26 April 2001

Financial Market Stability:

Self-Regulation or State Regulation?
Markets require Rules Rules range from those that can only be set by the state to tacit agreements between market operators. The challenge is to specify the borderlines, and the mechanism to move these rapidly as circumstances evolve. EMU is not the only Driver changing Europe’s Financial System – the Need for “Rules” is Paramount European Integration, demographic trends and the impact of technology are creating a revolution rather than a gentle evolution. Rules will need to solve hitherto unknown problems and be capable of rapid adaptation. “Lamfalussy Report”: Only part of the Solution The report dealt with many aspects of the rule-making process at the top of the chain – but did not address the issue of the boundaries with operational rules that market participants agree upon to regulate their own conduct. Required: Robust Contract Law Framework for Electronic Securities Trading The technology is advancing rapidly but the legal system is often based on 19th century notions of physical paper records. It needs to be comprehensively updated to create a genuine pan-EU financial market in the 21st century. UK: Too early to judge the Transition from a Value-based System to the FSA’s Rule-based System. Efficient in avoiding fraud and misbehaviour, but will investors pay the significant costs if they find an alternative via the Internet? US: A System heavily based on Self-regulation The SEC has prioritised arrangements to generate mutual trust between regulators and market participants – rather than mutual suspicion, often the case in Europe. Regulation by “Value”: Vital for Extraordinarily Successful Conversion to the Euro National legal complexities were avoided for the sake of an expedient decision – voluntarily entered into. Lessons: No Single EU Regulatory Authority - Self- regulation by Values is required to create a Globally Competitive Market in the EU While markets are in a period of revolution, the crucial requirement is to get market participants to agree their own rules –based on the imperative of shared commercial values.

SummaryThe advent of the euro opens up the possibility of consolidating Europe's capital markets into a single, world scale market that can intermediate the flow of savings from an aging population saving for its retirement to a wide spectrum of end-users. The challenge is to maximise the efficiency of this process by utilising the opportunities created by dramatic technological change. This could become a significant competitive advantage for the EU within the global market place for trading securities. The Heads of EU Governments have already set the completion of this single capital market as a strategic goal. This was re -confirmed at the Lisbon Summit in March 2000; emphasised by the appointment of the Committee of Wise Men (The “Lamfalussy Report”) and re-iterated at the Stockholm Summit in March 2001. But any market mechanism requires “rules” for its smooth operation and these can come in a variety of forms: At the highest level, Governments will prescribe laws that lay down the key elements – some of which may have criminal sanctions to enforce them. At the lowest level, market operators will agree on the layout of computer screens so that one box will describe the exact security that is bought/sold, another box specifies the volume of the securities, and so on. Thus, a sophisticated modern market system will have a vast range of rules. Some can only be specified by the State because of its power, and some would be ludicrous if government officials were involved in the discussions of the minutiae. The challenge is to specify the borderlines, and the mechanism to move these rapidly – in either direction – as circumstances evolve.

Contents
Introduction Europe faces Extra Problems The Nature of the Market to be regulated What Type of Regulation: Rules or Values? Appendix: How the SEC operates

Figures
Figure 1: The Chain of Market Participants in the Capital Market

© Graham Bishop