1. Legal Aspects of Finance Slide Set 2 The Role of Regulation on the Markets Matti Rudanko

2. Legal Aspects of Finance 2 2 Why Regulate the Markets? Mere policing purposes –investor protection –market functioning (efficiency): fair trading, codes of conduct, transparency, confidence guidance intervention –scope and breadth of the markets –cannot be justified (Zufferey)

3. Legal Aspects of Finance 2 3 Indications for regulation? Financialisation (over-developed financial markets): financial bubbles, “bancocracy” ? –No link to the underlying economy: too abstract for attempts to determine the proper size (guidance function) Increased volatility (no clear trend recently) –no regulation can control price fluctuations –markets include inherent risks –volatility may be advantageous for investors

4. Legal Aspects of Finance 2 4 Episodic volatility Hypervolatility and disorder of the markets undermine conditions of reasoned decisions Target for policing intervention aiming at normal volatility limited to market risks –domino effects –investor reliance, market psychology –impact on the underlying economy

5. Legal Aspects of Finance 2 5 Episodic volatility, cont´d Policing intervention –market stability through investor protection –price formation mechanism –trading halts in the event of a crisis –efficiency of clearing systems Target for guidance intervention? –Slowing down the market, increasing transaction costs (e.g. margin deposits imposed on investors on credit)

6. Legal Aspects of Finance 2 6 Investor Protection Direct protection: eg. ensuring transparency –sanctioned disclosure duties –anonymity of the market prevents investors from “contractual” information seeking Indirect protection –protection of the weaker (cf. institutional investors)? –Often a by-product of other (e.g. insider) rules

7. Legal Aspects of Finance 2 7 No Investor Protection? E.g. disclosure regulation: –capacity of investors to evaluate information is unequal and limited (cf. also the role of psychological “irrational” factors) –market forces take care of sufficient information by affecting prices (risk averse) investors are willing to pay –on efficient markets, prices reflect all information

8. Legal Aspects of Finance 2 8 Investor protection / market functions? Market efficiency may require –minimum quality standards of operators having access to the markets –codes of conduct for all participants to avoid malpractice –quality standards of traded products –the quality of market support systems (marketplaces, information and clearing systems etc.)

9. Legal Aspects of Finance 29 Insider offences: damages to whom ? Concealing information? Trading? These aspects together? Disclose or abstain rule Existence of damage? Would have purchased anyway? Consider the hypothetic impact of –insider abstaining / disclosure

10. Legal Aspects of Finance 210 (De)regulation? Pros and cons: Reliance on the market –fair play -rules –cf. (bad) luck -argument (random / regular gains) efficiency ethical aspects investor protection: damages? the position of the issuer and its management

11. Legal Aspects of Finance 211 Background: market efficiency

12. Legal Aspects of Finance 2 12 Informational efficiency Efficient Capital Markets Hypothesis (ECMH) making use of inside information - disclose or abstain - duty to disclose ? –Efficiency of information production –incentive effects –accuracy and speed of information production –protective measures within companies: costs of insider trading / costs of disclosure (procedure costs / secrets) –self regulation / public regulation

13. Legal Aspects of Finance 213 Issuer company and management Part of remuneration and incentive systems of management –moral hazard? Increased capital costs ? –Increased spread because of management activity and outsider reactions monitoring costs (agency costs) internal efficiency –information flows –misuse of management position e.g. in thwarting a takeover

14. Legal Aspects of Finance 214 Ethical aspects The unfairness of the possibility to make use of one’s position ethics / efficiency distributive aspects –impact on distribution of wealth –not based on productive work –cf. Labor and capital as factors of production (Marx)

15. Legal Aspects of Finance 2 15 Protection of the Market Function Technical efficiency –computerization: support by legal measures ensuring system reliability (responsibility of sponsors) Information efficiency (ECMH) Institutional efficiency –investor confidence leads to –liquidity and resistance to fluctuations –trading halts and suspensions

16. Legal Aspects of Finance 2 16 Protection of the Market Function, cont’d competition of systems, intermediaries and products pricing mechanisms, operator access and listed issuers self regulation based on general compulsory principles in law –avoidance of unfair competition –globalization of trading systems –moreover governed by competition rules

17. Legal Aspects of Finance 2 17 Conclusions Regulation should not eliminate market risk –cf. the Finnish investor compensation fund safeguarding the cash and claims of clients in case of insolvency or other non- performance of an investment firm important to seek optimal level of protection costs risk of “moral hazard” should be eliminated imperative of minimal intervention based on economic analysis

18. Legal Aspects of Finance 2 18 Increased competition Globalization increases competition between marketplaces (exchanges) –computerization leads to global dissemination of information –from “public service” exchanges to “enterprise” exchanges: diversification of products offered, campaigns increased competition of intermediaries –cf. e.g. online brokerage: customers’self service

19. Legal Aspects of Finance 2 19 Competition and Regulation International imperative: non-intervention –only self-regulation can support the really needed technical improvements –state regulation for increased competitiveness is economically inefficient –liquidity cannot be reached by regulation –regulation to increase international competitiveness would lead to a “race to the bottom” in e.g. investor protection

20. Legal Aspects of Finance 2 20 National competitiveness National imperative: intervention increasing competitiveness of domestic marketplaces –e.g. France, Germany, Austria, Switzerland guaranteeing a competitive level of competition is a legitimate cause for intervention –must be limited to the needs of investor protection and market function

21. Legal Aspects of Finance 2 21 Concentration Acceptable target for policy regulation when affecting market functions (the price formation ability) –e.g., concentration of intermediaries increases the risk of conflict of interests –codes of conduct no need for guidance intervention –e.g. growth, survival of the national branch –cf. competition law