the order book, and then trading starts again.
“One of the things that was not thought through enough was the effect Limit Up–Limit Down Rules can have on ETFs,” O’Hara says. “Suppose you have an ETF that’s composed of 10 different stocks. You buy the ETF, not the stocks themselves. If, because of volatility in the market, some of the underlying stocks are halted, how do you price the ETF?”
Something for Nothing
The innovation of modern financial markets has changed the world of finance, but the legal structure tends to lag behind dramatically, according to O’Hara. This led her to write Something for Nothing: Arbitrage and Ethics on Wall Street (W. W. Norton & Company, 2016). “In the university setting I feel we need to be very clear about the things that don’t make markets better—about activities that take advantage of the fact that the legal structure always lags behind,” O’Hara says. “These activities may not be illegal, but they are certainly unethical. So I decided to write a book to set out this premise that modern capital markets are actually rather complicated, and it may not be as easy to see those boundaries as you might think.”
The book is based on the notion that modern finance is about arbitrage—taking advantage of a price difference between markets by engaging in matching deals that capitalize on the imbalance, where the final profit is the difference between the two. While arbitrage is legal, it can lead to unethical practices when pushed too far. “We teach people in finance that you can arbitrage things that are inefficient, and that’s a good thing,” O’Hara says. “But when does taking advantage of a pricing algorithm cross the line into manipulating the market? When does making things more efficient cross the line into taking unfair advantage of people?”
O’Hara gives an example of JPMorgan Chase & Co., which was fined in excess of $400 million in 2013 in a settlement with the Federal Energy Regulatory Commission (FERC) on charges that they manipulated the California and Midwest electricity markets. JPMorgan had inherited 28 aging power plants when they acquired Bear Stearns in 2008. The plants were losing money, but JPMorgan optimized against the algorithm that was buying the electricity to sell to consumers, using what the FERC called manipulative bidding strategies, thereby making substantial profits.
“JPMorgan’s bidding strategies were within what was legally allowed, but they kept going,” O’Hara says. “Pretty soon they’d lost sight of the fact that this is a market that’s going to set electricity prices for consumers. At some point someone should have said, ‘We’re getting a little carried away here.’ Some firms seem to have forgotten that the point is to make markets better, to take care of their clients, and not just make money at all costs. Finance should be a force for good.”