Regulation of The Marketplace

Posted by Jeff Carter
on September 24th, 2012

Markets are hard enough to understand on their own. Most people are totally unfamiliar with the terms. Financial terms get abbreviated, or twisted. But that’s nothing compared to what happens with regulation. Regulators are nothing more than bureaucrats. They aren’t necessarily adversaries to the marketplace like the EPA or OSHA is. But, they aren’t there to help it function in the most efficient and correct manner either. Regulators are also supposedly kept in line by Congress.

Bureaucrats just want to keep and make their jobs more important than they really are.

There are several regulators out there. Whenever the US has had a problem in finance, it just creates a new alphabet soup of an agency. Additionally, there are several quasi-government organizations in the private sector that also regulate. That’s not any different than the accounting profession with its Financial Accounting Standards Board (FASB).

The two biggies in finance are the Securities and Exchange Commission (SEC) created in 1933. The other is the Commodity Futures Exchange Commission (CFTC), formed in 1975. The SEC is accountable to the House Financial Services Committee, and Senate Banking Committee. The CFTC is accountable to the Agriculture committees of each Congressional house.

But then, there is the Federal Reserve, Department of Treasury, FDIC, OCC, FINRA, CFPB, NCUA, and all 50 states have their own banking regulators. You can see why regulation becomes so complex. Bureaucrats engage in turf battles constantly to try and consolidate power. Politicians each have their favorite agency, and assist them in those battles. Instead of worrying about the average Joe on the street, bureaucrats are engaged with themselves. They worry about finding fault with their other regulators so they can pick up the ball and grab more power, and more budget for themselves.

Themis Trading has written extensively on the finer points of SEC regulation. The Streetwise Professor has written extremely clearly on Dodd-Frank. We don’t agree on every tiny detail, but I think we all would agree that the structure of the marketplace is broken today. The core reason that it’s broken isn’t simply computerization. It’s poor regulation. Computers are showing the weak points of that regulation, daily.

One example of that on the SEC side of the regulatory apparatus is Regulation NMS. Instead of curing the market fragmentation problem, it’s made markets even more fragmented! What the SEC should say instead is that all stock orders need to be placed on a regulated exchange. Then it should delineate what types of orders are acceptable to place. For example, Market, Limit, Stop, Market if Touched. That would end the fragmentation. It would end the game playing. It would end the race for speed, because all the shenanigans practiced in the back rooms of Wall Street would come out into the sunshine. Further, it would recognize that the stock market’s function is to raise capital for American businesses. If firms want to speculate, fine. But their role isn’t the primary one. Today, regulations are stacked in favor of the banks and speculators, not in favor of American businesses.

Each segment of the marketplace has its own unique problems. That is why a one size fits all solution with a lot of blanks like Dodd-Frank won’t work. Yesterday, I talked about how the OTC market is the wild west because it has little regulation and all the contracts are customized on an individual basis. Dodd-Frank mandates that those contracts be cleared by a central clearinghouse. While the goal is admirable, and certainly a small portion of OTC can be cleared, most of it cannot. The risk to the clearinghouse is too great. They don’t have a way to adequately quantify all the risk so they can margin correctly. Dodd-Frank’s solution: allow clearinghouses to access the Federal Reserve bank directly when they need cash to cover losses on OTC securities.

This is a guaranteed time bomb. Eventually it will blow up and the Federal Reserve will be on the hook for every single contract contained within that clearinghouse.

The CFTC has made a big deal about position limits lately. They think that limiting the position of customers in any particular commodity will lead to fairer pricing. It doesn’t. All it does is drive more trading underground into the OTC market. Once enough trading goes into the OTC market, the actual public price for the commodity becomes the dog that gets wagged by its tail. Private clearinghouses have an economic interest to margin correctly and watch positions of customers so that they don’t get too big. But, the CFTC has written a lot of crappy regulations in the last several years that hinder the private marketplace from correcting itself.

Additionally, there is a revolving door of regulation from Wall Street to Washington. As one moves up the ladder of an investment bank, sometimes a stint at a federal agency helps a career. If we look at other agencies, like the US Department of Agriculture, it’s not any different. Big Ag goes from the private sector to the public sector and back. Big Banking does the same thing. That’s one of the reasons we have so much crony capitalism in the US. The only cure is to eliminate the agencies and let markets regulate.

Rules and regulations need to be focused on the function of the market. They need to be written clearly. We need principled based regulation that designs marketplaces to be flat, have less layers, and work for customers, not institutions. The invisible hand of the market needs to have the power so that it can slap around anyone that deviates or tries to get an unfair edge in the market.

This isn’t rocket science. But because there is so much money involved, and top line revenue at the major Wall Street firms, regulation becomes more complex than theories of relativity. It shouldn’t be that way.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.