Unregulated exchanges

A system of checks and balances

Financial regulation is not always a good thing. Regulation can be over-zealous. It is too easy for a safety-first mentality to set in, where a regulator who bans everything achieves great safety and soundness, without a whiff of scandal. As an example, if the initial margin of a futures market is 100% of the notional value of the position, the clearing corporation is surely safe, but then you've lost the futures market.

It is useful to have a system of checks and balances whereby the regulated market is forced to compete, to some extent, with an unregulated market. Atleast some customers should make the choice of whether they want to be in the unregulated market. This will put pressure on regulators to not be over-zealous.

The natural participants on unregulated markets are `big' customers who can generally be expected to look after themselves, so that governments do not need to step into markets to protect them on the grounds of investor protection. The role of the State can then drop down to contract enforcement. On this subject, you might like to see page 150-152 of the MIFC report.

Unregulated fund management

The great success story of this approach, of course, is the hedge fund: an unregulated fund management vehicle accessible only to rich people. Rich people have a choice between going to a regulated mutual fund vs. an unregulated hedge fund. If the government is adding value through regulation of mutual funds, rich people will use mutual funds; else hedge funds will gain favour. The remarkable success of hedge funds worldwide suggests, to me, that regulation of mutual funds has gone too far in terms of imposing restrictions.

Unregulated exchanges

A new frontier seems to be opening up in this debate: unregulated exchanges. In the US, the Commodity Futures Modernisation Act setup a light regulatory mechanism for exchanges where there are no retail customers. This paved the way for Internet websites that do trading, and injected a new level of competition into the exchange industry.

The next frontier in private exchanges is exchanges where professionals trade in shares of unlisted companies. See this blog entry by Roger Ehrenberg. I think there are a few different fascinating angles here.

At the simplest, one can think of this as a harmless pre-IPO trading mechanism. At present, before the IPO, transactions do take place. They are preceded by old-fashioned negotiation through human networks and face to face meetings. So it seems natural to ask: Can computer technology be applied to reduce the frictions of trading? Since the firms are unlisted, and the participants are private equity investors, it seems reasonable to think that this is entirely unregulated.

But there are other, deeper implications. Suppose this works well. Then unlisted firms could treat this as a legitimate alternative to going public! Some firms could think they're better off without the entire barrage of legal and regulatory complexity which comes from doing an IPO.

In the old world, the stark tradeoff given to firms was: Stay unlisted, you have full freedom and flexibility, but there is no liquidity, and valuations are terrible. Alternatively, the firm could get listed, gain liquidity and improve valuations, but then there was a barrage of regulatory constraints.

These private exchanges could mature into offering a third path: where no constraints are imposed, a little liquidity is obtained, and maybe valuations are not as bad as used to be the case without liquidity.

I personally believe in the virtues of the `package deal' of listing on public exchanges and large-scale direct shareholding by households, backed by rules about disclosure and corporate governance, which gives remarkable liquidity and market efficiency. I've spent half my life trying to help build that ecosystem.

But we should not assume that this `package deal' is good. A viable framework for trading shares of unlisted firms, without any of the legal and regulatory overheads that come from going IPO, would improve competition against this package deal, and induce greater checks and balances in the economy.