The Federal Reserve Trading Scandal - Could it happen here?

And would we even find out if it did.

A scandal hit the US Federal Reserve after the recent discovery that several FOMC members had engaged in some very questionable financial transaction during the 2020 Covid-19 pandemic response. 

The senior Federal Reserve officials were making large trades in individual companies even while the Federal Reserve was actively supporting the pandemic-hit economy and warning about the many economic risks facing the economy. One of the more egregious examples of this conflict of interest was Vice Chairman Richard Clarida who sold millions of dollars of bonds and re-invested in stocks just before the Federal Reserve started to slash interest rates (which made the trade much more profitable).

The upshot of this scandal was a new set of ethics rules regulating the conditions under which Federal Reserve officers could invest in financial markets and a number of the worst offenders retired early including three members of the FOMC.

Interestingly none of these transactions were per se illegal or against the letter of the law restricting investments by FOMC members. They were however very much against the spirit of the Federal Reserve as the uproar made clear. In addition they were only discovered by the press through annual disclosure statements by the top officials (although even these disclosures initially omitted how bad the trading was).

We would never

Could the RBA ever find itself in a similar position? The short answer is we have no idea. 

That is because only the Governor and Deputy Governor of the Reserve Bank of Australia fully disclose their financial holdings and thus potential conflicts of interest. All the external members of the Board (with the possible exception of the Treasury Secretary?) only need to disclose their transactions privately to the Governor and Treasurer - the RBA refused to even provide them confidentially to the House Economic Committee! 

If a Board member of the RBA was making transactions of a similar nature then the press would have no way of knowing about it. I would hope that in the event that a Board member made a transaction that is inappropriate the Governor or Treasurer would step in to stop it from occurring.  However even that level of enforcement relies upon the rules on trading being sufficiently restrictive.

The problem is they are not.

The crime is what’s legal

The Code of Conduct for Reserve Bank of Australia Board members states that they are not allowed to transact in any “blackout financial instruments” in the days leading up to RBA Board meeting. As soon as the Board members receive their confidential briefing on the upcoming meeting (usually at 10am the Friday beforehand) they are not permitted to trade any financial instruments that could be affected by a move in the cash rate. 

However this restriction does not apply at any other time - including as late as the Thursday prior to the board meeting when the papers have yet to be sent out.

This restriction would make sense if we assumed that the Board members' only source of sensitive economic information was the papers that they received. However this is clearly not true.  In previous testimony to the Australian parliament the RBA has stated that the process of setting policy is an ongoing dialogue between meetings as members discuss the wide range of economic indicators and how much weight they play on each when setting policy over the months to come. 

Take for example the minutes for the July 2022 Board meeting in which they state 

“In making their policy decision, members considered the possibility of raising interest rates by 25 basis points or 50 basis points. Members agreed that arguments for raising interest rates by 50 basis points were stronger.”

The Board considered raising interest rates by 25 basis points or 50 basis points and ultimately decided on the 50.  How close that decision was and on what factors the decision turned is quite unclear. 

Was it unanimous? Or a 5-4 vote? What data series were the hawks and doves citing as their main argument? Obviously the people in the room having the hours-long discussion would have a massive informational advantage over whether the RBA would continue to go on hiking by 50 basis points at the next meeting and the information that would govern that decision.  

And under the current rules there is nothing prevent from trading on that information in the weeks between meetings.

Frankly it is crazy to believe that the RBA Board member’s informational advantage is constrained to the Board papers themselves. While the Reserve Bank of Australia often states that it doesn't have a fixed or pre-planned path for the cash rate, it must surely consider different trajectories for interest rates, the effect they would have on the economy and on what basis they would choose between them in the months to come.

Good intentions are not enough

The example of the Federal Reserve highlights exactly how important public disclosure is. The Federal Reserve officials were conducting transactions that were by the letter of the law permissible but certainly violated the spirit of the law. Not only that but even the knowledge that they would have to disclose these transactions did not seem to deter them -  it was only when the press combed through the financial records that questions were asked about whether these transactions were appropriate and the scandal blew up.

This is why it's important not just to have rules that are internally monitored but have a level of transparency that allows members of the press to make sure that the people trusted with the keys to the Australian economy behave in a way that is both legally and morally appropriate and most importantly are widely seen to do so.

It is not hard to design a set of rules that would enable central bankers to invest their savings in financial markets while also minimising the conflict of interest.

Banning central bankers from owning individual shares seems like a no brainer and indeed given the poor track record of picking individual stocks we would be doing them a favour by forcing them to diversify.

The same is true of limiting the timing of transactions in the stock market.  Trying to time the market is a mug's game and one that RBA Officers and Board members should be prevented from playing.

Amazing as it seems, even highly wealthy people trusted with positions of immense power and respect seem to still be tempted into micromanaging their investments to make themselves better off.   It is unreasonable to expect people to take a leaf out of the former Deputy Governors book (who refrained from investing in any financial instruments at all!) but a policy that restricted RBA board members to diversified, ASX-tracking, exchange trade traded funds with limited conditions under which they can be traded would be better for themselves, better for the Reserve Bank of Australia and better for the country as a whole.