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Sitting here at 4 a.m. unable to sleep as we experience the outer edge of the storm from Hurricane Irene, I came across this story on BlackRock’s (NYSE:BLK) intent for its iShares exchange-traded funds to follow proprietary indexes rather than those developed by third parties such as Standard and Poor’s. Just the heading alone BlackRock Seeks to Run Exchange-Traded Funds Using Own Indexes” was enough to start a flashing red light in my mind on the dangers of pure self regulation / self rating authority.

When the Global Financial Crisis (GFC) unraveled in 2008, there were many instances of companies and organisations too big to fail that did just that; fail – taking billions of dollars off the markets and out of investor’s hands in days, hours and minutes. Strangely enough, many of these failures came from companies in heavily regulated industries (some then and now argued not regulated enough). In the USA, the collapse of Lehman Bros, started a catastrophic collapse of large financial banks, financial services companies, and large multinational corporations (contagion that spread globally and is still not fully recovered). In Australia, we witnessed the collapse of Opes Prime and Storm Financial, which resulted in a Senate Inquiry into the regulation of the financial services industry (the Senate report can be viewed here).

Post crisis analysis indicates that lax regulatory regime makes it possible for financial crisis to occur, but poor regulation alone won’t be the ultimate cause. What is required to minimize financial risk and provide integrity to financial services institutions (including those viewed too big to fail/bail), is centralized regulation with the scope and resources required to regulate specifically large systemic institutions – who more than anyone else require independent oversight rather than SR2. BLK is a typical candidate given its size, capitalization, and the current whipsawing market.

In Australia’s example, a more heavily regulated financial services industry, infinitely smaller in size in comparison to the United States (and therefore one which you would expect be easier to regulate), still revealed such simple examples of failure that promoted a review of the adequacy of current regulation and independent review. While operating within the rule of the law, not operating in the spirit of the law raises investing moral and ethical dilemmas; exactly what occurred with Storm Financial.

A large degree of corporate governance compliance is reliant upon self regulation. In Storms case it was meeting compliance requirements on face value, but in a bull market, it became a question of who was keeping an eye out for the inevitable storm (excuse the pun) on the horizon. Storm Financial charged excessive client fees on entry (7%), utilised a standard statement of advice for clients regardless of individual circumstances (as shown in the Senate Inquiry), was too closely involved with the lending arm of one of Australia’s leading banks (CBA), and was gearing clients heavily into its own Storm branded funds.

When Storm collapsed the only silver lining was that the GFC occurred just prior to Storm’s plan to list on the Australian Stock Exchange, thus limiting the loss of capital to direct clients rather than spreading that risk further across a wider investor base. The outcomes from the Senate Inquiry seeks a continuation of the current prudential and financial regulation within Australia, a delinking of commissions between financial advisors/firms and the products they represent, and a fiduciary requirement to act in the best interests of the client. To that end, independent regulation and review is a necessary requirement to prevent the recurrence of consequences for clients and financial firms, when self regulation / self reviewing authority become self serving.

I don’t write this article to make any recommendation whatsoever on BLK’s financial performance or its suitability for current or potential investors, but I use the article that was written on them by Bloomberg to highlight the potential conflict of interest, and to outlay the potential perils as was witnessed with Storm Financial in Australia. As the Bloomberg article stated, “the SEC has limited the ability of ETFs to rely on in-house indexes out of concern that benchmarks run by affiliates might be prone to manipulation … What the SEC has always been concerned about is collusion.”

If, as BLK states on its website, that “the foundation of BlackRock's business is our belief that our clients’ needs are of paramount importance. Our commitment to investment excellence is anchored in a shared culture that always places a client’s interests first, from individual investors to the world’s largest institutions. We act always as a fiduciary for our clients, never trading as a principal on our own behalf”. If it is to be true to its word, then BLK should not be seeking approval for its exchange-traded funds to follow proprietary indexes rather than those developed by third parties. Instead it should remain at arm’s length, and allow true independent review and regulation to inform the market, and then let the market decide the true worth of the company and its financial products and services. Then and only then will its clients interests always be placed first.

About Blackrock: BLK offers a range of solutions — from rigorous fundamental and quantitative active management approaches aimed at maximizing outperformance to highly efficient indexing strategies designed to gain broad exposure to the world's capital markets. Our clients can access our investment solutions through a variety of product structures, including individual and institutional separate accounts, mutual funds and other pooled investment vehicles, and the industry-leading iShares® ETFs.

BLK closed trading on Friday at $160.99, up $2.35 (1.48%), and is currently trading at a $46.03 (22.23%) discount to its 52 week high.

Disclaimer: This advice is general in nature only, and investors should seek independent financial advice before making any investments of their own.

Source: Why BlackRock And Wall Street Need Independent Regulation And Review