Larry Tabb on Rethinking Market Regulation

Larry Tabb, founder and CEO of the eponymous financial-market research and advisory firm, has a provocative and strongly worded article in the new Advanced Trading magazine. Excerpts:

... Starting with Reg FD, through decimalization, Reg NMS, the Analyst Research Settlements and Sarbanes-Oxley, regulators and legislators have made it virtually impossible to raise equity capital, invest in publicly owned small and midsize companies, and provide investor liquidity. While these rules were intended to promote free and fair markets, they all have had unintended consequences: They have broken the intermediary (broker-dealer/market maker) business model.

Who cares about the intermediaries? Aren't they just speculators? Yes, but they are regulated speculators chartered to bridge demand and dampen volatility. In a world long ago (pre-2000), intermediaries developed research, underwrote new issues, supported securities in the secondary market, and provided insight to investors and corporations. All of these services have been undermined. ...

Read the full article for Mr. Tabb's discussion of the difficulties of research and capital raising; for this space I'll focus my excerpting on his commentary about trading:

... On the trading side, U.S. equity markets have seen spreads collapse, liquidity fragment and commissions decline. Isn't this a good thing? Yes, but the regulation, technology and competition that lowered trading barriers also have made it virtually impossible for market makers to display large blocks of liquidity. Without the ability to show size, liquidity has disappeared into dark pools, and the transparent market has become supported by less capitalized and less regulated shadow market makers (i.e., hedge funds and proprietary trading shops) that have no mandatory vested interest in the marketplace.

So what happens when the large dealers cede market making to smaller, more-automated and less regulated firms? First, these shadow market makers have less capital; less capital means less size, and less size means more volatility. Second, as opportunities vanish, dealers shift their focus elsewhere. As banks lost their ability to profit in the equity markets in the roles of market makers and agency brokers, they have shifted their resources to proprietary trading and other less transparent trading strategies.

Mr. Tabb's principles for rethinking market regulation:

We need to develop incentives for capital formation, price discovery, smooth capital transfer and better risk management, and ingrain them into the underlying framework of the markets. And if this means private equity may suffer because there are greater opportunities to raise capital in the stock market, or proprietary trading shops and hedge funds need to be regulated as market makers, or investors need to sacrifice low commissions for less volatility and greater liquidity -- so be it. Unless we rethink market regulation from the ground up, we will just be placing Band-Aids on a damaged market and will be doomed to repeat the sins of the recent past.

Do you agree or disagree? As always, your views are welcome in the comment box below.

Comments

[Tom Armistead:]

Larry's article is correct in identifying a serious problem - the market no longer supports capital formation and has become excessivley volatile.

He is incorrect in believing that less regulation is the answer.

After about episode number 40 of smart money investing in financials only to be immediately cut in half by the short and distort crowd, not to mention the CDS speculators empowered by the abiltiy to in effect indulge in naked short-selling of bonds, there was no more capital for any financial company. So now the government has been obliged to step in.

More regulation is the answer, and it needs to be directed at CDS and naked short-selling.

Apr 02 05:37 PM