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Home | Mises Library | Clogging Capital Markets

Clogging Capital Markets

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06/09/2006Gregory Bresiger

Did you hear the recent giant sigh of collective relief from the securities industry? It was the sound of those securities professionals who, for now, dodged a regulatory bullet.

Regulation National Market System's June 29th trade-through rule mandate had become a dead letter. Indeed, after months of confusing Reg NMS instructions from the staff of the Securities and Exchange Commission, a new trade-through rule schedule was announced that will be pushed back into next year. Some critics hope the rule will eventually be killed.

The announcement of the delay came much to the relief of brokerage officials, who feared that they could never meet the deadline because of the massive technological preparations required for a giant new set of trading rules. Some of these officials, by the way, were among those who had opposed the rule, which passed the United States Securities and Exchange Commission on a controversial 3-2 vote last year.

The two free-market oriented members of the commission loudly dissented. That's because they stated that Reg NMS amounts to a form of overregulation.

One of the dissenters, Commissioner Paul Atkins, called it "ill-conceived."

What is a trade-through rule?

A Trade-Through Seminar

It is a rule designed to ensure that the individual investor can find the best price for a stock. Supporters of the trade-through rule say it would protect investors by requiring brokers, investment managers, and exchanges to prove that they have sent all their orders to the exchange displaying the best price. This is part of what regulators, charged with protecting individual investors, call the obligations of "best execution."

But some exchanges fighting the rule had argued that best execution isn't always a question of the best price. The nature of best execution has a subjective element, they have argued. They have said that some of their clients sometimes prefer speed over the cheapest price; that quality of execution depends on more than the lowest number. Big transactions, they argue, must have the quickest execution. That's because these transactions, they add, have a large potential market impact that could move a stock price away from the desired stock price.

Speed can lessen this impact, a vital issue for those trying to trade millions of shares. Reg NMS detractors also fear that the administration of this complex rule — a rule contains many provisions — will leave much to doubt; that it will be easy to penalize anyone on almost anything. Said one critic of trade-through: "It gives too much discretion to the staff of the SEC." This critic hopes delay will eventually lead to the gutting of the rule.

The rule is identified with traditional auction markets such as the New York Stock Exchange, which has had a trade-through rule for years. The Big Board, which supported the rule's extension to other markets, has consistently argued that its manual trading system produces trading that is less volatile than its electronic competitors. NASDAQ, Big Board's primary rival, vigorously fought the trade-through rule at the same time it was trying to use its electronic system to take away listed business from NYSE.

Indeed, one of the goals of the trade-through rule is to encourage electronic trading. That's because, in general, only electronic systems can provide the exhaustive efforts required by the rule to find the best price. However, the NYSE, in the extra year or so it and everyone else now has to comply with all the provisions of Reg NMS, might go completely electronic in that time, making the trade-through rule superfluous.

The argument of trade-through critics last year, and quietly this year in some quarters, is let the client make up his or her mind. Indeed, Atkins, an SEC commissioner who voted against the Reg NMS, even today suggests the debate should be re-opened and that an opt-out provision should be considered. But even in undoing what many think was an example of overregulation, the SEC could make things worse.

If the SEC ever revisited the trade-through rule, and added an opt-out provision, would the net effect be to gut the rule?

"It would depend," said one broker who looks at the rule as a case of overregulation, "on how the SEC did it. If they allowed for an easy opt-out, then it would work. However, they could add so many conditions that the opt-out wouldn't be worth using," he said.

"The Big Board, in going electronic, in realizing that the floor is endangered, may very well realize that this rule will not help its efforts to compete with electronic exchanges," the broker speculated.

Regulatory Hell

But aside from the obvious legal and economic debates raised by Reg NMS, its passage and its implementation, there is a bigger issue that affects all overregulated economies: The credibility of regulation; its controversial and confusing nature.

Ultimately regulatory debates are limited to a select group of administrators who take on the powers of elected lawmakers, whether the latter appreciate this or not. And regulation, by its nature, almost always has unintended effects. It is often ineffective because a dynamic economy grows at a much faster pace than any commission can come up with relevant rules and regulations.

For example, it has taken some five years for NASDAQ just to go through the regulatory process and win exchange status. Actually, the process is still not quite completed. Commissioner Paul Atkins recently said the exchange "application process was horrendous." But it wasn't the first time for NASDAQ. Several years ago NASDAQ came up with a new trading system to aggregate quotes. It was called SuperMontage, and it was expected to help capture more business. It never worked as planned.

The idea might or might not have been a good one. But, because it took about a year and half for the SuperMontage specifications to win SEC approval, by the time the system became effective, it was no longer a technological leap ahead for NASDAQ. SuperMontage never was what NASDAQ had hoped it would be. Was it NASDAQ's fault for designing a system that wasn't first rate, or was it because the regulators are inherently slow in reviewing the application? My bet is on the latter.

A Reg NMS for Everyone

Finally, one can't leave the Reg NMS issue without another general observation about the democratic regulatory process. The delegation of power to commissions is an often messy, confusing, process. And it usually produces nugatory, sometimes ridiculous, results.

The Reg NMS cause célèbre — how it was passed and how it is put into effect — is an egregious example of how regulators tend to administer complex rules in a mature, minutely engineered, democracy. As government and regulation grow larger, rules must become more involved. As regulators try to keep up with a growing economy that moves much faster than any government regulatory commission can ever move, rules are often counterproductive.

Regulatory commissions — at the behest of the staff — often pass convoluted new rules. These are rules that usually only specialized attorneys can understand, no less than the average member of Congress, who spends a huge amount of time on the hustings and little time actually studying regulatory or economic issues. (An aside: Some seven years ago, in a town hall meeting in Kew Gardens, my member of Congress, Rep. Anthony Weiner (D-New York), said payroll taxes were "only" 7.65 percent. In fact, they are double that. The employer pays 7.65 percent on behalf of the employee. So payroll taxes for employees are actually 15.30 percent, one hundred percent more than my Congressman was telling his constituents!)

How do lawmakers oversee agencies such as the SEC? A member of Congress who becomes involved in these trading industry debates will often write letters at the behest of a stock exchange but usually has no clue what it is he or she is supporting. The quality of drivel in these letters to the SEC is about the same as the marvelous moonshine one gets whenever one writes to members of Congress about poor postal service or some other common mishap of our leviathan.

Members of Congress, with the exception of a few key committee chairmen, were hardly a factor in the whole Reg NMS debate. That's even though the SEC is a creature of Congress, which is supposed to oversee its operations. But Congress can no more effectively oversee these commissions than it can effectively oversee a president who wants to plunge the country into what is later revealed to be a needless war.

Most lawmakers seem to have neither the time nor the expertise to oversee specialized areas such as national security, Social Security, or trading. Nevertheless, this Reg NMS debate, which wasn't much of a debate on Capitol Hill, was about the greatest set of changes in market structure in the last 30 years. Congress held some hearings, but basically it was the SEC's call, which actually meant the staff more than the commissioners.

Often, even the appointed members of regulatory commissions — who are charged by the president to establish the policies, and supervise the staff — don't understand the complex issues or don't have the time to craft the regulations that govern vital parts of our economy. For example, Reg NMS generally has been viewed as the creation of the Market Regulation Division of the SEC, not the commissioners. This was an inevitable outcome of how regulatory commissions function in a world of government run amuck.

Regulatory Fun and Games

A Reg NMS critic said the recent announced delay shows the futility of the rule and the perils of regulation.

"They're delaying this another year and half. Hey, a hell of a lot can happen in market structure in a year and a half. This could all be academic," he said. This critic, a broker executive, said that funny things could happen to the rule. He suggested that the one definite way that the rule could be gutted or formally dropped would be if the New York Stock Exchange, the main defender of the rule and its extension, were to reverse its position and ask the SEC not to implement it.

And while this key market structure issue is playing out, what about Congress? For most, the only point of the debate was, and is, a political one. For example, most of the New York area lawmakers, probably at the suggestion of their staffs and their fundraisers, sent letters to the SEC supporting whatever the Big Board said in the trade-through debate.

I would speculate that most of the members of Congress had about as much chance of understanding the debate as I do of being penciled in as the starting second baseman for the New York Yankees in their next game. (Disclosure: I did play the Keystone in Highbridge in the Bronx. But that was over 40 years and 40 pounds ago).

Even the heads of these commissions often play minor roles in these regulatory debates. That's because SEC commissioners serve for relative short periods of time. But the civil servants who administer these rules usually serve many more years on these commissions than the policy makers. The latter are supposed to be the most important players in these regulatory dramas, but are usually reduced to bit roles.

The same happens, by the way, at the government cabinet level, as was depicted in the BBC television show, "Yes, Minister." This was a show in which the fictional minister — the head of a cabinet level department — was portrayed as a human blank. Nevertheless, a real life example from the United Kingdom can be found in "The Cabinet Diaries of Richard Crossman." He was a Home Secretary in the Wilson government of the mid 1960s and felt constant frustration in trying to run his department. Crossman couldn't even come into the office on Saturdays without a civil servant to let him in!

Finding Work for Lawyers

These massive regulatory rules amount to a kind of a Keynesian full-employment scheme for specialized attorneys and bureaucrats. They are part of an elite, un-elected group that may or may not actually understand how their actions can vitally affect the trading world and other regulated industries. An example: The staff of the Interstate Commerce Commission (ICC) was surprised when Penn Central railroad imploded in the early 1970s.

But why should the ICC staff have been surprised? The overregulated Pennsylvania Railroad, which had finally merged with the New York Central in the 1960s after over a decade of regulatory dithering, had been sick for decades.

Some of these regulators at the SEC have never run a trading desk. On the other hand, some of these civil servants, by virtue of their regulatory expertise, will be offered high-paid private sector jobs once they leave the precincts of government. Some firms, always conscious of the myriad ways they could run afoul of regulators, consider these hirings a kind of insurance policy. That's all part of a flawed regulatory system.

Our expanding regulatory system is not only massive, expensive, and Byzantine; it is ridiculous. It neither helps nor informs the people it supposedly serves. It only confuses, confounds, and runs up huge compliance costs. And, like so many other parts of our leviathan, no one official, group, or commission can be held accountable.

The commissioners come and go — as I write these words one of the two SEC commissioners to vote against Reg NMS announced her resignation — while the staff effectively makes policy without accountability. That's because it will often take new commissioners years to get up to speed, but then anon it's time for a commissioner to move on. The new commissioner will likely be heavily dependent on the staff for some time. By the time he or she learns how to say hello, it will be time to say goodbye.

Think about that and heave a huge sigh of relief when your business finds a way to avoid some new arcane government rule or a way to pass up a visit to some government commission, bureau, or agency.

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