Wednesday, January 28, 2009

A Skating Rink Guides Regulatory Reform

The issue of market regulation reform lurks behind the automaker bailouts and the stimulus packages. Social engineering is to regulation reform as pork spending is to stimulus packages. Both social engineering and pork should be avoided.

Contemplating an ice skating rink may help guide the philosophy shaping regulatory reform, especially of financial markets. An ice rink is flat, as a level regulatory playing field or market should be. The rink has walls, which define the limits of the playing surface. The rink doesn't limit how fast skaters can skate. Instead they must suffer any negative consequences of their own risk-taking. No one is preselecting winners or losers in the competition.

To stretch the analogy a large step further, unless someone provides the skating rink, the skaters would be skating out on a parking lot. The irregular surface with no boundaries is not conducive to efficient skating. The lack of boundaries and level playing surface enables skaters to pull dirty tricks on each other with impunity.

This philosophy applied to financial markets regulation suggests tranparency, good reporting, open price discovery, and regulated exchanges for all large markets. Credit Default Swaps and Collateralized Debt Obligations should be regulated this way. That's especially true if the Financial Accounting Standards Board holds to its mark-to-market accounting rule. The mark-to-market accounting rule applied to private, over-the-counter CDS market proved to be a dangerous combination when the markets began to seize up. In fact, some who know more about this than I do posit this as a key cause of the seize-up.

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