Rethinking Market Regulation

The markets are a mess. Credit markets are in cryo-stasis, equity liquidity is evaporating, blocks are disappearing, large dealers are melting and price discovery is increasingly being determined by unregulated firms leveraging technology that makes particle accelerators look antiquated. But while legislators, regulators and various attorneys general have tried to keep our markets "fair," their tinkering has hurt the markets rather than helped.

Starting with Reg FD, through decimalization, Reg NMS, the Analyst Research Settlements and Sarbanes-Oxley, regulators and legislators have made it virtually impossible to raise equity capital, invest in publicly owned small and midsize companies, and provide investor liquidity. While these rules were intended to promote free and fair markets, they all have had unintended consequences: They have broken the intermediary (broker-dealer/market maker) business model.

Who cares about the intermediaries? Aren't they just speculators? Yes, but they are regulated speculators chartered to bridge demand and dampen volatility. In a world long ago (pre-2000), intermediaries developed research, underwrote new issues, supported securities in the secondary market, and provided insight to investors and corporations. All of these services have been undermined.

Sarbanes-Oxley made it more difficult for small and midsize firms to go public. We have reduced the quality and quantity of branded, publicly available information through Reg FD, and destroyed the research business model through the Research Settlements. These regulations virtually eliminated IPOs, forced small and midsize firms into the private equity markets, and made it more difficult for individual investors to obtain branded corporate information and insight.

Although independent research still exists, it is expensive and out of reach for most investors. And while the Internet provides access to vast quantities of information, who can you trust? While brokers certainly colored their perspectives, at least their research was branded and their motives were transparent. Internet-based insight and, to a certain extent, independent research are less regulated and their biases more opaque.

On the trading side, U.S. equity markets have seen spreads collapse, liquidity fragment and commissions decline. Isn't this a good thing? Yes, but the regulation, technology and competition that lowered trading barriers also have made it virtually impossible for market makers to display large blocks of liquidity. Without the ability to show size, liquidity has disappeared into dark pools, and the transparent market has become supported by less capitalized and less regulated shadow market makers (i.e., hedge funds and proprietary trading shops) that have no mandatory vested interest in the marketplace.

So what happens when the large dealers cede market making to smaller, more-automated and less regulated firms? First, these shadow market makers have less capital; less capital means less size, and less size means more volatility. Second, as opportunities vanish, dealers shift their focus elsewhere. As banks lost their ability to profit in the equity markets in the roles of market makers and agency brokers, they have shifted their resources to proprietary trading and other less transparent trading strategies.

I wish that by rolling back the regulations of the past we could fix the markets of the future. But the world has changed and the genie's bottle is uncorked. Instead, as we rethink how the financial world should be regulated, we need to take into account how the markets should work, who the players are, their roles in the market and the level of regulation they need. We cannot just incorporate the current technologies, trading mechanisms and strategies into the regulations of the future.

We need to develop incentives for capital formation, price discovery, smooth capital transfer and better risk management, and ingrain them into the underlying framework of the markets. And if this means private equity may suffer because there are greater opportunities to raise capital in the stock market, or proprietary trading shops and hedge funds need to be regulated as market makers, or investors need to sacrifice low commissions for less volatility and greater liquidity -- so be it. Unless we rethink market regulation from the ground up, we will just be placing Band-Aids on a damaged market and will be doomed to repeat the sins of the recent past.