45.l: Objectives of market regulation
Regulators play an important role in ensuring markets operate in a fair and efficient way through:
• Protecting the interest of unsophisticated or relatively less informed investors.
• Addressing agency problem: Regulators set a minimum standard of competence for the market intermediaries such as brokers, financial advisors, insurance agents, investment managers etc. this ensures a minimum level of service to customers.
• Creating level playing field for participants: Regulators introduce rules like prohibiting insider trading which can result in outsized profits for insiders who have material information regarding a company, which is yet to be made public. Insider trading can cause losses to general public and this can lead to reduced liquidity as investors tend to shy away from trading after losses
• Setting financial reporting standards: Regulators set up common reporting standards to make it easy for investors/analysts to study a company’s financials and compare them with its peers to arrive at the fair value of its security.
• Ensuring financial firms are well capitalized: Regulators demand that financial firms are well capitalized at any point to a) honor any payments due to lenders and b) owners have an interest in the decisions that financial firms make and are exposed to risks associated. This reduces the chances of a firm failing to fulfill its obligations and safeguards the markets against disruptions associated with such failures (recall the 2009 global financial crisis). Also, owners interest in decision making prevents unwanted risky behaviors by the company management.
• Regulating insurance companies and pension funds which have long-term obligations to their client. Regulators ensure that these companies have long-term reserves available to fund these obligations.
The government, as well as industry bodies, can provide regulations. Some of the entities such as exchanges, clearinghouses etc regulate their own members. These are called Self-Regulatory Organizations (SROs).
Check your concepts:
(45.28) A market with a low cost of transactions can be termed as:
(a) Informational efficient market
(b) Operational efficient market
(c) Allocation efficient market
(45.29) Which of the following is least likely to be a role played by the market regulators?
(a) Setting financial reporting standards
(b) Prohibiting insider trading
(c) Protecting the interest of well-informed investors
Solutions:
(45.28) Correct Answer is B: A market with a low transaction cost is referred to as an operational efficient market.
(45.29) Correct Answer is C: The market regulators play a role in protecting the interest of relatively uninformed investors or unsophisticated investors. For sophisticated investors, the regulations are less as we see in the hedge funds and private equity markets.
