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

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

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

9. 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
Legal Aspects of Finance 2

10. (De)regulation? § ? Pros and cons: Reliance on the market efficiency
fair play -rules
cf. (bad) luck -argument (random / regular gains)
efficiency
ethical aspects
investor protection: damages?
the position of the issuer and its management ?
Legal Aspects of Finance 2

11. Background: market efficiency
Market efficiency concepts
Efficiency of the securities markets
Informational efficiency
Allocative efficiency (allocation of capital)
Operational efficiency

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
Legal Aspects of Finance 2

13. 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
Legal Aspects of Finance 2

14. 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)
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
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
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
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
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
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
Legal Aspects of Finance 2

21. no need for guidance intervention
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
Legal Aspects of Finance 2