Self-Regulation in the Financial Markets: Finale

Self-Regulation in the Financial Markets: My Thoughts by David merkel, CFA of The Aleph Blog.

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 w=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.



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.