The essential role of securities regulation…

Recognising and protecting the implied contract, to act in one’s best interests, between consumers of financial services and advisors should lead to more market efficient outcomes, should better maintain the integrity of the market place and raise the confidence of consumers in the advice they receive and the markets and securities in which they invest.

I wanted to address a central theme in Bill Rice’s recent address. This theme is the apparent regulatory focus on intermediaries (noted throughout his speech) to the exclusion of consumers.  

The following is taken from “The Essential Role of Securities Regulation, Duke Law Journal February 2006”.

“Any serious examination of the role and function of securities regulation must sidestep the widespread, yet misguided, belief that securities regulation aims at protecting the common investor….…The law of securities regulation may be divided into three broad categories: disclosure duties, restrictions on fraud and manipulation, and restrictions on insider trading.

Efficient markets are characterized by accurate pricing and high liquidity. Accurate pricing is essential for achieving efficient allocation of resources in the economy. Accurate pricing is also important to the market for corporate control, for monitoring and controlling the management agency problem, and for the allocation of resources through initial public offerings and secondary offerings. Liquid markets benefit the economy by reducing the cost of transacting and the risk associated with investments. Markets are liquid when traders can buy or sell large quantities, immediately, without causing a substantial price effect.”

At one level, securities market regulation is correct to ignore the role of the consumers of financial services.  But this assumes that their interaction with intermediaries is limited, efficient and rationale, as per Bill Rice’s comment from his speech:

Our securities regulatory regime in Canada is fundamentally built around the concepts of full, true and plain disclosure and the consequential ability of an investor to make an informed decision. These informed decisions by investors do not relate only to the securities they purchase and sell but also to the roles, expertise, duties and costs of the intermediaries they engage.”

But, if the investor is deferring to the recommendation of their advisors (for valid reasons) and hence not directly engaging fully and efficiently in the market place, there is a risk that transaction costs, efficient pricing and allocation of resources will be compromised.  

In reality, the market for retail financial advice is removed from the securities market, with investors delegating key decisions (asset allocation, security, risk/return and time frame) to their advisors.  Instead of consumers acting on their own behalf using advisors as intermediaries only, we have advisors implicitly representing that they are acting on their clients’ best interests, which invalidates the argument that allows one to ignore consumer protection in the securities market equation.

Failure to properly regulate the retail financial services market place, by raising the responsibility of advisors to that of a bests interests standard (which would raise the importance of their interaction with capital markets), impairs market pricing (and costs) and efficient resource allocation.  Instead of rationale efficient decisions we have conflicted/self interested decisions leading to inefficient market outcomes.

Securities regulation needs to close the loop by properly regulating the fiduciary type relationships that predominate in the retail financial services market place.  Such regulation re-establishes transactions (that pass through advisors) as closer to the efficient market interactions that they need to be become to protect the integrity of the market place. 

Recognising and protecting the implied contract, to act in one’s best interests, between consumers of financial services and advisors should lead to more market efficient outcomes, should better maintain the integrity of the market place and raise the confidence of consumers in the advice they receive and the markets and securities in which they invest. 

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