Magazine article The International Economy

Whom Do Today's Financial Markets Serve? Time for a Fundamental Discussion of Our Vision of Markets

Magazine article The International Economy

Whom Do Today's Financial Markets Serve? Time for a Fundamental Discussion of Our Vision of Markets

Article excerpt

America's financial markets have changed. They once served to generate wealth; today, they are more concerned with rearranging it. Their added volume once offered stability; today that added volume often exacerbates manic reactions to world events. We see these changes, but are yet to accept that they demand a reassessment of the goals and strategies of financial market regulation. We attempt here to further that discussion.

After the wreckage of the 2008 crash, the Dodd-Frank Wall Street Reform and Consumer Protection Act became the capstone of the regulatory regime. It was based on the premise that, when markets fail, it was because culprits like those who enabled the 2008 debacle--both individual and institutional--were to blame. Creating stable, "good" markets meant weeding out bad apples and passing rules that tightly constrained their behavior. So Dodd-Frank limited who could trade what (starting with the Volcker Rule), defined new rules for the securitization of assets, embraced anticipatory testing, and increased capital standards, all in an effort to preclude future misbehavior that could lead to another crash.

Yet despite these new barriers to misconduct, crises persist. Last year, exchange traded funds, the most rapidly growing segment of the equities market, were left without a workable pricing mechanism in the absence of sufficient liquidity in their underlying securities. And this year has seen further chaos in currency, commodity, and securities markets, driven by wild investor responses to Brexit, the mystery that is China, and a precipitous drop in oil prices. Defenders note that all these events bring new information that provides grist for the market's mill. But there can be no denying that they are also a trigger for the type of manic gyrations that give regulators pause.

As Edward G. Robinson's Pharaoh would say, where is your Dodd-Frank now? That is not to make a final judgment about Dodd-Frank's individual strictures. But all of these incidents lacked the identifiable culprits upon whose existence Dodd-Frank was based, and remind us that a search for "good guys" and "bad guys" in the market will not avoid future disruptions. Instead, these events are a reminder that today's markets have evolved in directions that transcend the conventional regulatory framework on which Dodd-Frank is premised, at the prospective cost of market stability.

The political season has cast a spotlight on this and related issues. Some see Dodd-Frank as an example of unnecessary regulatory overreach (leaving aside how they would instead prevent new crises from occurring). Others want to bring back Glass-Steagall (despite its irrelevance to the mechanics of the 2008 crash). Still others want to "break up" the big banks (without thought to the way in which this would be done, the sector's future efficiency, or its possible effects on counterparty risk). But before we begin yet another round of separating the black hats from the white, we should consider the fundamental premises that underlie regulation regarding the role of today's capital markets in the economy. That is, what job do we want markets to do, and are they doing it?

Back in the days of a different "Dodd"--David Dodd, who with his co-author, Benjamin Graham, published the revered text Securities Analysis and introduced the concept of "value investing"--markets existed to channel capital to its most productive uses by pricing companies and their securities. American markets were the envy of the world because, through reporting and listing standards and other regulatory safeguards, investors could participate in this fundamental exercise. This produced liquidity, which improved the pricing function, which dramatically reduced the cost of capital, with ensuing benefits for the U.S. economy. Regulators were tasked with overseeing this process by promulgating rules and standards that mandated transparency by issuers and ensured fairness for all market participants. …

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