Regulation of Financial markets? - perhaps its already done!

Rain, snow, slippery roads, we've had it all last week and most councils have run out of grit because the snow we've received is a "one in 20 year event". Perhaps the councils got a little over-confident that we would not see such weather in British winters so didn't stock up on salt and grit. I remember, when I was a kid, that it snowed every winter and there were always lorries running up and down our little village in Oxfordshire - that was in the 1970's though.

Is the council decision to stock "only enough to cope with a median winter" no different from a rating agency rating a pile of junk mortgage debt 'AAA' because , in the past, no more than 10% of it had ever defaulted so those holding the safest 90% would never lose money? I think yes - its just the way things are - we had better get used to it.

In my ramblings, I often (and will continue to do so) comment on the spanners that are often thrown into the market machine to alter its smooth running. These spanners are often regulatory in nature and tend to cause more problems than they solve. These spanners may be comments from governments, unaware of the money machine that punishes market inefficiency and actively seeks out ways to profit from such gaffes and ill thought out policies.

In my view, what we've seen in the past 18 months has demonstrated that there is no free lunch in the financial markets. Good I say! Reward has to come from trying to understand risk/reward and committing capital to that position. Where it doesn't work is buying a bond yielding 6% and borrowing money at 5% to finance it and telling your shareholders "don't worry - this bond won't default...it never has and look, even Moody's and Standard and Poors agree with us and have given it a AAA rating!" The clever chaps convince another bank to lend them a billion dollars to do the trade and a "profit" of $10m a year is created - right...yes..okay then..

Now its all gone pop - and to most people a huge surprise. But why? - everyone knows the phrase "no such thing as a free lunch" but everyone forgot about it...or did they. If you were a lucky hedge fund manager with our little 6% bond wheeze detailed above, that trade would make you up to $30m a year profit for your fund and up to $2m for yourself in "performance" fees. Often paid in cash, these performance fees were the asymmetrical golden goose that sustained the noble art of managing money for the length of the last boom in asset prices - ahh, good old days.

So, it popped, what happened to the hedgie after his fund imploded leaving the bank who lent the billion dollars with a headache? Off to set up a new fund perhaps, clean as a whistle.

Will it be so easy in future to make such profits...I'm not convinced. Even in the absence of regulatory muddling (which will provide some avenues for profit), the trusted models used to establish risk/reward have to be re-calibrated. This time, they will have to include these "25 standard deviation events" (A Goldman Sachs quote) rendering most of the staple diet of trades unviable. The modelling will just show the deals work for a period of time then blow up - this will have to be made clear to the investing clients under more stringent transparency rules pending.

So where does that leave us? - well, the long painful removing of layers of accumulated debt will continue. It will hurt and be longer than most expect. Easy money will not be found and "picking up pennies in front of the steamroller" a euphemism for the 6% bond game we described will no longer work. The market appears to have already re-regulated itself and we won't see the likes of it for a generation.

The opportunities? Well, Unleveraged Global Macro funds will flourish as will transparent trading opportunities (such as the product provided by my firm, www.cityodds.com). Perhaps CityOdds is the shape of future risk management and liquidity provision...I aim to find out.