Information Technology & the Securities Market: The Challenge for Regulators

Massive technological advances, including the increasingly widespread acceptance of the Internet, are revolutionizing U.S. financial markets. Information flows are becoming seamless and borderless, instantaneous and almost costless. The swift changes so far and the still more rapid changes ahead offer opportunities for new value-added services, for the new competitors, and for new forms of competition. They also underline the need for new thinking about regulating the nation’s financial markets.

Technology and the Securities Markets

New information technology has already transformed the securities markets. Order handling has largely been automated by mid-size and larger firms. Mutual funds are using the Internet to communicate with investors and to offer and distribute shares. Corporate issuers, large and small, conduct offerings on the Internet. Investors are starting to bypass traditional exchanges and dealer-based trading systems, using electronic networks to deal directly with each other at lower cost. Retail customers are trading stock on-line rather than calling or visiting a live broker. Certain small issuers have used the Internet to establish secondary trading markets for otherwise fairly illiquid stock without the benefit of the usual market intermediaries.

In the decade ahead, the continued growth of the Internet and its successors will present even greater opportunities for expansion and innovation in financial services, especially as consumers become more wired and more comfortable with electronic communications technologies and as security and confidentiality issues are resolved. The effects will be felt throughout the financial sector. And as the marketplace adapts to new technology, so must regulation.

Information Access and Analysis. Companies conveying more information about themselves through the Internet will level the information playing field between individual investors and institutional investors. Eventually, relatively instantaneous access to portions of management information systems will permit investors to analyze raw financial information as soon as it becomes available – information now aggregated, at great cost, into quarterly and annual financial statements. Improved telecommunications technology, combined with better analytics, search technology, and intelligent (or ?smart”) agent technology, will allow the market better to learn, absorb, and act on information, leading to more precise pricing of and innovative transacting in securities. Ultimately the perceived information risk of an investment will decline and, consequently, so will the corresponding cost of capital.

Corporate Governance. Electronic annual meetings will supplement and then replace “physical” ones. On-line voting will lead to more shareholder voting. Eventually, annual meetings may disappear altogether. Investors will use the equivalent of “chat rooms” to discuss company business. Shareholder activism will be energized. When a company needs improvement, shareholders will be able to use “voice” – corporate governance to enhance shareholder value – in real time, just as they use “exit” – selling their shares-today.

The Role of Intermediaries. Intermediaries who provide primarily communications without otherwise adding value (such as through analysis) will be replaced, sometimes by new intermediaries and new types of intermediation, and sometimes just by the technology itself. Offerings will be conducted electronically without masses of salespeople working for underwriters. Traditional exchanges and broker-dealers will transform themselves and provide new services.

Software providing “expert” financial planning advice for investors will eventually surpass in quality that provided by many human financial planners. Smart agents will compile an investor’s portfolio over the Internet, executing trades with increasingly less participation by the investor, providing convenience, speed, and diversification at low cost. New intermediaries will create the software and the means to run, sell, and promote it, as well as certify, rate, and rank it. As more investors use such technology, mutual funds and investment advisers will shift to add value in other ways.

Clearance and Settlement; Market Structure. Today’s three-day settlement time for securities will eventually become instantaneous, thereby removing the risk of default on trades. In the paperless world created by the new technology, shares would be held in book-entry form, just as mutual fund shares are today, with ownership transfers reflected just in the depository’s computer records. Improved fund transfer technology, electronic banking, and electronic cash will allow investors to pay for purchases and be credited for sales immediately. To the extent still necessary, then, credit card companies or companies like them will assume the guarantee function of clearinghouses by guaranteeing payment for securities purchases.

New trading systems custom-designed for different investor needs – boutique exchanges – will gain in acceptance. Ultimately, an investor will be able to choose from a world of competing marketplaces, domestic and international, with each market catering to the varying preferences of investors, whether immediacy of execution, or best price, or least market impact, or different type of trading system altogether. Finally, technology will continue to increase the globalization of the financial markets. The wall between competitors, built by geographic boundaries and time zones that once dictated and furthered nationalistic views toward commerce, will continue to fall because of better and lower-cost communications and analytics. Access to, and for, foreign capital markets and foreign users of capital through today’s technology will be increasingly simple.

Pressures for and against Change

All these innovations pose difficult questions for regulators. Should regulation be geared toward addressing fraud and manipulation or should technology itself be regulated, assuming it can be? For example, under the current regulatory scheme, “smart agent” software begins to resemble an investment adviser and the Internet begins to look like a trading market. And how should markets be defined where many markets (such as alternative trading mechanisms) no longer fit well within the definition of an “exchange” and often are regulated in some other manner? How will disintermediation – and the resulting loss of thousands of financial intermediaries acting as “eyes and ears” complementing governmental law enforcement efforts – affect the government’s ability to regulate effectively? And because the same innovations in information technology that foster growth and capital formation also provide a new venue for fraud and manipulation, how does one regulate to prevent abuse without curtailing innovation? (The case for law and regulation is too strong and obvious to suggest a return to pure caveat emptor.)

Historically, regulators have relied on a detailed, “command and control” approach to regulation to protect the public. But while that approach helps prevent abuse, it also slows the spread of innovation as new ideas languish awaiting regulatory approval. Still, notwithstanding the technology-induced need for a change in regulatory approach, the environment that fosters a command and control approach persists.

For example, industry, investors, the press, and Congress often ask regulators to address some specific issue or matter. Instead of rethinking existing requirements, regulators change them just enough to compensate for the new development. Consequently, the next change in technology requires a new modification to the rules just adopted.

In addition, regulatory agencies are usually scored by Congress or the press on the number of statements issued, rules affected, exams conducted, letters sent, or cases brought. Traditionally, the sign of an active and vibrant agency is a constant churning of activity. Many small steps count for far more than one giant step.

Sound-bite accountability also exerts a bias toward command and control, incremental regulation. Criticism is leveled at regulators far more often for failing to protect someone who becomes hurt than for failing to nurture something new or experimental that might – although no one is sure – have led to a better world. Consequently, regulators opt for specific and detailed rules that constrain behavior and channel activities to what is known and safe.

Moreover, as they have always done, regulators tend to look for standards they can efficiently inspect for and enforce – just as those who are regulated demand specific and detailed guidance. The search for certainty, both by those who have to enforce the law and by those who have to abide by it, encourages detailed regulation, not pronouncements of fundamental concepts that allow markets to develop on their own.

Finally, there are vested interests. Those market participants who are most successful under the current system often resist changes to it. Their loud voices become a force for the regulatory status quo.

Despite these understandable pressures for its continuance, incremental, command and control regulation can go terribly awry in a market whose fundamentals are changing rapidly. Unless regulators step back and look at these fundamentals, they can fail to see that the once-solid foundation on which they are building has been made unstable by shifting sands beneath it and that each small change they make is adding weight to an increasingly shaky structure.

Needed: Regulatory Flexibility

The rapid pace of innovation today demands a bolder, more flexible approach to regulation. Command and control regulation must give way to regulation that is more “goal-oriented,” with regulators articulating broad goals and allowing market participants to determine how best to satisfy them. In 1995, for example, the Securities and Exchange Commission used a goal-oriented approach to resolve the question of whether corporations could use electronic communications to satisfy the federal securities laws. Given the advantages afforded by the electronic media, the SEC determined that the goal should be to encourage electronic delivery of information. The SEC could have taken the traditional command and control approach that would have dictated specific formats, along with multiple conditions, that alone would have satisfied the regulation. That way both regulators and the regulated community would know exactly what would be permitted and what would not. It would certainly have made for easier monitoring by regulators. But it would also have allowed little flexibility for accommodating further developments or advances in technology.

So instead the SEC focused on two regulatory goals – whether an electronic communication provided investors with “notice” of and “access” to information similar to traditional paper delivery of information. Market participants themselves were left to find ways to satisfy the two concepts and, therefore, the regulation. As a result, technological innovations can now be used as soon as created without first having to be approved by regulators. The response to the SEC experiment has been overwhelmingly favorable.

Such goal-oriented regulation, however, requires a wholesale change in the way regulatory agencies approach their mission, as well as in the way lawmakers write laws. It takes creativity and a good deal more work than writing command and control prescriptions. It takes regulators who are highly trained because ensuring compliance in such a system takes far more skill. It also takes some faith. We have to be willing to believe that the future holds worthwhile innovations as well as potential problems and issues. And we have to be willing to believe that allowing innovation without dictates from regulators as to what it must look like is ultimately better for U.S. financial markets.

A New Model of Financial Services Regulation

Technology is also hastening a convergence among financial products and services and among financial services providers: a blurring of the lines between banks, securities firms, insurance companies, and futures merchants, and their products that requires yet another change in perspective for financial regulators. Agencies accustomed to competing with each other for regulatory turf must begin cooperating, and agencies accustomed to championing the industry they have traditionally regulated when inter-industry battles loom must instead work more to determine the best results for the financial services sector as a whole.

The traditional debate associated with convergence is whether the focus of regulation should shift from “entity regulation” to “functional regulation.” Providers of financial services historically have been regulated based on what they are – ?banks” are regulated by various banking regulators; ?securities firms” by the SEC and state securities administrators; the ?futures” industry by the Commodity Futures Trading Commission; and “insurance companies” by state insurance commissions. For many years, the four entities had little to no product overlap, and each entity was easily identified by the products it sold. Life was simple.

Today, because of competition and technological change, the entities sell products outside their traditional areas. In response, many reform advocates have pushed for “functional regulation,” where the activities relating to each specific product sold by an entity would be regulated by the agency with expertise in that product.

But as technology further melds the traditionally distinct financial products and services, distinctions based on product definitions – on whether something is or is not a security, a banking product, an insurance product, or a futures product – are becoming difficult to apply. Indeed, some financial products are increasingly viewed as near-perfect substitutes for others, and other products, such as variable universal life accounts and customized derivatives, blend some of the traditional products. In sum, both entity and functional regulation are becoming antiquated.

We need to step back then and remember why financial regulators regulate in the first place – in other words, we need to identify the goals of financial regulation – and reorganize our financial services regulatory structure accordingly.

Financial regulation has four obvious goals: protecting financial consumers and investors, controlling systemic risk, protecting against insolvency that places at risk federal insurance (taxpayer) or, in a different context, customer funds, and ensuring the integrity, efficiency, and competitiveness of markets. Under a system focused on satisfying these goals, one could conceive of a regulator like the Federal Reserve having authority over systemic risk issues, regardless of whether they stem from, for example, banks or securities firms. Similarly, an agency such as the SEC would focus on investor or consumer protection in connection with the sale of any financial service or product regardless of who is doing the selling or what product is being sold. The markets – equity as well as futures and commodities – would be regulated by an agency with a focus on market structure and competition theory (like the CFTC and some elements of the SEC), and agencies like the Federal Deposit Insurance Corporation or the Office of the Comptroller of the Currency would have jurisdiction over individual solvency issues, whether posed by banks, brokers, insurers, or futures merchants. Such a regulatory structure (which could be further simplified by combining some of the jurisdictions and agencies) could be effective over the long run and better able to adjust to technological advancements and competitive pressures. It would satisfy the four goals of financial regulation better, more efficiently, with less duplication, with more focused expertise, and at less cost than the existing system. It also would foster competition as all products and services could compete generally as “financial services.” Countries like the United Kingdom and Australia are already moving toward similar systems. If our financial services sector is to remain the best in the world, it will have to evolve something along these lines, notwithstanding such political issues as the need to reorient congressional committees and the need to encourage industries to accept more competitors on a larger playing field.

Sovereign Regulation

Yet another technology-related issue is how national regulation can continue in a global, electronic market. National governments have traditionally based their right to regulate on their sovereign right to do so within their borders – a right enabled by control over physical geography as well as by reasonably good controls over information flows. With the advent of new communications technologies like the Internet, control over information flows is increasingly tenuous.

The decline of territorial regulation raises other issues as well. For example, if a hypothetical exchange in Frankfurt posted quotes on the Internet for securities tradable by anyone anywhere in the world, how, and to what standard, would we in the United States regulate that exchange, especially if the home country thought their regulations were better than ours – just as we thought ours were better than theirs? And what do we do when, in the not distant future, someone sitting at a PC in Iowa wants to use cybercash to place funds in an account in Germany to buy securities trading on our hypothetical Frankfurt exchange or, perhaps even more likely, to trade globally securities on an exchange based solely in cyberspace, or not even on an exchange that is “organized” in any way we think of “organization” at the moment, but using smart agents that interact with other smart agents over the Internet?

Some have argued that although enhanced international coordination is a step in the right direction, it is an interim step on the way to what is really needed – a single international regulator for global financial markets. I doubt this goal will be realized any time soon. I would also argue that the existence of multiple regulators of international financial services having different perspectives and regulatory philosophies can be quite advantageous. For one thing, it reduces the likelihood that innovation will be stifled by a single, stodgy regulator. Sometimes, regulatory arbitrage has its benefits. Nevertheless, in today’s increasingly technology-linked world, enhanced international (and domestic) communication and cooperation among regulators is highly desirable, and more international coordination – especially to reduce further disparities that burden international commerce – is clearly required.

Toward a new financial future

Today’s innovations herald a new financial world that, if allowed to develop, will provide tremendous advantages to all consumers of financial services. The challenge is to ensure that traditional regulation, grounded in a very different world, does not damage the emerging new one. I am cautiously optimistic.