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Market Flares & Public Burns: Hit Ball, Not Thumb


In September, 2009, the Securities and Exchange Commission (SEC) created its newest division, named the Division of Risk, Strategy, and Financial Innovation.  To live up to that name, the new division needs to become a place in the SEC for creating new tools together with the SEC’s Office of IT.  The goal is to enable the Commission’s Divisions of Enforcement, Trading & Markets, and Corporation Finance to turn their experience and knowledge representation into action that changes market participant behavior.  This will take some doing.  It requires designing a regulatory framework and an active oversight capability that together change the operational incentives for market participants.  Today’s market participants are structured and incentivized to act in ways that work well for themselves, and sometimes for investors, but that do not reflect the public interest in a stable financial system.

[Edit note: This change refines the descriptors for the term “ratings process” in the paragraph beginning “A good start…” and “ratings tools” and “sentiment analytics” in the paragraph beginning “The above scenario…”  And the last change adds tags (forgot ’em–argh).]

A good start will be for the new Division to review the shortcuts made when the Commission first implemented its ontology for analysing financial statements filed with the SEC.  These shortcuts include relying on only some 250 or fewer sample financial statements as the basis for the SEC ontology that drives analytics across financial filings.  Another strategic starting point is to find traction for a new, continuous, in-house red-green-yellow sentiment discovery-based ratings process that refines emerging sentiment analysis as a key SEC tool.  The goal is a modern globally informed push to unbundle the participant incentives and intermarket problems that are as real today as in 1980.

The Commission has a track record on which it can build.  For example, the SEC undertook prescient work in 1980 (and abandoned it in 1981 from market pressure).  Specifically, the SEC’s Market Oversight Surveillance System (MOSS) integrated market participant, quote, trade, clearing, and settlement data across equity and derivatives markets, with issuer, registrant, and other in-house SEC data.  Then daily and for studies, it identified irregularities and imbalances.  MOSS enabled the SEC to see, rather than incompletely infer, systemic operational and behavioral matters of interest with stock and options trading, and intermarket self-regulatory matters in the National Market System created by amendments to the US securities laws.

Today as with MOSS, the SEC will face major push-back in any real effort it takes to monitor market behavior reflecting participant benefits more than the public interest in fair and stable financial markets.  In the early 1980s, as noted above, such resistance by securities exchanges and brokerage firms, carried out by then-incoming SEC Chairman John S. R. Shad, former vice chairman of E F Hutton & Co, did in fact stop the SEC from using its MOSS initiative to directly observe market behavior and detect operational gaps in intermarket self regulation.

However, these oversight and surveillance topics remain major problems, but now with even more scope, velocity, and cleverness due to significant new financial instruments, and new processing and communications technologies.  The new synthetic financial pyramid instruments work fine as long as prices or cash flows for implicit underlying reference objects keep rising or flowing.  In effect, the insurance business is great as long as the policies don’t need to be exercised.

The problem?  A significantly deregulated financial operating environment magnifies and accelerates a shark-like aim at leveraging systemically destabilizing opportunities.

Here’s how it works.  Break points between market participants once separated creators of risk, from issuers of risk-based securities, from market-based insurers of risk.  Now jump to 2005-2008.  A bank can make a loan, issue securities made from bundles of loans, then write options on the securities to insure against drops in security value.  The jerk on the rope comes when the loans go bad, the securities from the loans go bad, and the bank cleans up on its bet that the securities might indeed go bad.  Every step is legal today under any one big bank’s roof.  Every step is systemically valuable if not run under one roof.  But if run together within any one bank, disaster is waiting to happen from the cross-purpose incentives acting on the participants.  And big banks continue to have an active revenue incentive to keep driving the three-step process, rather than focusing on lending money to firms trying to build production, hire workers, and serve the demand for real goods and services.

The above scenario is a fine place for the SEC to apply new, globally informed and continuous ratings tools grounded in a systemic regulatory framework, ontology-based financial analytics, and active market oversight and surveillance tools.  There’s an important related point – the global rating tool’s market regulation value expands greatly if linked with new, non-intrusive and reality-based sentiment analytics to assess continually evolving participant influence points.

Upshot — what’s the navigation for introducing ideas in this process?

I think the SEC has a shot at this thing.  However, the Commission needs to seek new legislation for new market rules.  The SEC’s recent civil suit against Goldman Sachs may work as a transaction-based attention-grabber, but if any major witness defaults on testimony, the case may collapse, and the Commission could look silly and ineffective.

So here’s the theme to the pitch, if the right music can be found to keep all the players in their seats long enough to get the words…

The SEC needs to find its footing in framework issues grounded in oversight and regulation.  It does no good to pursue participants who track the incentives at play in today’s financial system framework.  They’ll all just keep on doing what the system encourages them to do.  Hammering Goldman Sachs people, egregious as their behavior may be, is pursuing a symptom.  The case itself is not a systemic path for building SEC tools to implement modern market oversight and surveillance.  At best, it might lay a political platform to get a chance to build modern regulatory tools that actually do re-frame the market and re-orient the operational incentives.  But to get there, the SEC needs a new regulatory framework based on realistic new incentives for newly re-demarcated market participants, and on modern technology not only for full financial disclosure, but also for market oversight and enforcement.

What do you think?

2 Comments leave one →
  1. 2010/06/08 8:20 am

    I agree that sometimes less can be more. We all are so busy today while we are inundated with ever increasing amounts of data, that you need to know what is the crucial list of key things to follow.

    That is why readers asked me to create a honed precise 5 questions fiscaltest, which your readers can take for free.

  2. 2010/06/08 3:51 pm

    Gary, thanks for your comment from your CFO perspective. We both must have picked up a sense of what’s useful from our years at the Stanford GSB. I’m thinking that CFOs might find the Economy of Meaning blog a good place to find significant cost-control and business expansion opportunities. For example, several posts point at resolving the very high US labor overhead burden for health benefits vs other countries. Other posts of interest to CFOs aim at savings and improvements in strategic operational resilience and reliability from action learning methodologies. Posts also look at ideas on systemic financial regulation to avoid the costs that hit the economy when it’s subjected to non-systemic regulation. And the growth accessible from some very unusual new social media tools is thoroughly vetted. Again, Gary, it was good to see your comment because there’s mutual interest across the people and firms you help, and the framework designers and operators with whom we work at the Center for Adaptive Solutions.

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