Vive Le Free Markets? Oh, Never Mind

French economist Frédéric Bastiat must be rolling over in his grave as more and more headlines decry capitalism in favor of stringent regulation. In "Policy Makers Weigh Fed Oversight of Derivatives" (February 2, 2009) Wall Street Journal reporter Deborah Solomon writes that Washington movers and shakers are all a twitter about whether to regulate over-the-counter derivative instruments. (One could argue that some regulation currently applies since federally regulated banks dominate this space but that's a discussion for another post.) House Financial Services Chairman Barney Frank (Democrat, Massachusetts) is quoted as saying that "It's not a brand-new regulation but an expansion of the authority of the Federal Reserve."

According to his official website, Senator Chuck Grassley (Republican, Iowa) - along with Senator Carl Levin (Democrat - Michigan) - have introduced legislation to "close a loophole in securities law that allows hedge funds to operate under a cloak of secrecy." In "Grassley and Levin introduce hedge fund transparency bill" (January 29, 2009), this new legislation, if passed, would empower the U.S. Securities and Exchange Commission ("SEC") to force hedge funds to register, thereby putting them under the auspices of the Investment Company Act of 1940.

In his January 29, 2009 statement, Senator Levin described three basic elements of The Hedge Fund Transparency Act, besides registration. These include the filing of an annual statement that would be available to the public, the maintenance of books and records as required by the SEC and the cooperation with the SEC as relates to examination or information requests.

Levin adds:

The information to be made available to the public must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund's primary accountant and broker; and the current value of the fund's assets and assets under management. This information is similar to what was required in the disclosure form under the SEC's 2004 regulatory effort. The bill also authorizes the SEC to require additional information it deems appropriate.

About two weeks earlier, the President's Working Group on Financial Markets ("PWG") released its best practices for hedge funds, encouraging market participants to adopt comprehensive policies and procedures to (hopefully) thwart problems. The institutional version, entitled "Principles and Best Practices for Hedge Fund Investors: Report of the Investors' Committee to the President's Working Group on Financial Markets" (January 15, 2009), includes an entire section devoted to fiduciary issues. Some of the text is overly broad but it is a good start in terms of getting people to think hard about subjects such as suitability and oversight.

The industry version, entitled "Best Practices for the Hedge Fund Industry: Report of the Asset Managers' Committee to the President's Working Group on Financial Markets" (January 15, 2009), has a noteworthy section about valuation (a topic near and dear to my heart). I am particularly interested in tracking which hedge funds decide to set up a valuation committee, if one does not currently exist. If hedge fund managers follow the report's recommendations, they will likely be spending lots of money on independent pricing services.

Two key questions loom. Will industry attempts at best practices slow down or possibly ward off increased regulation? If not, will regulation and enforcement parallel or conflict with suggested best practices?

This blogger gal goes on the record as favoring industry self-regulation. Sadly, when too few participants fail to recognize the benefits of taking responsibility to preserve open and fair markets, the strong arm of government is inevitable. Consider what Bastiat wrote in the 1800s, still relevant today:

• "Everyone wants to live at the expense of the state. They forget that the state wants to live at the expense of everyone."
• "Taxes must, in the end, fall upon the consumer."
• "The worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended."

Whether we end up talking about "smart" or "better" regulation, financial market participants STILL have a chance to eat, live and breathe best practices, for themselves and for their investors.

Comments

[morph366:]

Industry self regulation has self evidently failed - which part of that statement would you disagree with?
"Best practice" was to take bonuses on the entire assumed benefit of a series of complex transactions that hardly anyone (I am being generous) understood and when they failed there was no recourse to the person who took the bonus, or the management that was responsible for corporate governance.

Advocates of free markets flourish best on a subtle (sometimes not so subtle) form of predator/prey dynamics but with the total lack of any self-organization over the last several years even the predators get devoured in the end.

You don't have to be a believer in the virtues of a more active role for the State in the markets to recognize that the absolute "free for all"of recent years provided a regulatory vacuum which permitted egregious and stupid behavior across the whole spectrum of financial services.

Feb 03 06:19 AM

[biomedlives:]

I was planning to comment on this entry, but I can't improve on what morph366 has said. Right on!


On Feb 03 06:19 AM morph366 wrote:

> Industry self regulation has self evidently failed - which part of
> that statement would you disagree with?
> "Best practice" was to take bonuses on the entire assumed benefit
> of a series of complex transactions that hardly anyone (I am being
> generous) understood and when they failed there was no recourse to
> the person who took the bonus, or the management that was responsible
> for corporate governance.
>
> Advocates of free markets flourish best on a subtle (sometimes not
> so subtle) form of predator/prey dynamics but with the total lack
> of any self-organization over the last several years even the predators
> get devoured in the end.
>
> You don't have to be a believer in the virtues of a more active role
> for the State in the markets to recognize that the absolute "free
> for all"of recent years provided a regulatory vacuum which permitted
> egregious and stupid behavior across the whole spectrum of financial
> services.

Feb 03 09:07 AM

[kelm:]

This is a good article. It seems what really needs to happen is for a deep, thoughtful analysis to be conducted to scope out what the real needs of the investor community and economy are. "Needs" as distinct from "what can we can the investment community create and sell". Then scope regulation to allow those products and vehicles to flourish. That is, do a bottoms-up analysis of what the market space should look like, then determine what regulation is required to ensure stability and transparency and go fro there. It'll never happen of course. We will keep trying to patch regulations on to existing products and structures.

Too much of what has passed for investment vehicles in the past 10 years is really not oriented towards market efficiency but lucrative fees. We have to get back to where banking serves the real economy and not itself.

Feb 03 09:32 AM

[Larrysyr:]

Free markets work fine within limits. morpg366 hit the nail on the head with the comment about the recent "free for all" which knew no bounds.

Few free market proponents acknowledge how important a role governments play in enforcing property and contract laws. Without these, there would be no "market," simply banditry. Reasonable regulations requiring and enforcing honest disclosure are merely elements of these necessary laws.

Feb 03 10:39 AM

[Glen L.:]

Not just good, but a fine article. The Bastiat quotes are just what we need to hear, once again.

Once again, the non-believers aka statists jump in to claim that there is some kind of market failure here, and that self-regulation has failed. Thus, we get:

" Advocates of free markets flourish best on a subtle (sometimes not so subtle) form of predator/prey dynamics but with the total lack of any self-organization over the last several years even the predators get devoured in the end."

But this is the way the market SHOULD work - when there are predatory practices, the market shakes out and punishes the predators. You don't need on overbearing government to come in after the fact and invent reams of new regulations, a la Sarbox, to further stifle innovation and crush efficiency. The tax and regulation codes are already the size of several sets of Brittanica, and so Byzantine that almost noone understands them.

What is so obviously needed is less government, lower taxes, less regulation, and more market freedom. And the abolition/failure of the crony capitalism epitomized by the Fed, Treasury Dept, the Little Three in Detroit, and their busom buddy bankers being bailed.

Feb 03 02:57 PM

[American in...:]

That is just not true. Any businessman will tell you that predation works if the government is not watching.

Your comment smacks of an ideology blind to the facts.




On Feb 03 02:57 PM Glen L. wrote:

> Not just good, but a fine article. The Bastiat quotes are just what
> we need to hear, once again.
>
> Once again, the non-believers aka statists jump in to claim that
> there is some kind of market failure here, and that self-regulation
> has failed. Thus, we get:
>
> " Advocates of free markets flourish best on a subtle (sometimes
> not so subtle) form of predator/prey dynamics but with the total
> lack of any self-organization over the last several years even the
> predators get devoured in the end."
>
> But this is the way the market SHOULD work - when there are predatory
> practices, the market shakes out and punishes the predators. You
> don't need on overbearing government to come in after the fact and
> invent reams of new regulations, a la Sarbox, to further stifle innovation
> and crush efficiency. The tax and regulation codes are already the
> size of several sets of Brittanica, and so Byzantine that almost
> noone understands them.
>
> What is so obviously needed is less government, lower taxes, less
> regulation, and more market freedom. And the abolition/failure of
> the crony capitalism epitomized by the Fed, Treasury Dept, the Little
> Three in Detroit, and their busom buddy bankers being bailed.

>
>

Feb 03 04:01 PM