SEC's Attempts to Institute Financial Reform Could Also Have a Downside

Sep.18.09 | About: SPDR S&P (KBE)

The financial services industry is about to get its first attempt at genuine reform aimed at protecting consumers and retail investors, as the U.S. Securities and Exchange Commission (SEC) voted today for the first time on whether to ban flash-trading and whether ratings agencies must disclose how much they are paid by big banks.

(On a related note, California’s attorney general Edmund Brown is launching an investigation into the roles ratings agencies played in causing last year’s financial crisis).

The SEC vote is the most aggressive measure since the fall of Lehman Brothers (OTC:LEHMQ) last year that the regulator has sought to scale back the influence that ultra-large financial institutions hold over the direction of the economy.

The attempt is admirable, but the potential downsides to such reforms reveal how tough regulatory decisions that benefit everyone genuinely are.

Flash trading — trading that happens so quickly it excludes certain market participants from seeing certain orders — is considered by many investors to be the most unfair advantage that firms such as Goldman Sachs (NYSE:GS) hold. Many of today’s big-bank quantitative trading models are based around flash trading, which give them a huge buying and selling advantage.

Banks argue that flash trading is necessary for them to employ their models effectively, and in the process brings additional liquidity to the market. In part, that’s true: it’s undeniable that in certain areas of the market, there’s been a huge improvement in bid-ask spreads since the mid-90’s, when these trading platforms were introduced.

A ban on flash trading could therefore lead to a return of much higher bid-ask spreads in certain stocks, a result that investors won’t like very much at all. (It’s also questionable why retail investors, who most experts agree should be investing on a long-term basis anyway, would benefit from an absence of the flash trading advantage banks hold.)

The case for ratings agency reform is a little more clear-cut, but still difficult. On the one hand, there’s little reason for the argument that the ratings agencies shouldn’t be transparent in terms of disclosing where their income is coming from if investors rely on that information to make sound decisions.

Still, if they did disclose their income, who would be likely to follow it? Most probably the disclosures would be headline news for a week or so, and then ultimately get buried into the fine print of the multi-hundred page reports they produce.

One other reform Commissioners will be mulling is a June 2008 proposal that prevents mutual funds from having to rely on ratings agencies’ grades to invest in an asset. The downside to this suggestion is obvious: what other criteria do investors in mutual funds (most of which are small retail investors) have to assure them that their managers won’t be assuming outsize risks?