November 5, 2014

Regulatory Paranoia Is a Barrier to Wealth Creation

Hester Peirce

Former Senior Research Fellow
Summary

Regulatory attempts to anticipate whether investors and consumers will benefit from a particular product or service are a waste of resources. Markets are better laboratories than bureaucratic backrooms. Financial regulators have a commendable desire to protect the American public, but blocking people's access to potentially useful financial innovations is not the way to do it.

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In a recent speech, Richard Cordray, Director of the Bureau of Consumer Financial Protection, sounded the encouraging introductory note that "our laws must keep pace with the many innovations in the financial marketplace." He went on, however, to detail past and future enforcement actions without any mention of eliminating the regulatory obstacles to financial innovation. This omission was not surprising-financial regulators tend to be very suspicious of innovation. Regulators' fears prevent the American public from accessing innovative products and services.

Regulatory paranoia about innovation manifests itself in a variety of ways. For example, the Securities and Exchange Commission publicly announced last month that it would not approve the launch of a new type of exchange-traded fund. ETFs offer investors a low-cost alternative to traditional mutual funds. An ETF shareholder indirectly owns the many different companies that make up the ETF's portfolio. Unlike traditional mutual fund shares, which are bought and sold directly from the fund complex, retail investors buy and sell ETF shares on exchanges. Large securities firms deal directly with the fund complex; they exchange a basket of the ETF's portfolio securities for so-called creation units, which are large blocks of shares. This exchange process serves to keep the prices of ETF shares in line with the value of the ETF's underlying portfolio.

Most ETFs are index funds, so the composition of the portfolio of shares they hold is dictated by the relevant index, rather than an investment manager's decisions. Active management, which is popular in the broader mutual fund world, has not worked well in the ETF context because the SEC-which approves ETFs on a case-by-case basis-requires ETFs' portfolios to be very transparent. As a result, people can reverse engineer an active manager's strategy and jump ahead of the fund when it is trying to buy or sell.

This is where the innovation comes in. Several firms proposed to create actively managed ETFs that disclose their investments on the quarterly schedule applicable to traditional mutual funds, instead of daily as is standard for ETFs. To facilitate proper pricing of their shares, however, these ETFs would publish a running indicator throughout the trading day of the estimated value of the portfolio. Retail investors would be protected from severe pricing problems by a feature that allows them to sell their shares directly to the fund for cash instead of trading on an exchange.

After a lengthy vetting process, the SEC said no. Heavily informed by a commenter who has "a retained economic interest in a product concept that may be competitive with the" proposed ETFs, the SEC concluded these ETFs would be a marketplace flop. Without a full view into ETFs' portfolios, the agency reasoned, securities firms would not be willing to buy and sell ETF shares. Absent firms' participation in the market, ETF shares would trade at prices that do not reflect the actual value of the ETF's portfolio securities. ETFs would get a bad name, and investors would stop investing in all ETFs, not just actively managed ones. Never mind that firms have indicated an interest in-and plans for-making markets in these new ETFs. Certainly, this enthusiasm could fade and these less transparent ETFs could fail to take off, but why not let the marketplace be the test of that?

The SEC is not alone in its desire to vet financial products' market-worthiness. Last month, the CFPB issued a proposed no-action letter policy. Agencies issue no-action letters to reassure companies that they will not bring enforcement actions based on a particular set of circumstances. The Bureau proposes to use this process to bless new financial products and services before they are launched.

Although seemingly a way to put innovators at ease, the policy could end up impeding innovation. Once the process is in place, firms will feel compelled to get their innovations vetted. But, in order to get the relief, firms will have to go through a lengthy process, make an open-ended promise to generate data for the Bureau, and agree to any other conditions the CFPB chooses to impose. Sure, firms might like the certainty, but the CFPB doesn't even promise much of that-it can revoke or modify the relief any time it wants without prior notice.

Just as the SEC has made itself the arbiter of whether a particular ETF will succeed, the CFPB wants to be the arbiter of whether consumers will find value in particular financial products. The proposed process requires the applicant to explain "how the product is likely to provide substantial benefit to consumers differently from the present marketplace." Why not let consumers decide for themselves? A product that doesn't appear beneficial to a highly paid CFPB staff attorney with lots of financing options might be extremely useful for a less privileged consumer.

These actions by the SEC and the CFPB are just two examples of the wariness with which financial regulators approach innovation. Regulatory attempts to anticipate whether investors and consumers will benefit from a particular product or service are a waste of resources. Markets are better laboratories than bureaucratic backrooms. Financial regulators have a commendable desire to protect the American public, but blocking people's access to potentially useful financial innovations is not the way to do it.