Competition creates a Race to the TOP: The EU should seek Liberalisation not Harmonisation

The EU financial directives should be ditched. The Telegraph gives 6 reasons why. Yet we feel that there is a more important 7th reason: competition will create better regulation. Policy makers should remember that economic actors meet at stock marketes for mutual benificial gain (a stock market without investors is as useless as one without companies). Competition between stock markets will allow the stock markets which can deliver appropriate investor safegaurds to flourish.

In The Telegraph, Mark Hoban, Financial Secretary to the Treasury focusses on the problems the EU faces in agreeing on financial regulation. The Economist points to the flawed Dodd-Frank act as an example of bad regulation, yet feels that the harmonized Americans are doing a better job than the more dispersed Europeans. Both Mark Hoban and the Economist should read “Does Britain Need a Financial Regulator?” and realize that professional investors and exchanges have an incentive to develop the appropriate regulation and that this does not need to be a function of a transnational body or even national body.

In the same way that the process of producing and distributing bread changes, the financial system too is subject to innovation.  The best way too find the appropriate regulatory system  and to keep up with innovation is by allowing different stock-exchanges to compete.

Competition in regulation between exchanges creates a race to the top not to the bottom. Yes, an exchange may wish to stop short of suspending a listed company for misbehaving because of revenue loss, but an exchange needs investors as well as companies, as investors can walk away too. The companies want cash and the investors are looking for investments. All that is lacking is trust. To gain trust parties must find ways to communicate. Due to centralized regulation the most efficient way to communicate may not be found. 

Competition is a requirement to discover the best regulation and the best way for potential investors and companies to communicate. Different types of regulation impose different costs on different market users and constrain financial innovation in different ways. Throughout history we see that competition brings about important innovation in all industries including finance.

The early development of the Amsterdam stock exchange is remarkable example of spontaneous development of rules and enforcement systems in the most difficult of circumstances. The Amsterdam stock exchange began in 1602 and swiftly included facilities for future settlements and transactions, opening up the possibility of default. The exchange managed the risk of settlements, which was important for liquidity.  Many contracts were not recognized or even forbidden by Dutch law. The exchange developed its own rules and regulations, based on reputation, so that parties met their obligations even though they could not be enforced through the Dutch legal system. The punishments in this system were many based on industrial boycotts and loss of reputation.

The precursors of the London Stock Exchange (LSE) were the informal exchanges in coffee shops in the 18^th century. These also developed systems of rules and enforcement. Those that did not settle their accounts where “named and shamed”.

We must remember that too lacks regulation might allow companies to dictate terms, yet in a competitive environment they would struggle to find any investors on the exchange. Investors and companies need each other.

If this thinking applies to stock exchanges surely it also applies to  other regulation where economic actors have communication problems such as with, accounting standards, disclosure, corporate governance and deposit insurance. More on those topic will appear on this blog shortly.

In the constitution of Liberty F.A. Hayek noted that the ”power of the professional administrator … is now the main threat to individual liberty” (Hayek P. 305). The developed world should learn the lessons Hernando de Soto is trying to teach the developing world. Centralized rules exclude innovative ideas and unique knowledge. Societies will create their own rules in an extra-legal system. The best way to find the appropriate set of rules and regulations is by allowing different institutions to compete and evolve creating a race to the top.