With a Grain of Piquant Salt:


Financial and economic laws and regulations provide the rules of the game. It is the game of accepting, giving and managing money. And if the rules aren't good or fit for purpose, then people will take their ball and go play somewhere else where the rules are good. Basically speaking, a regulatory framework is considered to be 'good' if it provides an optimal mix of consumer protection, financial institution oversight and management, not too much bureaucracy, allows people to raise and deposit funds effectively and efficiently, etc. The American Capital Markets Regulatory System was rated to be one of the best in the world but is now showing its age. So the US Treasury has invited responses to 30 questions raised about the current state of US regulation.

Here are my thoughts on this interesting step.

I have already talked about this issue in much broader terms, but suffice to say, the US legal system pertaining to the capital markets is now showing signs of strain. It is high time that it was made fit for purpose and in a better shape to respond to rapidly changing financial markets of the future. I reiterate, this is just my personal opinion. This essay has nothing to do with my employers (either past, current or future). This is also not part of any investment advice. Do NOT take this seriously or your armpit hair will fall out.

Ok, now that we have that out of the way, I have to admit that this is one of the things which I like about western economies and that is its ability to learn, regroup, ask silly questions, consult widely, debate, discuss and change direction. This continuous improvement, a constant search for betterment and improvement is what feels good in terms of aiming for the betterment of humankind. So, the US Treasury knows that the economic and financial legal structure has been established over decades and centuries. And as usual, times have moved on and while there has been a valiant effort to keep up, mistakes have been made and there is now a deep seated concern in the corridors of power and finance that something needs to be done.

As I mentioned, the world financial markets are getting increasingly linked together as evidenced by the increased correlation between the world's equity market indices. More importantly, the world financial system is getting further and further atomized. In other words, the old familiar structure and ways of working are disappearing or morphing into new animals. In the 1980's, London went through the 'Big Bang', immediately sweeping away the decades old structures and ways of doing business. Quarter of a century later, all the old British Merchant Banks have disappeared into the ether. Japanese Banks came up very strong during that time and people were worried about Japan taking over the financial world and now they have re-trenched right back. Nobody could have imagined that a Chinese bank could make a pitch for an American Investment Bank or become primary shareholder in a major British Commercial Bank but it has happened now. Morgan Stanley (a large US investment bank) had 2 international offices in early 1980's but now has more than 45 dotted around the world.

The US economy is still the largest powerhouse, with a huge equity and risk taking culture. Which is one of the reasons why its equity markets are so good. It also has a large rich population. It also has very good financial institutions. It also has very smart fellows running its institutions. And it believes in creative destruction. Institutions and individuals go bankrupt, merge, de-merge, acquire, divest, you name it. This provides the churn, money follows to where it earns the most and where it doesn't, it is killed off rapidly. And for a long time, the domestic regulatory system was good enough to manage this as most of the financial transactions were developed, managed and settled internally.

But with the increase in imports and exports, international business, footloose professionals, ability to raise money anywhere, money coming in and out with ease (no capital controls), the regulatory system is not really good. The current rules based approach means that everything has to have a rule. Which means that given the complex society, there are zillions of rules and lawyers have fun in skirting around or bending the rules. Not good. It is not providing good consumer protection, it is making life very difficult for the financial institutions in terms of administration, regulation is fragmented between different bodies, cannot keep up with new fangled instruments which are traded across the world on a real time basis. It is not able to handle the financial institutions which have grown into behemoths straddling the globe and the financial natives are restless.

So the US Treasury is asking some very basic questions, such as

Does the 'functional' regulatory framework under which banking, securities, insurance, and futures are primarily regulated by respective functional regulators lead to inefficiencies in the provision of financial services?

Many countries have moved towards creating a single financial market regulator, some countries have adopted a twin peaks model of regulation, separating prudential safety and soundness regulation and conduct-of-business regulation.

What are the strengths and weaknesses of these structural approaches and their applicability in the United States? What ideas can be gleaned from these structures that would improve U.S. capital market competitiveness?

In recent years, debate has emerged about 'more efficient' regulation and the possibility of adopting a 'principles-based' approach to regulation, rather than a 'rules-based' approach. Others suggest that a proper balance between the two is essential.

What are the strengths, weaknesses and feasibility of such approaches, and could a more 'principles-based' approach improve U.S. competitiveness?  Does the current regulatory structure adequately address consumer or investor protection issues? If not, how could we improve our current regulatory structure to address these issues?

And some specific questions such as

Securities and Futures

Is there a continued rationale for distinguishing between securities and futures products and their respective intermediaries?
Is there a continued rationale for having separate regulators for these types of financial products and institutions?
What is the key consumer/investor protection elements associated with products offered by securities and futures firms? Should there be a regulatory distinction among retail, institutional, wholesale, commercial, and hedging customers?

The answers are pretty much self evident, I am afraid. The current capital markets structure where different regulators look after different bits of financial sectors is no longer appropriate. There are way too many firms which straddle the boundaries, there are way too many products which straddle the boundaries and there are way too many customers who straddle states and countries. Distributed regulatory bodies such as this is a recipe for disaster. It has to be clearly fitted into an overall structure reporting into the representatives of the people in the legislature, run by the executive and checked by the judiciary.

Whether you go for a single regulator (like the UK) or break it up into two (like the Netherlands), does not really matter to that extent as long as the responsibilities and accountability is CLEAR AND TRANSPARENT between the bits and the political masters. Also, in cases of crisis, it should be clear who is to be contacted for what and who makes the decision (learn from the UK Northern Rock Crisis where nobody was responsible and the British Prime Minister Gordon Brown hid under his desk ' bloody typical!).

I do not like rules based regulation at all. More rules the more rule breakers and then there are more rules and so on and so forth. Not good. And this is a classic way of trying to control everything and failing to do any controlling. So have principles and manage by exception. So if you are interested to make sure that the consumers are protected, say so cleanly. You will not lie, you will not bullshit, you will not over-promise, you will say clearly what are the risks, the returns and the administration involved. That's it. You don't have to sit there and write a 20 volume law rule book explaining in gruesome detail how, what, where, when, who of every financial product, consumer, place, time, event, etc. etc. We do have great precedents, look at the Ashok Code or the Hammurabi Code or the 10 Commandments. The best examples of principles based regulation. If the lawyers complain, tell them that every lawyer has to actually carve every rule they come up with into stone with their own hands using a chisel. I think that would cut down the rules dramatically, don't you think?

Two last comments. The first is that the regulation should not concentrate on product differentiation between futures and securities. That's the thin end of the wedge of trying to regulate products. I mean futures and insurance are conceptually the same. What's the big point in having 2 different regulators looking after this? Insurance has already merged heavily into futures and vice versa in the real life anyway. So instead of looking at the products, regulate what they will be used for. So the regulation should concentrate on making sure that the sellers explain each product based upon common standards and metrics. These can be age or tenure; the return based upon a common measure; the probability of loss based upon historical measures, etc.

And the last comment is that individual rights are paramount. So you need to make sure that you distinguish between different classes of consumers as well as made it very clear and transparent as to how people can switch between classes. Now you would ask, how do I distinguish between classes? Well, it is simple, look at the body. If the body is a warm one, then it is a private human customer. If it is an entry in the Companies House, then it is a company. In the interests of efficiency, you could split up the companies into basic companies (small and medium scale companies) who require much more hand-holding and protection versus bigger or firms who might want to give up protection for greater return. So three blocks, retail consumers, basic commercial firms, advanced commercial firms.

If I had to boil down the zillions of pages of rules, regulations and everything under the sun, I would point to the commandment, 'Thou shall not cheat'. Pretty simple no?

All this to be taken with a grain of piquant salt!