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Thomas Krantz Speech on "Why Regulated Markets? How Regulation Supports the World's Capital Markets?"
Date: 25 Apr 2017
Author: Krantz, Thomas
American University of Beirut seminar, 25 April 2017
Thomas Krantz, Senior Advisor Capital Markets, Thomas Murray, London.
This seminar is about human affairs and money. I have given it the title of:
“Why Regulation Matters.”“If we wish to understand the functioning of the economy, and its animal spirits, we must also understand the economy´s sinister side – the tendencies toward antisocial behavior and the crashes and failures that disrupt it at long intervals or in hidden places. Some economic fluctuations may be traced to changes over time in the prominence, and the acceptability, of outright corruption. Even more significantly, there are changes over time in the prevalence of bad faith – economic activity that, while technically legal, has sinister motives.”
George Akerlof and Robert Shiller, Animal Spirits. How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism: Princeton and Oxford, 2009.
Mr Akerlof and Mr Shiller, the two authors above, are Nobel laureates in economics, and not incidentally George Akerlof is the husband of US Federal Reserve Board chairman Janet Yellen. I would suppose that like me, many of you in this room would love to have dinner in their home, even just once, to hear that evening table conversation between the two of them!
The shortest answer to the question posed for this seminar is that regulation matters simply because measured risk – measured risk – is the only way for a business to flourish. I will spend the rest of the seminar developing this thought. For those of you in a rush, you have the essence of the argument already.
Distinguished guests, ladies and gentlemen, my fellow students, I wish to thank my host, Yasser Akkaoui, for this kind invitation – and for letting me choose the topic I wanted. It means a great deal to me to support Yasser and his passions about fairness for investors as a critical quality for individuals to be participating in society, as well as being the best use of scarce capital.
It also means a great deal for me to be invited to lead a seminar in Beirut. The first reason is that I remember the horror and sadness of AUB President Malcolm Kerr’s murder, which was a violation of so many things that matter to all of us here today. As a graduate student, I had read his writings on Middle Eastern politics. We must do some good work today to honour him. The second and more pleasant reason is the opportunity Yasser has afforded me to help advance public thinking, deep thinking, about the usefulness of securities markets for society.
As I close this introduction, sentimentally I cite two ties to Lebanon. In the first tie, I was born in Cedars of Lebanon Hospital in Los Angeles – this is a homecoming of sorts! In the second tie, I lived for 30 years in France, and was always struck by the pride the French take in calling Marseilles “the Phoenician city.” And then when I saw it, I was struck by the beauty of the site and the practicality of having a good port for ships –beauty and practicality have been Phoenician characteristics at their best for many thousands of years.
Now let’s get down to business.
Before we get to the point of regulated markets, the theme of this seminar, we must first think together about the value of a public securities market. We are not talking about fruit and vegetable and cheese stands, though there are some similarities. The Lebanese are rightly proud of being a nation of traders, and those commercial skills were honed over centuries – the Mediterranean archaeology of trading is a proud testament to the many successes. Still, there were always risks, both from other explorer-traders as much as from the changeable sea. We will return to risks in this seminar, but in the context of financial markets rather than commercial trading. For the moment, I state only what you probably feel in your bones, that without risk there is no profit, and with no profit there is no purpose to business. We agree – my point is to make risks explicit, in order to manage them successfully. And to speak very precisely about marketable securities, the contract-based, virtual (de-materialized) things called stocks and bonds, and which guarantee either a part ownership of a company, or else a loan of money to the government or a corporation.
Now to the capital market and its role in society: I believe Yasser invited me mainly to reflect on financial exchanges, which have been the subject of my work these past 25 years.
It was only 5-7 years into this work that I slowly realized several fundamental points. Yes, I was worse than slow off the mark. Exchanges were so visible that I did not really see them – that is quite typical of infrastructure, when you think about it. We do not, I don’t believe, think very often when switching on lights or whatever as to all it takes to get us a regular electrical current or clean, running water at the flick of a switch or tap. So it is with exchanges – most of us do not think much, if at all, about what it takes to operate them. When leading World Federation of Exchanges, I only gradually came to understand:
that a public market with multilateral actors establishes a price for assets, and that price is a critical piece of economic information. It is such a basic, evident point that it is hardly ever raised, except in slightly boring price theory and capital allocation courses at distinguished universities such as this. But prices are what exchanges produce. The whole economic debate about an exchange is whether the prices formed on them are qualitatively better for readers of those bits of information – officials, corporate treasurers, savers, analysts – than private market pricing. That is the competitive incentive for exchanges in the organization and requirements for listings of securities, and the structure and supervision they assure for the markets they operate.
that capital markets have a LOT of money listed and traded. A lot, a lot. Depending on measurements, these days the value of company common stocks listed on exchanges is some $ 65 trillion. That is the numbers 65 followed by 12 zeroes. For my first years in the field, I did not much think about all that value, and still today could not begin seriously to comprehend the trillions involved. It just seemed like a lot at the start, and then grew and grew as I slowly took it in.
that the banks had by the late 1990s begun to dominate the organisation of public markets, the so-called “market structure,” which is where the market participants earn their bread in trading. I always this this was a rather dull bit of execution, like turning on that proverbial light switch or opening that water tap. I was entirely wrong- this debate is central, because this is where access to that stash of capital is to be found, and this is the part of the system that moves. I should have realized that if the debates were this vigorous on the rules and regulations framing market structure, there must have been something at stake. There was: money, and a great deal of it at that. It was not just about flicking on the light switch.
exchanges may make a lot of “noise in the news” every evening after trading as to how the market moved, and by how much; and they be very visible national institutions. But they are themselves very small enterprises for all that. They were closed shops, guilds, since their first casual formation of them began some 400 years ago, and only in the 1990s was the idea born that they might actually transform themselves into proper corporations. The point of the demutualization of exchanges was indeed to salute the value of corporations in society; and although that legal innovation began in Holland in 1602, it spread world-wide over the centuries. It seems to suit a human need of sharing in risk capital. That is one reason why common stocks of companies are also called shares. That literally means sharing in risks and profits. Being a publicly listed and traded company compels a certain behaviour – and all too often misbehaviour. Corporations with limited liability are one of the great socioeconomic inventions of European civilisation – curiously, the idea of being a corporation like those issuers had long been on their markets only spread to exchanges themselves some centuries later, as from the mid-1990s.
Besides establishing prices “fairly” by offering access to the public of bids to buy and offers to sell stocks and bonds or financial derivatives – and we would rightly spend hours on the topic of fairness, but should not – exchanges offer something fundamental for society, the possibility of pooling savings and transforming them together into long-term investment capital formation for entrepreneurs.
In 2017, public, regulated exchanges are very seriously challenged by private investment capital-raising models for those insiders. By definition given my work, and because of the values I hold dear, I reject private financing as the first choice, except for the initial riskier stages of a company getting started in business. As a citizen, I like the idea of fair and equal access of every other citizen to investment possibilities, and personally I do not like being cut out of attractive possibilities reserved for a few insiders, the private part. For the public in this room, both national leaders and students and us ordinary citizens, I believe it important to spread opportunity to the widest possible swath of citizens – knowing very well that the right to contract bargains among citizens is also fundamental to society. It is, then, a matter of balance between public and private markets that merits our attention.
While discussing fairness and investment opportunity, it is useful – indeed essential – to focus on shareholder rights. Much of the reason behind the founding of capital markets authorities in most of the world’s capital cities, or other equivalent governmental supervisors, was the realization that corporate executives were not treating the owners of those companies fairly in terms of business objectives, management, cost controls, employee development, and their own remuneration. There have been, and continue to be, scandals when it comes to the matter of declared corporate profitability. Senior management has an overwhelming information advantage over even boards of directors, let alone the investing public. To rebalance this to the extent possible, corporate governance principles have been written for the past two decades, national commissions as well as global standards, notably the OECD Principles first written in 2000.
Exchanges get involved in good governance work via the listing requirements they specify in order for companies to issue shares on their markets. The general idea is to protect shareholders against the information disadvantage they suffer, to be sure that management is always mindful of their best interests.
A current topic in shareholder rights is whether there should be differential, preferential classes of shares with varying dividends and voting rights. The World Federation of Exchanges always put forward the importance of one share one vote at the annual assembly, and one dividend to every shareholder of record on the payment date. More than a year ago, the Chinese internet giant Alibaba wanted to go public. The Hong Kong commission refused its shareholder structure, which gave the existing owners preferential rights. To the contrary, the US SEC authorities and New York Stock Exchange were all too happy to accept this compromising position, as it has done for so many Silicon Valley businesses these past two decades where the entrepreneurs get public money but keep control. It is a practice I have fought for decades, and most often lost. The question is very current in Singapore where the exchange is now conducting a public enquiry on the subject.
Shareholder rights – well, in principle if the shareholder is being properly treated by management, all else should fall into place. But as ever in markets and governance, it is never quite that simple.
The more usually forgotten element in this is issuer rights – to make sure the corporate whose securities have been floated gets good information back from the market, and its share trading is correctly handled according to the rules. Management and boards need the clearest possible information back from the exchange in terms of pricing and market interest, to evaluate capital raising possibilities.
If both shareholders and issuers are being treated fairly, that improves the changes of better capital markets functioning.
It is the exchange, the market operator, which ties the two sides together – the shareholders and the issuers. From that it follows that the remaining question concerns the bankers and brokers who stand in between the two final constituencies. There is only one question to be asked: is the middle taking too much from either side compared to the risks it is running? What is necessary for bankers and brokers to earn when it comes to raising capital and assuring liquidity for the market? To put this question in tangible terms, if you pour a glass of beer, what is the right balance between the foam on top and the liquid refreshment in the rest of the glass?!
Now that we have established the value to society of public capital market support to enterprises, we will at last get to the heart of the matter, why regulation matters.
I would suppose that the simplest and best reason for being a supporter of regulated markets is that finance so often drives off the road. It is a sad fact of history and human behaviour. Very badly wrong, from the Mississippi Bubble in the early 1700s that crippled European investors for years to the crises of 2007-2009 whose impacts we all still suffer. In the opening citation, Mr Schiller and Mr Akerloff wrote about the risks inherent in the social psychology of the markets and participants in them. I would add other causes for things going wrong:
-politics – that requires no further comment in 2017!
– technology – markets have moved from the coffee house to the telephone to the computer, and now to microwave transmitters
– Geology – in this part of the world, to give but two examples, in antiquity the collapse of society after the Santorini volcanic explosion off your coast, and the water wars today given the rugged terrain of the Levant.
– Discoveries – things that come at us from out of the blue, new ideas change the way society functions, and modify social goals
– Finally, sequences of unplanned and unplannable events– when the Bretton Woods system of global monetary management post-World War II ended in the early 1970s, computer capacity and hand-held devices were just about complex enough to be programmed for the Black-Scholes options valuation formulae. Given innate human curiosity, financial motivation, and those new instruments’ possibilities, and the proximity to the futures markets for agricultural and industrial commodities right there in Chicago, a few people in that same city, at that time and in that place, had the good idea to get to work on financial derivatives. Circumstance, accidents, they all matter greatly in public life.
The point of this section is that change is a constant, requiring very regular adaptations of governing the markets to assure what should be their abiding values of basic fairness and value to society.The hierarchy of regulation
No, regulation is not a single topic. It comes in many forms, and interacts with overarching public law that is legislated, and, at the level below it, the very detailed rules that an exchange can write when it implements the more general regulatory objectives set for it. Exchanges can also be more strict than the authorities, and often are in order to distinguish themselves commercially.
Self-regulation of securities trading began in the coffee houses of Amsterdam and London where stocks were exchanged in the 1700s, and for that matter in its own forms also in the street markets of fruits and vegetables thousands of years earlier. It has essentially been about proper behaviour in the group, making sure one trader keeps his word when concluding a deal with another. And pays on time at the price agreed, or delivers the securities on time if on the other side of the trade. Self-regulation is group policing; it is more social anthropology than financial theory. A trader not following the coffee house rules would have been ejected from the group, losing his livelihood and possibly also having to settle fines. The group sociology of trading securities face-to-face was a daunting thing to see – one finds that harder to imagine in today’s virtual, dematerialized marketplaces where trading takes place on computer screens. Yet even on screens, people still recognize counter-parties and pick up the telephone to learn more about what is being posted on screen.
Self-regulation is front line supervision of broker-dealer behaviour.
When a possible problem is detected by the self-regulator, most often an exchange or its compliance department or subsidiary company, it usually then gets handed to the market supervisor for collaborative investigation. The market supervisor has behind it the authority of the government, of law and the courts; and it must back up the market operator to give effect to rules and regulations. Again, this is usually collaborative, and exchange committees and departments in theory and practice are meant to aid and support the capital markets authority.
Governmental regulation is what governments provide to set the framework for the market operator. It does not always work well enough to assure a sense of fairness for investors, but that is true about human affairs.
In moving towards some conclusions, I add that when writing to our host about this invitation, what came to mind was the constant complaining that I have heard for decades about regulation. “It makes me do this, I can’t do that, I now have to fill out all these forms, I don’t know what they mean or what they want.” Well, I asked myself – and Yasser Akkaoui – about what would be important to discuss with you in this seminar in April 2017, some years after the consequential financial crises of 2007-2009, and the massive rewriting of global and national regulations and principle and standards to head off such disastrous behaviour once again in future. What actually could be more important for setting the framework for handling all this money?
Will all that has been promulgated by global and national authorities work? Let me only say that I remain a constant worrier, not a forecaster. But let me also say, if there were no regulations in financial services, I would be completely at sea. They frame my plans, they are my compass to navigate. They are deeply based in social philosophy, and they matter. But they can veer into the overly prescriptive, most especially when due to conflicting rules and regulations as a financial actor crosses a border. Which one to follow if a trade transaction is completed across national frontiers, as is more the case than it has been since before World War I?
What do I want you to remember and think about? Two points only.
Public, regulated markets matter to society in terms of efficiency and social inclusion.
Public, regulated markets are readily turned aside by poor behaviour, which is why we simple humans need guidance in the form of regulation.
I warn you, the balance between market forces and regulation and society needs constant adjusting. This work is never done. If something seems not right or fair, you are probably right. Please do not give up the thinking and action required for the proper, efficient handling of all this money, yours and other people’s.
Suggested ReadingThese global standards texts can be found on search engines under these names, and there are many others:
“G20 Leaders Statement: The Pittsburgh Summit,” September 24-25, 2009.
“IOSCO Objectives and Principles of Securities Regulation and the IOSCO Assessment Methodology”
“Basel III Capital Accord”
“The Compendium of Standards – Financial Stability Board”
Law and regulation are specific and force compliance, as composed to principles or standards which are broader, aspirational, and largely lacking in enforcement other than the goodwill and common sense incorporated in them.
Markets in Financial Instruments Directive 2004/39/ECCommentary
“The Economic Rationale for Financial Market Regulation,” by Randall Dodd. Washington, DC, Derivatives Study Center, December 2002.
“Regulated Exchanges and the Ethos of Public Capital Markets,” Atsushi Saito in Regulated Exchanges: Dynamic Agents of Economic Growth, Larry Harris, General Editor. New York: Oxford University Press, 2010.
“A Retrospective on the Unfixing of Rates and Related Deregulation,” Roberta S. Karmel in Regulated Exchanges: Dynamic Agents of Economic Growth, Larry Harris, General Editor. New York: Oxford University Press, 2010.
Running the World’s Markets: the Governance of Financial Infrastructure, Roben Lee. Princeton and Oxford: Princeton University Press, 2011.
And as one example among thousands on line for those wanting regulatory relief, “Departing tough bank regulator is a pivotal moment for Wall Street. After Tarullo, the prospect of regulatory relief for financial firm looms.” Financial Times, 31 March 2017.
As an example of those proning the value regulatory guidance, “Give Us Global Standards of Give Us Chaos: Open Letter to Congressman McHenry.” FinReg Alert website, 23 March 2013.