>>Paulson tells G7 let markets regulate hedge funds.<<
Everyone should read the words of Alan Greenspan from a speech in Sept of 2002. This is when the Federal Reserve finally put both feet in bed with the major NYSE member banks and pulled up ythe covers. I found this except below with a link to the full speech. Of course it is written in Greenspeak but I think you may come away with the same translation as I – exploitation of the less informed by the mega-banks (or as Greenspan refers to them as “private counterparty surveillance”) is not only permissible but should be embraced, without regulation, at times of sub-optimal economic performance……
Greenspan: Owing to persistent advances in information and computing technologies, the structure of our financial institutions is continuously changing, I trust for the better. But that evolution in financial structure has also meant that supervision and regulation must be continually changing in order to respond adequately to these developments. In today's markets, for example, there is an increased reliance on private counterparty surveillance as the primary means of financial control. Governments supplement private surveillance when they judge that market imperfections could lead to sub-optimal economic performance.
But let us consider now another aspect of market regulation efforts: transparency.. There should not be much dispute that markets function best when the participants are fully informed. Yet, paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth.
No one can deny that fully informed market participants will generate the most efficient pricing of resources and the most efficient allocation of capital. Moreover, it could be argued that, if all information held by individual buyers or sellers became available to all participants, the pricing structure would more closely reflect the underlying balance of supply and demand. Thus full information would appear to be the unambiguous objective. But should it be?
Take, for example, the real estate developer who conceives of an innovative project that will significantly raise the value of the land on which it will be situated--provided that the site possesses suitable characteristics. Suppose further that it is costly for the developer to determine whether a given site is suitable. If he or she discovers a suitable site and is able to quietly purchase the land from its current owners without revealing the value of the project, the developer makes a substantial profit, and the community overall presumably benefits from improved land use.
But what if, before the purchase of the land, the developer was required to disclose his or her purchase intentions and, in particular, the value enhancement created by the project? The sellers then seeing the bigger picture would elevate their offers sufficiently high to extract the full value of the innovation from the developer. Under these circumstances, would any projects go forward? Clearly not, because developers would be unwilling to bear the cost of evaluating potential sites knowing that they would reap none of the benefit of discovering suitable ones. A requirement for fuller disclosure of the potential, heretofore undiscovered value of the land would engender neither more disclosure nor improved land use.
An example more immediate to current regulatory concerns is the issue of regulation and disclosure in the over-the-counter derivatives market. By design, this market, presumed to involve dealings among sophisticated professionals, has been largely exempt from government regulation. In part, this exemption reflects the view that professionals do not require the investor protections commonly afforded to markets in which retail investors participate. But regulation is not only unnecessary in these markets, it is potentially damaging, because regulation presupposes disclosure and forced disclosure of proprietary information can undercut innovations in financial markets just as it would in real estate markets.
All participants in competitive markets seek innovations that yield above-normal returns. In generally efficient markets, few find such profits. But those that do exploit such discoveries earn an abnormal return for doing so. In the process, they improve market efficiency by providing services not previously available.
Most financial innovations in over-the-counter derivatives involve new ways to disperse risk. Moreover, our constantly changing financial environment supplies a steady stream of new opportunities for innovation to address market imperfections. Innovative products temporarily earn a quasi-monopoly rent. But eventually arbitrage removes the market imperfection that yielded the above-normal return. In the end, the innovative product becomes a "commodity" made available to all at a modest, fully competitive profit.
To require disclosure of the structure of the innovative product either before or after its introduction would immediately eliminate the quasi-monopoly return and discourage future endeavors to innovate in that area. The result is that market imperfections would remain unaddressed and the allocation of capital to its most-productive uses would be thwarted. Even requiring disclosure on a confidential basis solely to regulatory authorities may well inhibit such risk-taking. Innovators can never be fully confident, justly or otherwise, of the security of the information.
Regulators may not always be able to differentiate easily between secrecy to protect intellectual property and secrecy to deceive or to commit outright fraud. Yet a supervisory system must make that distinction as best it can. There is nothing unusual about making difficult tradeoffs in regulation. In fact, it is the rule rather than the exception for most regulatory regimes--whether in the financial or nonfinancial sectors of our economies. Indeed, such tradeoffs, in a wider sense, determine the differing regulatory regimes we see around the world. Those differences in regimes reflect largely attitudes toward competition.
Competition is the facilitator of innovation. And creative destruction, the process by which less-productive capital is displaced with innovative cutting-edge technologies, is the driving force of wealth creation. Thus, from the perspective of aggregate wealth creation, the more competition the better.
But unfettered competitive capitalism is by no means fully accepted as the optimal economic paradigm, at least as yet.
federalreserve.gov
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