Regulations are the operating system of the financial world. Strategy in finance starts with the market needs of the ecosystem parties (whose existence is often based in the regulatory structure), the regulations, and only then, the choice of technology. There is a necessary feedback loop in here, as new technology can make new products possible and change the structure of the ecosystem by changing the roles of firms. We are currently in an exciting era because of the potential blockchain technology has to do exactly that.
The most common statements we see about regulations are complaints, particularly from new entrants to this space. The purpose of this article is to examine how regulations fit into the securities industry.
Financial regulations come into existence because governments deem certain behaviors to be unacceptable. Some cause direct harm to other people, like fraudulent securities practices; some are unacceptable because they have consequences in a larger societal context, like payments to fund terrorists. Governments pass laws against these acts and then turn them over to regulators to see that these laws are carried out.
In the securities business, we have two primary types of regulations. The first type constrains the movement of value, both currencies and securities, to hinder all sorts of crime, including terrorism. Another element of this control is monitoring and reporting to ensure that the government receives tax revenues that are due. For decades, governments have been eliminating bearer instruments to further both of these objectives.
The second type, regulations around securities, seeks to make sure that the offerings are genuine, that sales practices are appropriate, that risks are made public to the marketplace, and that investors’ assets are protected all along the way. All nations with significant securities markets have enacted voluminous legislation in this area.
In order to carry out their mandates in the financial markets, regulators create the requirements for individuals and firms to be registered in order to operate and then supervise their conduct. A company operating any of the processes where there is a risk of violating these financial regulations must expect that they will have to be registered and perform regulatory functions as part of their daily operations.
Note that the regulators mostly supervise, while the actual ongoing regulatory activity is generally performed by the industry. In other words, the cost of regulation is borne by the party that has a profit interest in offering the product or service. This means that the regulatory cost is embedded in the price to all customers of that product. It also means that for-profit firms have the same incentive to find regulatory efficiencies as they do for other costs, benefiting customers in the long run.
As Alvin Roth, who won the Nobel Prize in economics in 2012, wrote in his book Who Gets What – and Why, “When we speak about a free market, we shouldn’t be thinking of a free-for-all, but rather a market with well-designed rules that make it work well.” We will have a lot to say at another time about market design, but in spite of excesses resulting in the need to find and even prosecute firms and individuals, requiring participants to perform the necessary regulatory functions has worked extremely well in the securities markets. The participation, liquidity, and efficiency of transactions are a huge success and a source of competitive advantage for developed nations.
As painful as it may be, the industry should generally embrace this role. Where regulators are part of the direct operations of a regulatory function, the result, from an industry perspective, is less positive. One example is the approval by the SEC of prospectuses. The SEC does not have any market incentive to make the process friendlier or easier to navigate. As a result, they logically see any eventual criticism as a failure on their part that they have to avoid, thus drawing out the process and making it more expensive for issuers. A market-based process would recognize that perfection is impossible and balance the important role of encouraging the growth of the market while putting a focus on those issues that really have a significant impact on investors.
We are regularly amused at statements that crypto market regulations are finally becoming clear. While it is true that governments took some time to issue statements on cryptocurrencies and other tokens, it has never been unclear to knowledgeable securities market players where the regulations would end up. The only questions were when and exactly how the existing regulations would be applied.
I was once told by a securities attorney that every regulation exists because somebody lost money. None of us likes the prospect of telling a client “No,” and it’s way more fun to just get on with the business that got us interested in the first place. However, faults and all (and you should hear our private conversations), the $170 trillion of compliant capital in OECD countries continues to grow because of the web of regulation that creates confidence in the liquid global market where we all participate.
To sum this up, the purpose of securities regulation is to protect investors and create an environment where markets can flourish. We, as industry leaders, are active participants and we have the opportunity to proactively include regulatory operations in our new ventures. If we choose not to, then the technology will either be discarded as too unsafe and expensive to operate, or outside parties will impose them, most likely in less elegant ways than we would have done ourselves. Blockchain technology and more specifically distributed ledgers can have significant advantages for the securities industry. We see the potential for exciting developments like changing the relationships between issuer and investor and enabling new products, as well as more basic opportunities to create market efficiencies, increase transparency, and lower risk. In order to reach the lofty heights though, it’s of equal importance for all of us to work to make sure that we simultaneously achieve the aims of our regulatory framework
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