FOUR PATHS TO SUCCESS

For markets to function, all players — state, regulator, intermediary and customer — must pull together

Financial markets play a major role in facilitating interaction between the entities that form an economy, be it the global village or its remote local equivalent. Financial markets create the medium of exchange between entities of various kinds, over space and time. They allow us to leave cash in a safe place, accessing it when we need it. They give us the means to defer consumption to enjoy it later, as with retirement savings. They enable the pricing, pooling and management of risk. They allow us to lend to and borrow from one another.

All of this is made possible through intermediaries. Banks and insurers, stock exchanges and burial societies, mortgage providers, foreign exchange dealers and microlenders make it possible for these markets to work effectively. Since they are intermediaries, their role is to act between economic players.

Market complexity

Financial markets are not just becoming more complex, they are becoming increasingly interlinked. When Opec pauses for thought, oil prices rise and markets around the world respond. The US announces surprising employment figures and the central banks of 200 countries need to reconsider their strategies for managing their own market risks. So financial markets are indispensable and complex, but they are also fragile, famously compared to a pyramid of sand on the brink of dramatic change as particles are added.

The purpose of the regulator is to ensure that the potential for disaster is kept as low as possible.

To do that, the regulator needs to understand the types of failure that might occur. The collapse of a significant intermediary, such as a bank, is an obvious failure, not least because such a collapse, like that pile of sand, can lead to widespread difficulty. The regulator takes steps to ensure that intermediaries are soundly managed, meet minimum capital requirements and report their financial position honestly and publicly. We call this prudential regulation.

Other types of market failure are more subtle and perhaps more dangerous. Intermediaries may misrepresent their products or services, leading customers astray. They may use their pricing power, or their knowledge of market intricacies, to charge their customers in hidden ways, or they might misrepresent that pricing in various ways. They may make side deals with third parties concerning the distribution of products that ultimately hurt their customers. These are also market failures because they distort the way in which efficient markets are supposed to operate, bringing entities to an arrangement in a fair and transparent manner. We call the intervention that addresses this problem market conduct regulation.

Who ensures market effectiveness?

Any power to effect change must come with commensurate responsibility. We consider a few parties.

The policymaker. The regulator receives its power and mandate from the government, the policymaker. Every regulator is subject to founding law. It reports, under the terms of that law, to a defined entity and ultimately, through the processes of parliament, to the people of the country. The responsibility for policy, in the case of SA’s financial markets, vests with the National Treasury, but it shares this with others such as the SA Reserve Bank and the department of trade & industry. What is clear though is that success can only be achieved through unambiguous objectives, supported by clear measures of progress. This is a critical challenge when so many interests diverge. But we’re making progress.

The regulator. The regulator can only issue regulation within the framework set for it by the policymaker. We may want to hold the regulator to account for the state of our financial markets, but if policymakers aren’t clear about their priorities and those priorities aren’t publicly available in law and policy, we can’t expect intervention to take place.

The intermediary. Entities providing services in financial markets also have the power to ensure market effectiveness. They typically regard this power — and its responsibility — as limited to the rules stated under the law by the regulator. They may also consider themselves to be bound by an ethical code of corporate citizenship to do more than this, erring in favour of their customers when the rules are opaque, for example, or directing assets to socially responsible initiatives. A soundly functioning market would encourage this, giving to intermediaries the goal to do right even when it is not required of them. The customer pays for bad service, dishonest conduct or poor investments. In the long term, this leads to a smaller market, for which intermediaries will also pay.

The customer. Customers have the right and responsibility to see that financial markets work effectively. They have the right to receive what they were promised at an appropriate price, but it is also in the long-term interests of themselves and all other market participants if they hold intermediaries to account. A market with weak customers is typically unfair and ineffective.

Financial markets are not only complex because of the enormous variety of transactions that they sustain. They are complex also because of the nature of interactions between participants, typically referred to as principalagency interaction. When the goals of the principal and the agent conflict, and they frequently do, a market failure results, thanks to the absence of some mediating influence. Regulators have a great deal to consider concerning their role as mediators, but everybody else has a part to play as well.

Financial markets are indispensable and complex, but they are also fragile