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Self-Regulation in the Financial Markets: My Thoughts

Self-regulation: let’s think about a person.  Can he regulate his own life on his own?  Of course he can.  But will he?

The same is true of markets. SROs can be effective if the culture is good, and people are willing to take actions against friends.  But an SRO can also develop a culture that has a blind eye toward offenses, until the media embarrasses them.  The same can be true of regulators, though.  They can be “in bed” with the industry if the wrong culture exists in the regulatory body.

2) The trouble with financial companies and products is that they make promises, whether sharp or vague, about the future.  That leads some people to commit money today to those products, which may be bad or good.  When done across a whole economy, that can lead to booms and busts.  That is a great reason to regulate the promises made by financial firms.

3) But how do you regulate?  Do you have a sharp separation between the regulators and the regulated, which can make regulation adversarial, or do you introduce a third party, the SRO?  The SRO is a kind of middleman, who executes the will of the regulator, but takes into account the special conditions in each market, and talks with the regulator about where they might be wrong in what they would ordinarily do.

4) SROs have specialized knowledge, drawing from the firms they regulate.  Well, regulators could have the also, if they hired the best, and paid them what they could earn in the private sector.  My but the regulated would be baffled if they faced the “stone wall” of their equals in dealing with regulators.

But our government is chintzy where it should be bold.  Aside from idealistic investors like me, (and I have applied to various government positions without the decency of a reply) it is difficult to attract top talent without paying top dollar.  And as such, they have not gotten top talent.  Academics are not top talent.  They don’t really know how the markets work.  They know how their models of the markets work.

Ideally, you need investors who understand the academic research, like me.  If you have regulators with that strength of knowledge, you could regulate well.

5) Many of the speakers today talked about mining big data to get results.  I will tell you that the only way to get those results is to hire talented programmers, then train them in the markets.  Waste time teaching them; they’re bright, they will learn.  Then after the initial training, propose the first project.  You will create a cadre of clever programmers that can sniff out problems.  Pamper them, and you will have a fantastic corps for sniffing out financial irregularities.

The guy from the National Futures Association emphasized the idea that mandatory membership in the association as a requirement to do business was paramount for an SRO and I can see that.  The SRO then has the “death penalty” hanging over the heads of those they regulate.  That said, consider this: the CFA Institute may dream of the day when all involved in investing *must* hold a CFA Charter.

I have no doubt that this would be a good thing.  Ethics codes are good for the industry, and to kick out bad apples would be a good thing.

6) When there are more than two parties in any economic arrangement, regulation gets tough.  It becomes difficult to separate the various interests, and come up with the right division of duties toward the ultimate consumer.

7) On Rules-based vs Principles-based regulation, in the American context, I lean toward rules-based.  Rules-based has the advantage of comparability.  Let the analysts make their adjustments, and let the companies provide the data to do so.  But provide a consistent set of rules that all need to comply with first.

8 ) Finally, on derivatives.  Regulate them as insurance, and let the states deal with it.  Require insurable interest such that only bona fide hedgers can initiate trades.  Speculators should not be allowed to trade with each other; that is gambling.  If we did this, the derivatives market would shrink dramatically, and no one would be hurt.

That is what I would do, and Wall Street would fight it, tooth and nail.






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One Response to Self-Regulation in the Financial Markets: My Thoughts

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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