WHEN THE LEVEES BREAK

RE-VISIONING REGULATION OF THE SECURITIES MARKETS

KAREN KUNZ AND JENA MARTIN

Published by Luingcon Books An imprint ofTht Rowman amp Littlefidd Publishing G roup Inc

450 1 Forbes BoulevHd Suhe 200 Unham 1hryland 20706

wwwfOwmanco nl

Unir i Whitacle ~1(W 26-34 Slann~1) SIt~r 1()I1ltJon SE l l 4AB United Kingdom

CopYlight 0 201 7 by uxinglon Books

All rightr mint No pan of Ihis book may be reproduced in any form 0 1 by any dtCtronic Of mechan ical m~ans induding information SlOrJge and relfin-al synenn without written

pclmission from the publisher excepl by a reviewer who Illay quote passages in a rcmiddotiew

British Ublll) Cataloguing in Publication InfOimalion Available

Library of CongrdS Cataloging- in-Publication Data Available

978-0 -739 1-9604-5 (d olh l1k p3]Xr)

9 78-0-739 1-9605-2 (ekmonic)

sect~ T he papcr uscd in this publication Tl1~U Ihe minimum requirements of Amerkan

National Standard fO I Information Sciences- Permanence of Plpcr

fOI Printed Lib~I) ~htcrials ANSIJNISO Z394S-1992

rimed in he United SalCS of America

Published by Luingcon Books An imprint ofTht Rowman amp Littlefidd Publishing G roup Inc

450 1 Forbes BoulevHd Suhe 200 Unham 1hryland 20706

wwwfOwmanco nl

Unir i Whitacle ~1(W 26-34 Slann~1) SIt~r 1()I1ltJon SE l l 4AB United Kingdom

CopYlight 0 201 7 by uxinglon Books

All rightr mint No pan of Ihis book may be reproduced in any form 0 1 by any dtCtronic Of mechan ical m~ans induding information SlOrJge and relfin-al synenn without written

pclmission from the publisher excepl by a reviewer who Illay quote passages in a rcmiddotiew

British Ublll) Cataloguing in Publication InfOimalion Available

Library of CongrdS Cataloging- in-Publication Data Available

978-0 -739 1-9604-5 (d olh l1k p3]Xr)

9 78-0-739 1-9605-2 (ekmonic)

sect~ T he papcr uscd in this publication Tl1~U Ihe minimum requirements of Amerkan

National Standard fO I Information Sciences- Permanence of Plpcr

fOI Printed Lib~I) ~htcrials ANSIJNISO Z394S-1992

rimed in he United SalCS of America

Contents

Li sl of Figures and Tables vii

Acknowledgments

IlHroduC lion

PART I THE DISCLOSURE PARADIGM

(alChi ng ti l Waes Rollin 3

2 T ry ing to Evaporate ValCf wih Sunshine Movi ng Beyo nd Disclosu re 23

3 Pluggi ng Ihe Leaks 33

PART II WHOLE MARKET REGULATION 57

4 Variations on a Theme 59

5 Secu rit ies as Products (A ToaSler by An) Other Name) 73

G Whole MtrkcI Regulation 95

PART III IMPLEMENTATION AND IMPLICATIONS 115

7 A Rcgul alOry Triad 11 7

8 Oh Captai n My Caplain The New Model from the Corporate Pcrspclttive 139

9 Building a New Levee 159

Conclusion I II

Introduction

Halle yo u evcr stood in front of a twenty-foot dam and watched as a tidal wave crashtd over it

No Neither hwc wc However if we wrrr [0 imagine stich a scene we believe

thaI it would be replete widl chaos destruction and confusion with almost nothing left in its wake

Now imagine hat inSlcad of a (wcmy-foOi dam we itwe the 1-I00( r Dam At 726 feCI tall it can make you fed prolcwd Btu now instcad ofa idal wave it s a tsunami that comes with such a quick and ferocious force thaI it destroys rvnylhillg in its path

T hin k back to 2005--do you know where you were when hurricln c Katrina struck New Orleans Most of us watched 0 11 TV as floodwaters surged th rough the ciry dcsrfoying buildings and Iivcs lc3ing some residentS stranded on their rooftops waiting for help The cu lprit was not rhe hurricane itsdfbut the lC vCCs Most thought the govern rnelU had prepared fo r such emergencies The dikes and dams were there 10 contain local bodies of water and enable them to absorb everyday rains and the occasional downpou r or severe thunderstorm the levees were for the major evelUS sueh as deadly floods resulti ng from tropical sto rms and hurricanCs or C CIl a tsu nami But the) were all old and flUlty and not re shymotely in shape to withstand Katrin a

In the Un ited States thu describes our current securi ties framework Th e regul atory dikes levees and dam s-the regulatory agencies and regul ations th at have becn enacted si nce the stock market ctash of 1929-surround us and make us feci protccted H oles in the dike tppear every once ill a while but if the leaks become t OO serious we know Ihc US government will activatc the leyees and pttch things up when the t ters calm down But what happens whcn the dikes crumble and the levees break

xi i I N T ROD UCT ION

In this book we explore those concerns From our combin~d fOrly- f1v~ )ears of experience in industry r~gula t ion and academia we hav~ ~xamined the world of selturil ies regul ation and are preparing the li feboats as we write This book is fo r those who work in th e securities industry whetll er for a all Stre~ t or boushytique firm all exchange or self-regulatOry age ncy or a federal or state regul ator as well as thos~ policymakers consultants lobbyists l nd lcademi cs who study il It is fo r investors who Wlllt to beu er ullderSIlml the structure of the securities markets and those fea rful of another pendi ng fl ood or curious about how regushylation might preem futu re fa ilures The purpose is to start a nadonal or ben er yet a global conversation ahom how [0 shore up the securitics markels before the next floodwa ters wreak even more havoc

The trut h of the matter is that the evolution of the markets advm cemellls in technology and devclopmem of quuHitative trad ing and the consolidation of fi rms and exchanges have punched a mult itude of new holes in th~ regulatory di kes Enfo rce ment as we know it and the Dodd-Frank reforms arc ineffective at plugging anyone leak let alone contai ni ng the fl ood of changes that have occu rred in the induslry in Ihe las t decade T his is primarily because 111( regulashytory Struct ure envisioned when federal secu riti~s laws were enacted in the 19305 is not applicable to fi nancial markets Ihal no longer remotely resembl e those it was designed to control

Here we ident ify these leaks-dIe changes that have taken pl ace in Ihe inshyd ustry particularly o~ r the last few decades-and the ways they have c1um l the dams to cru mble And instead of devising one more way to patch the holes in Ihe hope that the barriers will hold a li ttle longer wc offer plans to build a whole new letc sySlem Ihat will ensure that we are prepared to weather any storm

To this end we develop a regulatory framework that incorporatcs the paradigm shift neCC5S1ry to embrace alternative interpretations of invCSllnent products and markets and the role of regulation Ye begin with a discussio n of the increasing sophistication of new prod ucts l nd th e impact of technological progress on rrading and execution processcs Vle then exami ne how the regulashytory envi ronment has attempted but fai led to keep up with these advancements and th e ways in which pending rulemaking is ill-equi pped to keep pace let alone become eq uipped to move ahead and ~ngage in proaClive measurcs

O n Ihal foundation we begin to develop a Ira l1Sformational framework that incorpora tes an ent irely lew market orientation one that goes beyond the cu rshyrent regulatory shortfllls Ou r model is inida l1y applied to US markets however we concl ude the book with ideas about how the implcmentation of our model implicatcs an international framework

Our model is predicated on tWO key arguments O ur central premis~ is that Ihere is a disconnect or more precisely a disaggregation in the markets between

INTRODUCTION xiii

thc companics within our regulatory framework and dlc stocks that purport m represclH them No longer do participalHs in the stock market purchase a particshyular stock becausc they would like to invest in thc company Now invcstor5-Qr more accurately purchasers- buy stock because of ilS value separate and apart from the company Specifically we document how modern lraders no longer rypically look at Ihe fu ndamentals of a particular company in deciding whether or nOI 10 buy ils stock Inslead Ihey exami ne the stock as a product in and of itself (like a maHer or a car) with a value that is separate and apart from the value of the underlying corporation l Thi~ disaggregation marks a fundam ental shift from an investor parJdigm to a consum er parldigrn This perception is evidenced at all levels ofiJwesting activity from mom -and-pop investors and day traders to institutional investors and laquoall Street traders

An example of this disaggregation at the micro level is the recent Linkedln acquisition by Microsoft a publicly traded company that was purchased for $262 billion without ever having shown a profit More pernicious still is its manifestation on a macro level where computerized trading-the use of algoshyrithms that barely take illlo account the fundamentals ofa company-represents the majority of trlding vol ume on US and international exchanges Ye argue that since the markets have become dominated by this new consumer paradigm we should completely divorce the theory of the firm lI1d corpo rate governln ce from the regulatory marker strucUlre treating the securities of the firm as a ~widgetraquo that consumers buy and regulate them as such

Our second premise fo llows from the first we assert that the regulatory srrucrure currently in place is wodully inadequate to regulate the products and markets as they have evohed to thei r present form Specifically the fundam en tal regulatory DNA of all federal securi ties agencies (spearheaded b) the Securit ies and Exchange Com mission) is one of di sclosure As regulation cont inues to

focus on disclosure it ignores the usc of increaSingly complex electronic systems and equipm ent that can be sabotaged by sophislicated hackers Ihe ascent of social media and the reliance on self-regul atory orgl niz1rions to police their own- all while corruption extends to even those selling marker s(andards~

T here arc numerous books written about the financial markets investing quallli tatle trading and technical analysis as well as regulatOry structures crisis manlgemelll and reform efforts This book is unique in th)( it proposes a radical new way of looking at imestmelll proltlucts and markets and encomshypasses that paradigm shift within our regulatory model For example while the 2008 financial crisis was nexorably intermined with the deri ~H i ves markets we consider it to be merely the most extreme manifcstation of the growing di sconshynect between thc perception of securities as invesunelllS lnd their actual usc as something far diffc rent ~ Our method of plugging the letks which we envision

xiv INTRODUCTI ON

as a total reengineering of the SYSlCIll deals wi this di sconnect head on and add resses all products in the securities markets system Nonetheless OllT primary focus is on th e equity markets and their role in the overall stability of the system

For ease and clarity this book is divided inm three primal) pans Loosely they describe what is what should be and how we plan to get there from here Pan I provides a thorough description of regulalOl) life as we now know it Si nce the dawn of regulation the greatest single change in the secu riti es markets is the way in which sccurit ies arc bought and sold Increasi ngly complex investshymem products and the introduction and adapt ion of increasingly sophisticated tcchnologies used in trading execution and operuion have revolutionized the exchanges making them virtually unrccognizable from those envisioned when the Securities Act of 1933 and the Securit ies Exchange Act of 1934 were enshyactClt1 Here we ideillify the ways in which the financial markets have changed the (lilure of regulations to keep up and th e resulta nt risks and vulnerabilities

We begin in chapter 1 with a discussion of the tcchnological advancements that have revolutionized individual and inst itutional trading execution and brokerdealer opel-nions over the last few dCCldes As a result of these innovashytions a seismic shift has taken place in the securities markets T he fault lines have been present for quite some time however it is only now in the last few years that the ramification s of these displacemeills have been felt The lYpical approach for traders has gone from examining companies to determine whether they will be a good long-term irwesunent to examining the markets as a whole Nowhere is thi s shift more apparent than in the ri$e and increas ing prealenee of quantitative trading models As a result therc is now a di sco rHHct between the markets themselves and the companies that are traded on the markets Algoshyrithm ic trading embodies this theorctical model on a ubiquitOus level What a company docs or does not do rnaners very liule to whether the companys stock should be bough t or sold Instead algorithms aTe usclt1 to determine whether the companys stock is a good ~ buy baSClt1 on how the Jlock is doing and how the marktt is behavi ng This shift has had a broad impact on retail and institutiorral investor behavior and the global economy at large but relatively lillie impact on regulatOry structures and the role of governrnem in overSight

T he regulatol) framework thai hislOricall y and currently dominates our markets has flil ed to keep pace with technological advancemellls In chapter 2 we address Ihe shortcomings of the regulatol) structure currently in place with emphasis on tir e evolution of the responsibilities of the Securities and Exchange Commission Here we show that the SECs focus on disclosure is inadequate and dangerous Subsequently in chapler 3 we offer a detailed cri tique of the overall regulatory model identifying the numerous agencies self-regulatory organizations and exchanges th at are charged with oversight of

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AX NOJlH1ClOlIJN I

Introduction

Halle yo u evcr stood in front of a twenty-foot dam and watched as a tidal wave crashtd over it

No Neither hwc wc However if we wrrr [0 imagine stich a scene we believe

thaI it would be replete widl chaos destruction and confusion with almost nothing left in its wake

Now imagine hat inSlcad of a (wcmy-foOi dam we itwe the 1-I00( r Dam At 726 feCI tall it can make you fed prolcwd Btu now instcad ofa idal wave it s a tsunami that comes with such a quick and ferocious force thaI it destroys rvnylhillg in its path

T hin k back to 2005--do you know where you were when hurricln c Katrina struck New Orleans Most of us watched 0 11 TV as floodwaters surged th rough the ciry dcsrfoying buildings and Iivcs lc3ing some residentS stranded on their rooftops waiting for help The cu lprit was not rhe hurricane itsdfbut the lC vCCs Most thought the govern rnelU had prepared fo r such emergencies The dikes and dams were there 10 contain local bodies of water and enable them to absorb everyday rains and the occasional downpou r or severe thunderstorm the levees were for the major evelUS sueh as deadly floods resulti ng from tropical sto rms and hurricanCs or C CIl a tsu nami But the) were all old and flUlty and not re shymotely in shape to withstand Katrin a

In the Un ited States thu describes our current securi ties framework Th e regul atory dikes levees and dam s-the regulatory agencies and regul ations th at have becn enacted si nce the stock market ctash of 1929-surround us and make us feci protccted H oles in the dike tppear every once ill a while but if the leaks become t OO serious we know Ihc US government will activatc the leyees and pttch things up when the t ters calm down But what happens whcn the dikes crumble and the levees break

xi i I N T ROD UCT ION

In this book we explore those concerns From our combin~d fOrly- f1v~ )ears of experience in industry r~gula t ion and academia we hav~ ~xamined the world of selturil ies regul ation and are preparing the li feboats as we write This book is fo r those who work in th e securities industry whetll er for a all Stre~ t or boushytique firm all exchange or self-regulatOry age ncy or a federal or state regul ator as well as thos~ policymakers consultants lobbyists l nd lcademi cs who study il It is fo r investors who Wlllt to beu er ullderSIlml the structure of the securities markets and those fea rful of another pendi ng fl ood or curious about how regushylation might preem futu re fa ilures The purpose is to start a nadonal or ben er yet a global conversation ahom how [0 shore up the securitics markels before the next floodwa ters wreak even more havoc

The trut h of the matter is that the evolution of the markets advm cemellls in technology and devclopmem of quuHitative trad ing and the consolidation of fi rms and exchanges have punched a mult itude of new holes in th~ regulatory di kes Enfo rce ment as we know it and the Dodd-Frank reforms arc ineffective at plugging anyone leak let alone contai ni ng the fl ood of changes that have occu rred in the induslry in Ihe las t decade T his is primarily because 111( regulashytory Struct ure envisioned when federal secu riti~s laws were enacted in the 19305 is not applicable to fi nancial markets Ihal no longer remotely resembl e those it was designed to control

Here we ident ify these leaks-dIe changes that have taken pl ace in Ihe inshyd ustry particularly o~ r the last few decades-and the ways they have c1um l the dams to cru mble And instead of devising one more way to patch the holes in Ihe hope that the barriers will hold a li ttle longer wc offer plans to build a whole new letc sySlem Ihat will ensure that we are prepared to weather any storm

To this end we develop a regulatory framework that incorporatcs the paradigm shift neCC5S1ry to embrace alternative interpretations of invCSllnent products and markets and the role of regulation Ye begin with a discussio n of the increasing sophistication of new prod ucts l nd th e impact of technological progress on rrading and execution processcs Vle then exami ne how the regulashytory envi ronment has attempted but fai led to keep up with these advancements and th e ways in which pending rulemaking is ill-equi pped to keep pace let alone become eq uipped to move ahead and ~ngage in proaClive measurcs

O n Ihal foundation we begin to develop a Ira l1Sformational framework that incorpora tes an ent irely lew market orientation one that goes beyond the cu rshyrent regulatory shortfllls Ou r model is inida l1y applied to US markets however we concl ude the book with ideas about how the implcmentation of our model implicatcs an international framework

Our model is predicated on tWO key arguments O ur central premis~ is that Ihere is a disconnect or more precisely a disaggregation in the markets between

INTRODUCTION xiii

thc companics within our regulatory framework and dlc stocks that purport m represclH them No longer do participalHs in the stock market purchase a particshyular stock becausc they would like to invest in thc company Now invcstor5-Qr more accurately purchasers- buy stock because of ilS value separate and apart from the company Specifically we document how modern lraders no longer rypically look at Ihe fu ndamentals of a particular company in deciding whether or nOI 10 buy ils stock Inslead Ihey exami ne the stock as a product in and of itself (like a maHer or a car) with a value that is separate and apart from the value of the underlying corporation l Thi~ disaggregation marks a fundam ental shift from an investor parJdigm to a consum er parldigrn This perception is evidenced at all levels ofiJwesting activity from mom -and-pop investors and day traders to institutional investors and laquoall Street traders

An example of this disaggregation at the micro level is the recent Linkedln acquisition by Microsoft a publicly traded company that was purchased for $262 billion without ever having shown a profit More pernicious still is its manifestation on a macro level where computerized trading-the use of algoshyrithms that barely take illlo account the fundamentals ofa company-represents the majority of trlding vol ume on US and international exchanges Ye argue that since the markets have become dominated by this new consumer paradigm we should completely divorce the theory of the firm lI1d corpo rate governln ce from the regulatory marker strucUlre treating the securities of the firm as a ~widgetraquo that consumers buy and regulate them as such

Our second premise fo llows from the first we assert that the regulatory srrucrure currently in place is wodully inadequate to regulate the products and markets as they have evohed to thei r present form Specifically the fundam en tal regulatory DNA of all federal securi ties agencies (spearheaded b) the Securit ies and Exchange Com mission) is one of di sclosure As regulation cont inues to

focus on disclosure it ignores the usc of increaSingly complex electronic systems and equipm ent that can be sabotaged by sophislicated hackers Ihe ascent of social media and the reliance on self-regul atory orgl niz1rions to police their own- all while corruption extends to even those selling marker s(andards~

T here arc numerous books written about the financial markets investing quallli tatle trading and technical analysis as well as regulatOry structures crisis manlgemelll and reform efforts This book is unique in th)( it proposes a radical new way of looking at imestmelll proltlucts and markets and encomshypasses that paradigm shift within our regulatory model For example while the 2008 financial crisis was nexorably intermined with the deri ~H i ves markets we consider it to be merely the most extreme manifcstation of the growing di sconshynect between thc perception of securities as invesunelllS lnd their actual usc as something far diffc rent ~ Our method of plugging the letks which we envision

xiv INTRODUCTI ON

as a total reengineering of the SYSlCIll deals wi this di sconnect head on and add resses all products in the securities markets system Nonetheless OllT primary focus is on th e equity markets and their role in the overall stability of the system

For ease and clarity this book is divided inm three primal) pans Loosely they describe what is what should be and how we plan to get there from here Pan I provides a thorough description of regulalOl) life as we now know it Si nce the dawn of regulation the greatest single change in the secu riti es markets is the way in which sccurit ies arc bought and sold Increasi ngly complex investshymem products and the introduction and adapt ion of increasingly sophisticated tcchnologies used in trading execution and operuion have revolutionized the exchanges making them virtually unrccognizable from those envisioned when the Securities Act of 1933 and the Securit ies Exchange Act of 1934 were enshyactClt1 Here we ideillify the ways in which the financial markets have changed the (lilure of regulations to keep up and th e resulta nt risks and vulnerabilities

We begin in chapter 1 with a discussion of the tcchnological advancements that have revolutionized individual and inst itutional trading execution and brokerdealer opel-nions over the last few dCCldes As a result of these innovashytions a seismic shift has taken place in the securities markets T he fault lines have been present for quite some time however it is only now in the last few years that the ramification s of these displacemeills have been felt The lYpical approach for traders has gone from examining companies to determine whether they will be a good long-term irwesunent to examining the markets as a whole Nowhere is thi s shift more apparent than in the ri$e and increas ing prealenee of quantitative trading models As a result therc is now a di sco rHHct between the markets themselves and the companies that are traded on the markets Algoshyrithm ic trading embodies this theorctical model on a ubiquitOus level What a company docs or does not do rnaners very liule to whether the companys stock should be bough t or sold Instead algorithms aTe usclt1 to determine whether the companys stock is a good ~ buy baSClt1 on how the Jlock is doing and how the marktt is behavi ng This shift has had a broad impact on retail and institutiorral investor behavior and the global economy at large but relatively lillie impact on regulatOry structures and the role of governrnem in overSight

T he regulatol) framework thai hislOricall y and currently dominates our markets has flil ed to keep pace with technological advancemellls In chapter 2 we address Ihe shortcomings of the regulatol) structure currently in place with emphasis on tir e evolution of the responsibilities of the Securities and Exchange Commission Here we show that the SECs focus on disclosure is inadequate and dangerous Subsequently in chapler 3 we offer a detailed cri tique of the overall regulatory model identifying the numerous agencies self-regulatory organizations and exchanges th at are charged with oversight of

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AX NOJlH1ClOlIJN I

xi i I N T ROD UCT ION

In this book we explore those concerns From our combin~d fOrly- f1v~ )ears of experience in industry r~gula t ion and academia we hav~ ~xamined the world of selturil ies regul ation and are preparing the li feboats as we write This book is fo r those who work in th e securities industry whetll er for a all Stre~ t or boushytique firm all exchange or self-regulatOry age ncy or a federal or state regul ator as well as thos~ policymakers consultants lobbyists l nd lcademi cs who study il It is fo r investors who Wlllt to beu er ullderSIlml the structure of the securities markets and those fea rful of another pendi ng fl ood or curious about how regushylation might preem futu re fa ilures The purpose is to start a nadonal or ben er yet a global conversation ahom how [0 shore up the securitics markels before the next floodwa ters wreak even more havoc

The trut h of the matter is that the evolution of the markets advm cemellls in technology and devclopmem of quuHitative trad ing and the consolidation of fi rms and exchanges have punched a mult itude of new holes in th~ regulatory di kes Enfo rce ment as we know it and the Dodd-Frank reforms arc ineffective at plugging anyone leak let alone contai ni ng the fl ood of changes that have occu rred in the induslry in Ihe las t decade T his is primarily because 111( regulashytory Struct ure envisioned when federal secu riti~s laws were enacted in the 19305 is not applicable to fi nancial markets Ihal no longer remotely resembl e those it was designed to control

Here we ident ify these leaks-dIe changes that have taken pl ace in Ihe inshyd ustry particularly o~ r the last few decades-and the ways they have c1um l the dams to cru mble And instead of devising one more way to patch the holes in Ihe hope that the barriers will hold a li ttle longer wc offer plans to build a whole new letc sySlem Ihat will ensure that we are prepared to weather any storm

To this end we develop a regulatory framework that incorporatcs the paradigm shift neCC5S1ry to embrace alternative interpretations of invCSllnent products and markets and the role of regulation Ye begin with a discussio n of the increasing sophistication of new prod ucts l nd th e impact of technological progress on rrading and execution processcs Vle then exami ne how the regulashytory envi ronment has attempted but fai led to keep up with these advancements and th e ways in which pending rulemaking is ill-equi pped to keep pace let alone become eq uipped to move ahead and ~ngage in proaClive measurcs

O n Ihal foundation we begin to develop a Ira l1Sformational framework that incorpora tes an ent irely lew market orientation one that goes beyond the cu rshyrent regulatory shortfllls Ou r model is inida l1y applied to US markets however we concl ude the book with ideas about how the implcmentation of our model implicatcs an international framework

Our model is predicated on tWO key arguments O ur central premis~ is that Ihere is a disconnect or more precisely a disaggregation in the markets between

INTRODUCTION xiii

thc companics within our regulatory framework and dlc stocks that purport m represclH them No longer do participalHs in the stock market purchase a particshyular stock becausc they would like to invest in thc company Now invcstor5-Qr more accurately purchasers- buy stock because of ilS value separate and apart from the company Specifically we document how modern lraders no longer rypically look at Ihe fu ndamentals of a particular company in deciding whether or nOI 10 buy ils stock Inslead Ihey exami ne the stock as a product in and of itself (like a maHer or a car) with a value that is separate and apart from the value of the underlying corporation l Thi~ disaggregation marks a fundam ental shift from an investor parJdigm to a consum er parldigrn This perception is evidenced at all levels ofiJwesting activity from mom -and-pop investors and day traders to institutional investors and laquoall Street traders

An example of this disaggregation at the micro level is the recent Linkedln acquisition by Microsoft a publicly traded company that was purchased for $262 billion without ever having shown a profit More pernicious still is its manifestation on a macro level where computerized trading-the use of algoshyrithms that barely take illlo account the fundamentals ofa company-represents the majority of trlding vol ume on US and international exchanges Ye argue that since the markets have become dominated by this new consumer paradigm we should completely divorce the theory of the firm lI1d corpo rate governln ce from the regulatory marker strucUlre treating the securities of the firm as a ~widgetraquo that consumers buy and regulate them as such

Our second premise fo llows from the first we assert that the regulatory srrucrure currently in place is wodully inadequate to regulate the products and markets as they have evohed to thei r present form Specifically the fundam en tal regulatory DNA of all federal securi ties agencies (spearheaded b) the Securit ies and Exchange Com mission) is one of di sclosure As regulation cont inues to

focus on disclosure it ignores the usc of increaSingly complex electronic systems and equipm ent that can be sabotaged by sophislicated hackers Ihe ascent of social media and the reliance on self-regul atory orgl niz1rions to police their own- all while corruption extends to even those selling marker s(andards~

T here arc numerous books written about the financial markets investing quallli tatle trading and technical analysis as well as regulatOry structures crisis manlgemelll and reform efforts This book is unique in th)( it proposes a radical new way of looking at imestmelll proltlucts and markets and encomshypasses that paradigm shift within our regulatory model For example while the 2008 financial crisis was nexorably intermined with the deri ~H i ves markets we consider it to be merely the most extreme manifcstation of the growing di sconshynect between thc perception of securities as invesunelllS lnd their actual usc as something far diffc rent ~ Our method of plugging the letks which we envision

xiv INTRODUCTI ON

as a total reengineering of the SYSlCIll deals wi this di sconnect head on and add resses all products in the securities markets system Nonetheless OllT primary focus is on th e equity markets and their role in the overall stability of the system

For ease and clarity this book is divided inm three primal) pans Loosely they describe what is what should be and how we plan to get there from here Pan I provides a thorough description of regulalOl) life as we now know it Si nce the dawn of regulation the greatest single change in the secu riti es markets is the way in which sccurit ies arc bought and sold Increasi ngly complex investshymem products and the introduction and adapt ion of increasingly sophisticated tcchnologies used in trading execution and operuion have revolutionized the exchanges making them virtually unrccognizable from those envisioned when the Securities Act of 1933 and the Securit ies Exchange Act of 1934 were enshyactClt1 Here we ideillify the ways in which the financial markets have changed the (lilure of regulations to keep up and th e resulta nt risks and vulnerabilities

We begin in chapter 1 with a discussion of the tcchnological advancements that have revolutionized individual and inst itutional trading execution and brokerdealer opel-nions over the last few dCCldes As a result of these innovashytions a seismic shift has taken place in the securities markets T he fault lines have been present for quite some time however it is only now in the last few years that the ramification s of these displacemeills have been felt The lYpical approach for traders has gone from examining companies to determine whether they will be a good long-term irwesunent to examining the markets as a whole Nowhere is thi s shift more apparent than in the ri$e and increas ing prealenee of quantitative trading models As a result therc is now a di sco rHHct between the markets themselves and the companies that are traded on the markets Algoshyrithm ic trading embodies this theorctical model on a ubiquitOus level What a company docs or does not do rnaners very liule to whether the companys stock should be bough t or sold Instead algorithms aTe usclt1 to determine whether the companys stock is a good ~ buy baSClt1 on how the Jlock is doing and how the marktt is behavi ng This shift has had a broad impact on retail and institutiorral investor behavior and the global economy at large but relatively lillie impact on regulatOry structures and the role of governrnem in overSight

T he regulatol) framework thai hislOricall y and currently dominates our markets has flil ed to keep pace with technological advancemellls In chapter 2 we address Ihe shortcomings of the regulatol) structure currently in place with emphasis on tir e evolution of the responsibilities of the Securities and Exchange Commission Here we show that the SECs focus on disclosure is inadequate and dangerous Subsequently in chapler 3 we offer a detailed cri tique of the overall regulatory model identifying the numerous agencies self-regulatory organizations and exchanges th at are charged with oversight of

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AX NOJlH1ClOlIJN I

INTRODUCTION xiii

thc companics within our regulatory framework and dlc stocks that purport m represclH them No longer do participalHs in the stock market purchase a particshyular stock becausc they would like to invest in thc company Now invcstor5-Qr more accurately purchasers- buy stock because of ilS value separate and apart from the company Specifically we document how modern lraders no longer rypically look at Ihe fu ndamentals of a particular company in deciding whether or nOI 10 buy ils stock Inslead Ihey exami ne the stock as a product in and of itself (like a maHer or a car) with a value that is separate and apart from the value of the underlying corporation l Thi~ disaggregation marks a fundam ental shift from an investor parJdigm to a consum er parldigrn This perception is evidenced at all levels ofiJwesting activity from mom -and-pop investors and day traders to institutional investors and laquoall Street traders

An example of this disaggregation at the micro level is the recent Linkedln acquisition by Microsoft a publicly traded company that was purchased for $262 billion without ever having shown a profit More pernicious still is its manifestation on a macro level where computerized trading-the use of algoshyrithms that barely take illlo account the fundamentals ofa company-represents the majority of trlding vol ume on US and international exchanges Ye argue that since the markets have become dominated by this new consumer paradigm we should completely divorce the theory of the firm lI1d corpo rate governln ce from the regulatory marker strucUlre treating the securities of the firm as a ~widgetraquo that consumers buy and regulate them as such

Our second premise fo llows from the first we assert that the regulatory srrucrure currently in place is wodully inadequate to regulate the products and markets as they have evohed to thei r present form Specifically the fundam en tal regulatory DNA of all federal securi ties agencies (spearheaded b) the Securit ies and Exchange Com mission) is one of di sclosure As regulation cont inues to

focus on disclosure it ignores the usc of increaSingly complex electronic systems and equipm ent that can be sabotaged by sophislicated hackers Ihe ascent of social media and the reliance on self-regul atory orgl niz1rions to police their own- all while corruption extends to even those selling marker s(andards~

T here arc numerous books written about the financial markets investing quallli tatle trading and technical analysis as well as regulatOry structures crisis manlgemelll and reform efforts This book is unique in th)( it proposes a radical new way of looking at imestmelll proltlucts and markets and encomshypasses that paradigm shift within our regulatory model For example while the 2008 financial crisis was nexorably intermined with the deri ~H i ves markets we consider it to be merely the most extreme manifcstation of the growing di sconshynect between thc perception of securities as invesunelllS lnd their actual usc as something far diffc rent ~ Our method of plugging the letks which we envision

xiv INTRODUCTI ON

as a total reengineering of the SYSlCIll deals wi this di sconnect head on and add resses all products in the securities markets system Nonetheless OllT primary focus is on th e equity markets and their role in the overall stability of the system

For ease and clarity this book is divided inm three primal) pans Loosely they describe what is what should be and how we plan to get there from here Pan I provides a thorough description of regulalOl) life as we now know it Si nce the dawn of regulation the greatest single change in the secu riti es markets is the way in which sccurit ies arc bought and sold Increasi ngly complex investshymem products and the introduction and adapt ion of increasingly sophisticated tcchnologies used in trading execution and operuion have revolutionized the exchanges making them virtually unrccognizable from those envisioned when the Securities Act of 1933 and the Securit ies Exchange Act of 1934 were enshyactClt1 Here we ideillify the ways in which the financial markets have changed the (lilure of regulations to keep up and th e resulta nt risks and vulnerabilities

We begin in chapter 1 with a discussion of the tcchnological advancements that have revolutionized individual and inst itutional trading execution and brokerdealer opel-nions over the last few dCCldes As a result of these innovashytions a seismic shift has taken place in the securities markets T he fault lines have been present for quite some time however it is only now in the last few years that the ramification s of these displacemeills have been felt The lYpical approach for traders has gone from examining companies to determine whether they will be a good long-term irwesunent to examining the markets as a whole Nowhere is thi s shift more apparent than in the ri$e and increas ing prealenee of quantitative trading models As a result therc is now a di sco rHHct between the markets themselves and the companies that are traded on the markets Algoshyrithm ic trading embodies this theorctical model on a ubiquitOus level What a company docs or does not do rnaners very liule to whether the companys stock should be bough t or sold Instead algorithms aTe usclt1 to determine whether the companys stock is a good ~ buy baSClt1 on how the Jlock is doing and how the marktt is behavi ng This shift has had a broad impact on retail and institutiorral investor behavior and the global economy at large but relatively lillie impact on regulatOry structures and the role of governrnem in overSight

T he regulatol) framework thai hislOricall y and currently dominates our markets has flil ed to keep pace with technological advancemellls In chapter 2 we address Ihe shortcomings of the regulatol) structure currently in place with emphasis on tir e evolution of the responsibilities of the Securities and Exchange Commission Here we show that the SECs focus on disclosure is inadequate and dangerous Subsequently in chapler 3 we offer a detailed cri tique of the overall regulatory model identifying the numerous agencies self-regulatory organizations and exchanges th at are charged with oversight of

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AX NOJlH1ClOlIJN I

xiv INTRODUCTI ON

as a total reengineering of the SYSlCIll deals wi this di sconnect head on and add resses all products in the securities markets system Nonetheless OllT primary focus is on th e equity markets and their role in the overall stability of the system

For ease and clarity this book is divided inm three primal) pans Loosely they describe what is what should be and how we plan to get there from here Pan I provides a thorough description of regulalOl) life as we now know it Si nce the dawn of regulation the greatest single change in the secu riti es markets is the way in which sccurit ies arc bought and sold Increasi ngly complex investshymem products and the introduction and adapt ion of increasingly sophisticated tcchnologies used in trading execution and operuion have revolutionized the exchanges making them virtually unrccognizable from those envisioned when the Securities Act of 1933 and the Securit ies Exchange Act of 1934 were enshyactClt1 Here we ideillify the ways in which the financial markets have changed the (lilure of regulations to keep up and th e resulta nt risks and vulnerabilities

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T he regulatol) framework thai hislOricall y and currently dominates our markets has flil ed to keep pace with technological advancemellls In chapter 2 we address Ihe shortcomings of the regulatol) structure currently in place with emphasis on tir e evolution of the responsibilities of the Securities and Exchange Commission Here we show that the SECs focus on disclosure is inadequate and dangerous Subsequently in chapler 3 we offer a detailed cri tique of the overall regulatory model identifying the numerous agencies self-regulatory organizations and exchanges th at are charged with oversight of

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xmiddoti I NTRODU CT ION

assessment of the e(feC the lIew regime wi ll hae 0 11 th e market ltIe consider how the new market Structu re could affect everyth ing from busi ness and human rights issues 10 stabilizi ng global markets ro assisting in capital for mations

This section begins with a poimmiddotby-poi nt discussion of the impact of our ntv holistic market regulation system on the current regularory system In chapter 7 we propose a new agency struclUre that is much more nimble and stream lined Vjth less to regulate on a micro level it can devote ilS attenrion to prognosticating on the strengths and weaknesses in Ihe markets This will enable il to take qu ick and decisive actions when necessa ry (eg implementin g n igger mechani sms or re-rouli ng order fl ow) and to deelop proactive alternatives hat can be employed to stop leaks and floods before they happen

From there we ill us trate in chapter 8 how th is innovarive perspective offers companies less regulation and more frCltdom in the markets and is benefi cial to corporate America and to society Here we describe step by step how compashynies navigate the IPQ process to bring their products to market In additio n we discuss how our Illore aligned approach to regulation actually reflects where the market is and protects custolll ers where they need the prOlcction Ihe most

Finally in chapter 9 we look at what it would take politically 10 rea lize the transition 10 this new regime (Ihat underscores the reluctance and in some cases aClll al push back from stakeholdNs ltIhal is in it for them to take the plunge ltIe also briefly examine how our scheme migh t fit withi n global marshykets activities and regu lation We look at threats posed to global economics by current praClices and Structures such as those tr igge-red by social media and elecshytronic order activation and begill to look u ways that the consumer protection paradigm could minimize those risks worldwide Making this shift gives the US an opportu nity to take a letdership role--or at teaSt a seat at the table which is considerably more than ou r antiqua ted system currently provides-in developshying a collaborative globl l markets Igtaradigm and regulatory Structure

We realize Ihal this is a complete paradigm shift An d lets be honest noshybody likes change Even when f1 ced with a leaky l-loocr Dam man) (indlcd most) people would 1I1her bail out th e water (or th l compan ies) and plug up the leaks than confront the problem at its source lip rilla so 10 speak

Recelll eents in th e securities markets have shown lIS our vulnerabili ties Right now there is no levee to hold back l hurricane-size storm T here is nOt even a current infrastructure to weather Ihe small leaks that can quickly transshyform inlO catastroph ic floods The only way to fix it is to sran over- to build a new levce-with the technology and equipm l lH needed to SlOp both smal1l laks and big floods before they co me

I NT RODUCTI ON xvii

JUSt so you know there s a difference betwee n a dike and a levee A dike normally rllns along or parallel to a body of water such as a river or a sea a dam runs across or through a body of water A dike has water only on one side a dam has water on bot h sides The main purpose of a dike is protecting the land bchind it from floodi ng whereas a dams purposc is ro retain the water Dikes and leees art t mban kmellls constructed (0 prevent floodi ng Levees may be formtd naturally or artificially They prevent the water from overflowing and flooding surroundi ng arcas6

Similarly in our markets rhere arc many d ifferent infrastructures at play that help 10 kttp our economy aOoat Ye have age ncies we have SROs we have private plaintiffs and we have legislarufts Right now however each of these entishyties seems to be worki ng at cross purposcs rathcr th an in harmony The results are not prt t1y

Gont are the days of tht Linle Dutch Boy7 who plugged leaks wi th his thumb Vith all the tcchnology we hae at our disposal now we can usc nOt just bener equipment but the right equipment fo r the job That way when the waters rise we l be ready

Notes

1 According to lhe US Geological Surycy ~although bot h arc sca waVC$ a tSunami and a tidal wave ~ re twO diffcrcnt phenomena A tidal wac is a sh ~ llow Wishy

ter wave cil uscO by the gnvitational inrerac tiOllS between thc Sun Moon and Earth T $unamis arc occan WaCli uiggcrcd by large Ca rt hquakcs that occur n~r or unmiddot

dl r thl ocean okanic I rupl ions submarine landslides and by onshore bndslidCS in which large olumes of debris fall inlO hc W1 llr (huplIwwwusgsgomiddotfaq ca tcgo rils197553 14 1) Comparativel) rhe nash c rash of 20 10 could be considered a lidal wavc whereJs rhe more fundam ental market c rash in 2008 and rhe resulting depresshysion wo uld be a tsunami

2 StU Woo Jnd Lynn Cowa n ~ linkedln 42 Billion Valuat ion ROli scs E)ebrows~

TIN flall Stru t jouna (May 1920 11 ) 3 Microsoft Purchase of Linkedln is one of thl Most upensic T exh Deals in H isshy

lOry It May not be One of the SmartCSM TIlt EcollollliSl Uunl 18 2016) Equally ama-v ing is that when rhe acquisil ion ts announcro the slock price jumpcJ approxi mately S60 per sharc from SI30 10 5 190

4 Alyssa Ch~ng ~Whln Lobbyists Li tera lly W rite rhl Bill NPR Its all Poilia (No 112013) See also Jonathan Spicer and Emily Srlpilensons ~ret tapes of Fed mcelshyings on Goldman prOmp r Q Il for US h (a rings~ in Rmttrs BlISil1m News (Sep 26 20 11)

5 To that end there are num(rOus scholars who in the wakc of the finJncial crisis hal discussed the per ils of deriva tives and heir comparison to gambli ng (Eric A Posner and E Glln Weyl MA Proposal for limit ing Speculation on Derivaries An FDA for Fin anciallnnov~tion UllillfTJiry ojCiJi(tlgo Imtitlltt for LillI) 0- Ecollomics Olin R~rch

xviii INTRODUCT ION

Pa~r No 594) speculalio ll (Lynn A SIOUI ~ Regublc O TC Derivalilt($ by Deregulalshying Thcm~ ComlIlaw Fallllry fuhicatiom Paper 754 hIlPfsc holarshipJawcomdl w ulfacpub754) and co(n weapons of mass desUUClion (Buff Cit as quoled by Tony Bord in ~Warrcn BuffclI SlilI $lt1)5 der ivatives arc wcltamppons of mass dest ruct ion ~ Fillal middot cia RnJiw Uuly 15 2015)) Ye tend 10 agrC with Ihcse intellectuals assesslnen t of the derivaliv(S mark(1 and discuss Ihis nmhn in Pari Ill

G Agri waler~dia hltpagriwaterpcd ia infowiki Dikes_dams_I(v(Cs 7 Peter Miller n UIII Dutch Boy (Encrc1oplaquolia MYlhica 2016) httpwww

panlhronorgariideslilliltle_dmch_boyhlmi ~ Dulch legend has il thallhere was once a small boy who upon passi ng a dike on his way 10 school noticw a slight leak as Ihe sea uickled in Ihrough a small hole Knowing Ihal he would be in lrouble ifhe were 10 be bte for school the boy poked his finger imo Ihe hole and so stemmed the now of water Sornelime later a passerby saw him and went to gCI help This came in the form of Olher men who were able to cTeel rcpain on the dike and seal up Ihe leak This Story is told to children lO teach them th~t if they an quickly and in time even they with their limited Strength and resources ca n avcr disaners The faci that the little Dutch Boy used his fin ger to SlOp he now of water is used as an illustration of sdf-sacrifce The physical lesson is also laughl a small trickle of gtIraler soon becomes a Slream and the slrClm a tOTshyrem and the lOrrell a nood sweeping all before ii dike malerial roadways and cars and eCn rA ilway lUCks and blidgcs and whole Irains This laic originates from the Ametian wrilcr Mal) Mapes Dodge and is in ract nor a (cal mlh although many people belico it is She published Ihis tale in HailS Brinker or Ihe Silver Skala in 1865

I NT RODUCTI ON xvii

JUSt so you know there s a difference betwee n a dike and a levee A dike normally rllns along or parallel to a body of water such as a river or a sea a dam runs across or through a body of water A dike has water only on one side a dam has water on bot h sides The main purpose of a dike is protecting the land bchind it from floodi ng whereas a dams purposc is ro retain the water Dikes and leees art t mban kmellls constructed (0 prevent floodi ng Levees may be formtd naturally or artificially They prevent the water from overflowing and flooding surroundi ng arcas6

Similarly in our markets rhere arc many d ifferent infrastructures at play that help 10 kttp our economy aOoat Ye have age ncies we have SROs we have private plaintiffs and we have legislarufts Right now however each of these entishyties seems to be worki ng at cross purposcs rathcr th an in harmony The results are not prt t1y

Gont are the days of tht Linle Dutch Boy7 who plugged leaks wi th his thumb Vith all the tcchnology we hae at our disposal now we can usc nOt just bener equipment but the right equipment fo r the job That way when the waters rise we l be ready

Notes

1 According to lhe US Geological Surycy ~although bot h arc sca waVC$ a tSunami and a tidal wave ~ re twO diffcrcnt phenomena A tidal wac is a sh ~ llow Wishy

ter wave cil uscO by the gnvitational inrerac tiOllS between thc Sun Moon and Earth T $unamis arc occan WaCli uiggcrcd by large Ca rt hquakcs that occur n~r or unmiddot

dl r thl ocean okanic I rupl ions submarine landslides and by onshore bndslidCS in which large olumes of debris fall inlO hc W1 llr (huplIwwwusgsgomiddotfaq ca tcgo rils197553 14 1) Comparativel) rhe nash c rash of 20 10 could be considered a lidal wavc whereJs rhe more fundam ental market c rash in 2008 and rhe resulting depresshysion wo uld be a tsunami

2 StU Woo Jnd Lynn Cowa n ~ linkedln 42 Billion Valuat ion ROli scs E)ebrows~

TIN flall Stru t jouna (May 1920 11 ) 3 Microsoft Purchase of Linkedln is one of thl Most upensic T exh Deals in H isshy

lOry It May not be One of the SmartCSM TIlt EcollollliSl Uunl 18 2016) Equally ama-v ing is that when rhe acquisil ion ts announcro the slock price jumpcJ approxi mately S60 per sharc from SI30 10 5 190

4 Alyssa Ch~ng ~Whln Lobbyists Li tera lly W rite rhl Bill NPR Its all Poilia (No 112013) See also Jonathan Spicer and Emily Srlpilensons ~ret tapes of Fed mcelshyings on Goldman prOmp r Q Il for US h (a rings~ in Rmttrs BlISil1m News (Sep 26 20 11)

5 To that end there are num(rOus scholars who in the wakc of the finJncial crisis hal discussed the per ils of deriva tives and heir comparison to gambli ng (Eric A Posner and E Glln Weyl MA Proposal for limit ing Speculation on Derivaries An FDA for Fin anciallnnov~tion UllillfTJiry ojCiJi(tlgo Imtitlltt for LillI) 0- Ecollomics Olin R~rch

xviii INTRODUCT ION

Pa~r No 594) speculalio ll (Lynn A SIOUI ~ Regublc O TC Derivalilt($ by Deregulalshying Thcm~ ComlIlaw Fallllry fuhicatiom Paper 754 hIlPfsc holarshipJawcomdl w ulfacpub754) and co(n weapons of mass desUUClion (Buff Cit as quoled by Tony Bord in ~Warrcn BuffclI SlilI $lt1)5 der ivatives arc wcltamppons of mass dest ruct ion ~ Fillal middot cia RnJiw Uuly 15 2015)) Ye tend 10 agrC with Ihcse intellectuals assesslnen t of the derivaliv(S mark(1 and discuss Ihis nmhn in Pari Ill

G Agri waler~dia hltpagriwaterpcd ia infowiki Dikes_dams_I(v(Cs 7 Peter Miller n UIII Dutch Boy (Encrc1oplaquolia MYlhica 2016) httpwww

panlhronorgariideslilliltle_dmch_boyhlmi ~ Dulch legend has il thallhere was once a small boy who upon passi ng a dike on his way 10 school noticw a slight leak as Ihe sea uickled in Ihrough a small hole Knowing Ihal he would be in lrouble ifhe were 10 be bte for school the boy poked his finger imo Ihe hole and so stemmed the now of water Sornelime later a passerby saw him and went to gCI help This came in the form of Olher men who were able to cTeel rcpain on the dike and seal up Ihe leak This Story is told to children lO teach them th~t if they an quickly and in time even they with their limited Strength and resources ca n avcr disaners The faci that the little Dutch Boy used his fin ger to SlOp he now of water is used as an illustration of sdf-sacrifce The physical lesson is also laughl a small trickle of gtIraler soon becomes a Slream and the slrClm a tOTshyrem and the lOrrell a nood sweeping all before ii dike malerial roadways and cars and eCn rA ilway lUCks and blidgcs and whole Irains This laic originates from the Ametian wrilcr Mal) Mapes Dodge and is in ract nor a (cal mlh although many people belico it is She published Ihis tale in HailS Brinker or Ihe Silver Skala in 1865

xviii INTRODUCT ION

Pa~r No 594) speculalio ll (Lynn A SIOUI ~ Regublc O TC Derivalilt($ by Deregulalshying Thcm~ ComlIlaw Fallllry fuhicatiom Paper 754 hIlPfsc holarshipJawcomdl w ulfacpub754) and co(n weapons of mass desUUClion (Buff Cit as quoled by Tony Bord in ~Warrcn BuffclI SlilI $lt1)5 der ivatives arc wcltamppons of mass dest ruct ion ~ Fillal middot cia RnJiw Uuly 15 2015)) Ye tend 10 agrC with Ihcse intellectuals assesslnen t of the derivaliv(S mark(1 and discuss Ihis nmhn in Pari Ill

G Agri waler~dia hltpagriwaterpcd ia infowiki Dikes_dams_I(v(Cs 7 Peter Miller n UIII Dutch Boy (Encrc1oplaquolia MYlhica 2016) httpwww

panlhronorgariideslilliltle_dmch_boyhlmi ~ Dulch legend has il thallhere was once a small boy who upon passi ng a dike on his way 10 school noticw a slight leak as Ihe sea uickled in Ihrough a small hole Knowing Ihal he would be in lrouble ifhe were 10 be bte for school the boy poked his finger imo Ihe hole and so stemmed the now of water Sornelime later a passerby saw him and went to gCI help This came in the form of Olher men who were able to cTeel rcpain on the dike and seal up Ihe leak This Story is told to children lO teach them th~t if they an quickly and in time even they with their limited Strength and resources ca n avcr disaners The faci that the little Dutch Boy used his fin ger to SlOp he now of water is used as an illustration of sdf-sacrifce The physical lesson is also laughl a small trickle of gtIraler soon becomes a Slream and the slrClm a tOTshyrem and the lOrrell a nood sweeping all before ii dike malerial roadways and cars and eCn rA ilway lUCks and blidgcs and whole Irains This laic originates from the Ametian wrilcr Mal) Mapes Dodge and is in ract nor a (cal mlh although many people belico it is She published Ihis tale in HailS Brinker or Ihe Silver Skala in 1865

Part I

THE DISCLOSURE PARADIGM

$wrics about the flnancial markets have become 3 sllttple in news repon s and on the Jmcrnel Reading them can somet imes lgte like w~uching a tm in wreck especially when the repons arc about market crashes or malfunclions-whether you fully undcrsrand what theyre telling you or nm it s hard to turn away The information can be co u[usi ng particularly when the comrnCrlIHors arc not speshycifi c abom which aspect of the financial markets they are talking about There is commercial bm king which is responsible for checking 11(1 savings accounts investment products such as cert ificatcs ofdeposit commercial paper and other imcrcs l-ocaring pnxiuctS And there is imes trncnt banking which encompasses rhe securities mukets-srocks bonds options commodilies futures deriva~ tives etc-and the cOon s by bankers lO produce new issucs that arc bouglu and sold on exchanges with in these markets Up ull1ilthe ate 1990s commercial banks cou ld on ly engage in the securi ties markets in tWO ways they could sell irweslmem products such as slOcks bonds and mmual funds th rough a pan ner~

sh ip with a securities firm and they could invest their cash reserves-the funds they usc to make loans for example-in securities as a way to incrcase profit s

That bright line between th e tWO meant that commercial banks were not allowed to engage in investment banking act ivities and investment banks shi ed away from cornmcrchtl banking aClivities (which is still th e case) Rtgulation and lines of aut hority tnd respo nsibility-which regulatory bodies oversaw securities produCls and markets and which were accounttble for deposit accounts lendshying commercial paper and Treasury securit ies-were detrer then as well Now absent those del ineations maki ng the d isti nction between which agencies arc responsible for regulati ng wh ich products and mtrkets can be confuSing even to writers and regulators

Our focus throughout this book is on the securities markets tnd the relevant participants involved ltIe do touch on the banking industry where we focus on

2 PART I

Treasury securities and more specifical ly on the invCSilllelll banking portion of the markets Vhile the lOo-big-to-f1i1 banks have become so in pan through thei r engagement in securi ties activities-JP Morgan Chase and Citibank come to mind herC-ltOlll lllercial banking and regulation arc not included in this co nversation except 10 ally extent that those activities and regulations pertai n direcdy 10 the securit ies markets Our interest lies solely in investment products and pan icipants trading and regulation

In this section we examine thc current structure of the US scxurit ies markets and ident ify some of thc fundamemal flaws in the currem system Ye begi n with a broad ovcrvicw of thc markets the salie m issues and the poccntial pitf111s Vc contend that thc disintcgration of thc wall betwcen commercial and investment banking prol ifcrat ion of unrcgulated producpounds advanccmcnts in technology and insti tutionalization ofelectronic trading havc substantially changcd how wc view and engage with these markcts

In the second chapter we move on 10 an analysis of thc disclosurc paradigm on which the ex isting regulatory structure is based The SECs regulatory rcgime aka the disclosure model was designed around corporate financial disclosures in part to ensure investor protection This method assumes that investors use in shyformation provided in those disclosures to make intelligent investment choices However there arc flaws in that design The di sclosure system was based on the failings of the 19205 securities markets Things have changed considerably since then Morcover companies have found a multitude of ways to skin the rcquireshymelllS The disclosure system is wodiJlly our of date

The history of the changing nature of thc securities markets and the failure of regulation to keep up is the foc us of the third chapter Sincc the 1933 and 1934 Acts the regulatory structure has been chasing advancements and has been consistently unsuccessful in its attempts to c1tch th em The result is a sophisshyticated market system overseen by a patchwork of uncoordinated ineffectual regulatory organizations SROs exchanges and ancillary entities

All of this to state the obious the regulators have run ou t of fingers and toes lO use to plug thc holes in the now-crumbling regulatory dike Thc las t tsunami in 2008 almost wiped it out The ncxt onc is surc to

Part II

WHOLE MARKET REGULATION

In Ihe previous seclion we acknowltdged thaI the current disclosure model and its patchwork rcgulawry structure arc no longer efTcclivc In (1(1 they have no t been for some lime T he occasions when markets arc sinH down due 10 Icxhnical difficulties-be if a TwillT feed update glitch or worse-arc happe ning with in creasing frequency Regulators arc ill-equipped to writ e regulation (evt ll with ~guida llcc from ind ustry giants) enforce the OIiCS o n the books or determin e how 10 keep up with let alone anticipate new trends

In this section we look at poss ible alternatives H ow might we create an efshyfective d11dc nt regulatory structure Ihal is able (Q keep pace in an increasi ngly

sophisticated ellvironment While we app laud the work done by Professor Loss in the 1970s we have someliling more streamlined than his 700-page Federal Securit ies Code in mind And while we agree with the 1988 reporl by the Presishydential T ask Force on Markel MCChanisms that a whole- market perspective is csshysetHial we are nOt convinced by thei r rCCommendatio n that the Federal Resec should be lasked with Icading such a charge

O ur exploration o f al ternatives d oes not stop with regubwry Strucnrrcs Vlc move beyo nd the cry core o f o m cu rrent regulatory composition- the d iscloshysure regime-to develop a paradigm hat embraces whole market regu lation one that acknowledges the di saggregation of investment practices and develops the idea o f securities as products as a means to oOcr aClual invcstor protection

Part III

IMPLEMENTATION AND IMPLICATIONS

In Ihis section we discuss the derails of implemcmalion includi ng the regulashylOry hu rd les hat will need to be overcome to implement our model We also explore the vcry real issue of how we might achieve the polirical will necessary 10 accomplish such an ambilious result Finally this scclion provides some preshyliminary blueprints for cstablishing such a system both subsralllivcly- th rough legislatio n-and procedurally-by ove rhauling our current agency suuclUre

Here we ofTer an honest and critical assessment of (he COCCI lite new regi me will have on the markel Here we prognosticate on how the lIe w rnarkcl StruCshy

turc could afice( everything from business and human rights issues to siabilizing global markets to assisting in capital fo rmations before consideri ng the poten titl unintended consequences that could occur from adoption of this model

As we th ink abom how we might beSt create this new overSight Slructure we have to th ink aoom what exactly we wan t to regulate Xlhat current regulations arc effective and worth keeping For example

bull Is it feasible to allow corporations to opt-om of this new system and rnailltain some variant of a disclosure protocol

bull How does the new structure provide the investor wit h at least the level of conshyfide nce engendered by the ctlrre tH disclosure lllodel-and preferably morc

bull What role does IOb-S play in this new system bull H ow does th is new system mesh wi th the global markets

In the previous section we tal ked at length- and in theory-about our model a comprehensive new paradigm in which securit ies arc treated as COI1shy

surner proltiucts within a world of whole market regulation In this section we opcrationali zc our theo ries by looking at what it would take to make our para shydigm a reality In chapter 7 we ill ustrate the ways in wh ich the new regulatory

l IS

11 6 PART III

model a collaborativ~ agency srrUClUre wi ll reduce bloat and make regulato ry agencies more nimble Vhh less to regu late Oil a micro lee1 we show how agenshycies witl be able to devote their attention to forecasting and invcstigating weakshynesses in the markcts and developing prolctive fram eworks for building 21st eentury financial markets Cha pter 8 covers th e corporate perspective the new requiremell ts for corporate and Illunicipal entities in their quest to raise debt and equiry capital by bringin g ncw issues-new products-to market And finall y in chapter 9 we show how these changes might be brought about by exam ining rhe political and legal roads to implementation There we also brieR) explore how this structu re might help stabi lize global markets

• 1-2
• 3-4
• 5-7
• 8-10
• cover

2 PART I

Treasury securities and more specifical ly on the invCSilllelll banking portion of the markets Vhile the lOo-big-to-f1i1 banks have become so in pan through thei r engagement in securi ties activities-JP Morgan Chase and Citibank come to mind herC-ltOlll lllercial banking and regulation arc not included in this co nversation except 10 ally extent that those activities and regulations pertai n direcdy 10 the securit ies markets Our interest lies solely in investment products and pan icipants trading and regulation

In this section we examine thc current structure of the US scxurit ies markets and ident ify some of thc fundamemal flaws in the currem system Ye begi n with a broad ovcrvicw of thc markets the salie m issues and the poccntial pitf111s Vc contend that thc disintcgration of thc wall betwcen commercial and investment banking prol ifcrat ion of unrcgulated producpounds advanccmcnts in technology and insti tutionalization ofelectronic trading havc substantially changcd how wc view and engage with these markcts

In the second chapter we move on 10 an analysis of thc disclosurc paradigm on which the ex isting regulatory structure is based The SECs regulatory rcgime aka the disclosure model was designed around corporate financial disclosures in part to ensure investor protection This method assumes that investors use in shyformation provided in those disclosures to make intelligent investment choices However there arc flaws in that design The di sclosure system was based on the failings of the 19205 securities markets Things have changed considerably since then Morcover companies have found a multitude of ways to skin the rcquireshymelllS The disclosure system is wodiJlly our of date

The history of the changing nature of thc securities markets and the failure of regulation to keep up is the foc us of the third chapter Sincc the 1933 and 1934 Acts the regulatory structure has been chasing advancements and has been consistently unsuccessful in its attempts to c1tch th em The result is a sophisshyticated market system overseen by a patchwork of uncoordinated ineffectual regulatory organizations SROs exchanges and ancillary entities

All of this to state the obious the regulators have run ou t of fingers and toes lO use to plug thc holes in the now-crumbling regulatory dike Thc las t tsunami in 2008 almost wiped it out The ncxt onc is surc to

Part II

WHOLE MARKET REGULATION

In Ihe previous seclion we acknowltdged thaI the current disclosure model and its patchwork rcgulawry structure arc no longer efTcclivc In (1(1 they have no t been for some lime T he occasions when markets arc sinH down due 10 Icxhnical difficulties-be if a TwillT feed update glitch or worse-arc happe ning with in creasing frequency Regulators arc ill-equipped to writ e regulation (evt ll with ~guida llcc from ind ustry giants) enforce the OIiCS o n the books or determin e how 10 keep up with let alone anticipate new trends

In this section we look at poss ible alternatives H ow might we create an efshyfective d11dc nt regulatory structure Ihal is able (Q keep pace in an increasi ngly

sophisticated ellvironment While we app laud the work done by Professor Loss in the 1970s we have someliling more streamlined than his 700-page Federal Securit ies Code in mind And while we agree with the 1988 reporl by the Presishydential T ask Force on Markel MCChanisms that a whole- market perspective is csshysetHial we are nOt convinced by thei r rCCommendatio n that the Federal Resec should be lasked with Icading such a charge

O ur exploration o f al ternatives d oes not stop with regubwry Strucnrrcs Vlc move beyo nd the cry core o f o m cu rrent regulatory composition- the d iscloshysure regime-to develop a paradigm hat embraces whole market regu lation one that acknowledges the di saggregation of investment practices and develops the idea o f securities as products as a means to oOcr aClual invcstor protection

Part III

IMPLEMENTATION AND IMPLICATIONS

In Ihis section we discuss the derails of implemcmalion includi ng the regulashylOry hu rd les hat will need to be overcome to implement our model We also explore the vcry real issue of how we might achieve the polirical will necessary 10 accomplish such an ambilious result Finally this scclion provides some preshyliminary blueprints for cstablishing such a system both subsralllivcly- th rough legislatio n-and procedurally-by ove rhauling our current agency suuclUre

Here we ofTer an honest and critical assessment of (he COCCI lite new regi me will have on the markel Here we prognosticate on how the lIe w rnarkcl StruCshy

turc could afice( everything from business and human rights issues to siabilizing global markets to assisting in capital fo rmations before consideri ng the poten titl unintended consequences that could occur from adoption of this model

As we th ink abom how we might beSt create this new overSight Slructure we have to th ink aoom what exactly we wan t to regulate Xlhat current regulations arc effective and worth keeping For example

bull Is it feasible to allow corporations to opt-om of this new system and rnailltain some variant of a disclosure protocol

bull How does the new structure provide the investor wit h at least the level of conshyfide nce engendered by the ctlrre tH disclosure lllodel-and preferably morc

bull What role does IOb-S play in this new system bull H ow does th is new system mesh wi th the global markets

In the previous section we tal ked at length- and in theory-about our model a comprehensive new paradigm in which securit ies arc treated as COI1shy

surner proltiucts within a world of whole market regulation In this section we opcrationali zc our theo ries by looking at what it would take to make our para shydigm a reality In chapter 7 we ill ustrate the ways in wh ich the new regulatory

l IS

11 6 PART III

model a collaborativ~ agency srrUClUre wi ll reduce bloat and make regulato ry agencies more nimble Vhh less to regu late Oil a micro lee1 we show how agenshycies witl be able to devote their attention to forecasting and invcstigating weakshynesses in the markcts and developing prolctive fram eworks for building 21st eentury financial markets Cha pter 8 covers th e corporate perspective the new requiremell ts for corporate and Illunicipal entities in their quest to raise debt and equiry capital by bringin g ncw issues-new products-to market And finall y in chapter 9 we show how these changes might be brought about by exam ining rhe political and legal roads to implementation There we also brieR) explore how this structu re might help stabi lize global markets

• 1-2
• 3-4
• 5-7
• 8-10
• cover

Part II

WHOLE MARKET REGULATION

In Ihe previous seclion we acknowltdged thaI the current disclosure model and its patchwork rcgulawry structure arc no longer efTcclivc In (1(1 they have no t been for some lime T he occasions when markets arc sinH down due 10 Icxhnical difficulties-be if a TwillT feed update glitch or worse-arc happe ning with in creasing frequency Regulators arc ill-equipped to writ e regulation (evt ll with ~guida llcc from ind ustry giants) enforce the OIiCS o n the books or determin e how 10 keep up with let alone anticipate new trends

In this section we look at poss ible alternatives H ow might we create an efshyfective d11dc nt regulatory structure Ihal is able (Q keep pace in an increasi ngly

sophisticated ellvironment While we app laud the work done by Professor Loss in the 1970s we have someliling more streamlined than his 700-page Federal Securit ies Code in mind And while we agree with the 1988 reporl by the Presishydential T ask Force on Markel MCChanisms that a whole- market perspective is csshysetHial we are nOt convinced by thei r rCCommendatio n that the Federal Resec should be lasked with Icading such a charge

O ur exploration o f al ternatives d oes not stop with regubwry Strucnrrcs Vlc move beyo nd the cry core o f o m cu rrent regulatory composition- the d iscloshysure regime-to develop a paradigm hat embraces whole market regu lation one that acknowledges the di saggregation of investment practices and develops the idea o f securities as products as a means to oOcr aClual invcstor protection

Part III

IMPLEMENTATION AND IMPLICATIONS

In Ihis section we discuss the derails of implemcmalion includi ng the regulashylOry hu rd les hat will need to be overcome to implement our model We also explore the vcry real issue of how we might achieve the polirical will necessary 10 accomplish such an ambilious result Finally this scclion provides some preshyliminary blueprints for cstablishing such a system both subsralllivcly- th rough legislatio n-and procedurally-by ove rhauling our current agency suuclUre

Here we ofTer an honest and critical assessment of (he COCCI lite new regi me will have on the markel Here we prognosticate on how the lIe w rnarkcl StruCshy

turc could afice( everything from business and human rights issues to siabilizing global markets to assisting in capital fo rmations before consideri ng the poten titl unintended consequences that could occur from adoption of this model

As we th ink abom how we might beSt create this new overSight Slructure we have to th ink aoom what exactly we wan t to regulate Xlhat current regulations arc effective and worth keeping For example

bull Is it feasible to allow corporations to opt-om of this new system and rnailltain some variant of a disclosure protocol

bull How does the new structure provide the investor wit h at least the level of conshyfide nce engendered by the ctlrre tH disclosure lllodel-and preferably morc

bull What role does IOb-S play in this new system bull H ow does th is new system mesh wi th the global markets

In the previous section we tal ked at length- and in theory-about our model a comprehensive new paradigm in which securit ies arc treated as COI1shy

surner proltiucts within a world of whole market regulation In this section we opcrationali zc our theo ries by looking at what it would take to make our para shydigm a reality In chapter 7 we ill ustrate the ways in wh ich the new regulatory

l IS

11 6 PART III

model a collaborativ~ agency srrUClUre wi ll reduce bloat and make regulato ry agencies more nimble Vhh less to regu late Oil a micro lee1 we show how agenshycies witl be able to devote their attention to forecasting and invcstigating weakshynesses in the markcts and developing prolctive fram eworks for building 21st eentury financial markets Cha pter 8 covers th e corporate perspective the new requiremell ts for corporate and Illunicipal entities in their quest to raise debt and equiry capital by bringin g ncw issues-new products-to market And finall y in chapter 9 we show how these changes might be brought about by exam ining rhe political and legal roads to implementation There we also brieR) explore how this structu re might help stabi lize global markets

• 1-2
• 3-4
• 5-7
• 8-10
• cover

Part III

IMPLEMENTATION AND IMPLICATIONS

In Ihis section we discuss the derails of implemcmalion includi ng the regulashylOry hu rd les hat will need to be overcome to implement our model We also explore the vcry real issue of how we might achieve the polirical will necessary 10 accomplish such an ambilious result Finally this scclion provides some preshyliminary blueprints for cstablishing such a system both subsralllivcly- th rough legislatio n-and procedurally-by ove rhauling our current agency suuclUre

Here we ofTer an honest and critical assessment of (he COCCI lite new regi me will have on the markel Here we prognosticate on how the lIe w rnarkcl StruCshy

turc could afice( everything from business and human rights issues to siabilizing global markets to assisting in capital fo rmations before consideri ng the poten titl unintended consequences that could occur from adoption of this model

As we th ink abom how we might beSt create this new overSight Slructure we have to th ink aoom what exactly we wan t to regulate Xlhat current regulations arc effective and worth keeping For example

bull Is it feasible to allow corporations to opt-om of this new system and rnailltain some variant of a disclosure protocol

bull How does the new structure provide the investor wit h at least the level of conshyfide nce engendered by the ctlrre tH disclosure lllodel-and preferably morc

bull What role does IOb-S play in this new system bull H ow does th is new system mesh wi th the global markets

In the previous section we tal ked at length- and in theory-about our model a comprehensive new paradigm in which securit ies arc treated as COI1shy

surner proltiucts within a world of whole market regulation In this section we opcrationali zc our theo ries by looking at what it would take to make our para shydigm a reality In chapter 7 we ill ustrate the ways in wh ich the new regulatory

l IS

11 6 PART III

model a collaborativ~ agency srrUClUre wi ll reduce bloat and make regulato ry agencies more nimble Vhh less to regu late Oil a micro lee1 we show how agenshycies witl be able to devote their attention to forecasting and invcstigating weakshynesses in the markcts and developing prolctive fram eworks for building 21st eentury financial markets Cha pter 8 covers th e corporate perspective the new requiremell ts for corporate and Illunicipal entities in their quest to raise debt and equiry capital by bringin g ncw issues-new products-to market And finall y in chapter 9 we show how these changes might be brought about by exam ining rhe political and legal roads to implementation There we also brieR) explore how this structu re might help stabi lize global markets

• 1-2
• 3-4
• 5-7
• 8-10
• cover

11 6 PART III

model a collaborativ~ agency srrUClUre wi ll reduce bloat and make regulato ry agencies more nimble Vhh less to regu late Oil a micro lee1 we show how agenshycies witl be able to devote their attention to forecasting and invcstigating weakshynesses in the markcts and developing prolctive fram eworks for building 21st eentury financial markets Cha pter 8 covers th e corporate perspective the new requiremell ts for corporate and Illunicipal entities in their quest to raise debt and equiry capital by bringin g ncw issues-new products-to market And finall y in chapter 9 we show how these changes might be brought about by exam ining rhe political and legal roads to implementation There we also brieR) explore how this structu re might help stabi lize global markets

• 1-2
• 3-4
• 5-7
• 8-10
• cover