The image of a blind-folded person trying to figure out where the building ends is the point of this opinion – as applied to financial services, the question is the uncertain outline of “the regulatory perimeter.” When I am the party advancing funds, am I in a relatively well-regulated environment? Where in financial services does financial oversight end? How much is oversight worth anyway?
Strictly speaking, is there a regulatory perimeter as one uses the term? In fact, there is no sharp line; it is above all blurry when one is involved in financial product segments that approach its ever diminishing, vague “end[1].” There is a lot of “sort of” and “partly” involved in judgment calls as to what is reviewed and what low level oversight means. As financial complexity accelerates, I think IFCs have an enhanced communications role to play.
There are good reasons to work in regulated and unregulated environments. The point is to understand where one is relative to that perimeter, what falls inside and what falls outside of what is, in fact, not a clear demarcation. This uncertainty can be an advantage - depending upon one’s objectives and appetite for risk.
The Goal of Financial Oversight
First, a word of caution: financial oversight cannot and does not guarantee every outcome. I will begin with the exception. In many countries, central bank supervision of credit institutions comes with guarantees for deposits, up to a published limit. That is the most specific regulatory result I can think of. As to the rest, financial services regulation is an art, like lawyering and auditing. Nothing replaces thoughtful analysis by all participants.
Regulators strive to have banks and insurers, corporations, financial advisors and infrastructures provide basic financial information in their areas of expertise in somewhat standardized format. The authorities do not provide investment advice; their work is to facilitate risk/reward analysis by participants.
WAIFC is a global network, so I will use the Financial Stability Board’s definitions. “Regulation promotes global financial stability by coordinating national authorities and international standard-setting bodies. The FSB aims to develop strong regulatory policies that address system vulnerabilities, prevent crises, and foster a level playing field across sectors and borders.[2]” Regulation evolves as financial services change.
The core purposes of regulation are:
- Assessing and Mitigating Vulnerabilities: identifying risks on an ongoing basis from a macroprudential perspective, preventing small cracks in the financial system from turning into major crises. The FSB has set up information systems to get early warnings of potential vulnerabilities.
- Coordinating Global Standards: establishing and promoting the consistent implementation of internationally agreed minimum regulatory and supervisory standards across all business areas to limit cross-market arbitrage.
- Supporting Sustainable Growth: ensuring that financial institutions and markets are resilient enough to absorb economic shocks, thereby protecting the wider economy and the ongoing provision of services. This work entails surveillance of, and participation in, emerging technologies, like digital currencies at the time of writing.
The Value of Oversight
What do we get for all this effort? Simply put, better information for decision-making instills confidence. This is why citizens in many countries deposit their cash in a regulated bank, knowing that the central bank is behind it. The proof of value is that liquidity is higher and pricing is tighter in more regulated securities market segments than in their private counterparts.
Oversight does not mean that the authorities will make up for a private sector loss.[3]
Working Closer to the Perimeter
This is a matter of judging risk/reward for all actors. The less valuable the information provided about a particular service or product and the party offering it, the riskier the proposition. That can entice people who can manage the risk appetite in the hope of something cheaper or offering a higher return, at a cost of low liquidity and irregular pricing.
Here is my word of caution. Unlike the person in the image above, there is no clear cut-off as one gradually moves away from core areas of regulation, most frequently related to equities and supervised derivatives markets. Usually, bonds are less regulated than stocks. Private equity is, by definition, not for sale in a public market. The same is true for private credit markets run by institutions that are not regulated banks.
But there are subtleties. The effect of market oversight is a matter of gradation, of gradually diminishing effect. An investor in private equity or an OTC contract of some kind may have the registered shares or certificates of ownership held in a well-regulated custody bank, and that assures that ownership is maintained and interest and dividends are properly paid. Part of the transaction takes place in a heavily regulated environment with the protection that affords, part not.
Investors may choose to have the entire transaction take place outside the regulatory environment. That avoids the costs incurred in paying for regulatory disclosures and protections, and some may prefer that.
The Sophisticated Investor
A critical goal for regulatory agencies is to protect investors, the parties advancing money. In their work, the authorities usually distinguish between experienced investors and their ability to assess risk, and everybody else. Just who is considered “a sophisticated investor” able to assess these questions varies. This opinion contrasts two views, that of the US Securities and Exchange Commission and the European Securities Markets Authority.
The SEC defines a sophisticated investor as someone who, alone or with a purchaser representative, has:
- sufficient knowledge and experience in financial and business matters.
- the capability to evaluate the merits and risks of the prospective investment
The ESMA regime first distinguishes professional clients automatically presumed to have the financial expertise and knowledge to manage investment risks. They include credit institutions and authorized financial firms, insurance companies, pension funds, national governments and central banks, and undertakings with set minimum financial resources.
The second category includes retail clients with significant experience and financial backing; they may request to be treated as professional clients. These actors must undergo a qualitative and quantitative assessment by their investment firm to verify they can understand and bear the investment risks. To qualify, the individual must demonstrate sufficient cash and expertise.
For ESMA, no one else is a professional, and the investment advisor is strictly limited in what can be offered.
What I do not see in investment discussions is understanding of where one is positioned relative to regulatory oversight – that is the question this opinion brings to the foreground.
IFCs and The Regulatory Perimeter
The strength – and therefore the value – of regulatory oversight is best viewed as a spectrum, going from the largest, most liquid and heavily traded stocks and bonds to the smaller issues, and then fading out somewhere in the OTC markets, and finally the purely private contracts agreed. A parallel financial services term and concept would be liquidity, and in fact the two are linked.
For the more heavily regulated market segments, investors might find that the costs are worth it for the confidence engendered. The issuers or clients might find that the costs of oversight are worth it for a better overall value. For those who do not, all businesses are free to offer their services. The goal of WAIFC members is indeed to encourage a broad offer with clear communication on what all this is, including on the value and limitations of public oversight.
[1] A favorite analogy comes from the field of physics. The first interplanetary space probes were launched in the 1970s; years later, as they reached “the edge” of the solar system on their way to interstellar space, scientists gave lessons on how the Heliosphere fades out. It took Voyager 1 exactly 35 years to leave the solar wind's bubble (the Heliopause) and enter interstellar space. But like financial regulation, there are other effects at work: because the Sun's ever diminishing gravitational pull extends far beyond this region, it will take the spacecraft another 30,000 years to completely fly beyond our solar system. If the sun were a financial regulator, the planets would be considered more supervised than objects further away.
[2] https://www.fsb.org/about/
[3] The massive public bailouts for bank and insurance company failures in 2008-2009 created what economists call the problem of “moral hazard.” The parties taking the risk were insulated from its costs, which greatly skewed incentives then and since. Public authorities are reluctant to announce in advance what coverage they would provide to failing institutions. A more recent example was the Swiss National Bank’s urgent and forced merger of Credit Suisse and UBS, the terms of which are still being disputed in the courts.