Thursday, March 8, 2018
The main premise behind self-regulation is that an industry has an incentive to police its ranks if industry members bear the costs of misbehavior. An organized industry won't tolerate particular industry members cheating or taking advantage to get an edge for themselves if it imposes greater costs on the industry as a whole. Notice here that profit-seeking industry self-regulators will construe “misbehavior” as actions that impose costs or reduce the profits of the industry as a whole—not necessarily as activities that generate costs elsewhere. For example, self-regulating manufacturers may not limit environmental pollution because distant customers do not bear the environmental costs generated by their operations. Their customers may even prefer pollution-spewing factories because they pay less for goods and bear no liability for the environmental cleanup.
The New York Stock Exchange's history as a self-regulating exchange bears this out. Traditionally, the NYSE aggressively policed its own ranks to prevent its members from undercutting the standard fixed commission rates. It did not, however, aggressively police its members’ extraordinarily profitable market-manipulating stock pools. The incentive to self-police, therefore, failed to check exploitation of the public for at least two reasons: (i) the NYSE members that did not participate in the stock pools still profited because of the heightened trading volume; and (ii) the stock pool operators controlled the NYSE governing committee.
The incentive to self-police and crack down on stock pool operators may also have been limited because Wall Street’s broker-dealer firms internalized only a limited portion of the costs that their misbehavior imposed on the public. In theory, contractual relationships between broker-dealer firms and their customers should allow customers to impose costs incurred from misbehavior and disloyalty on the industry. When contractual relationships do not transfer the costs of misbehavior back to the industry, this incentive to self-police diminishes. If customers lack the bargaining power to negotiate these types of contracts, the industry may under-invest in enforcement and monitoring.
Today, the brokerage industry imposes significant costs on the public through conflicted financial advice. To be sure, wronged investors can seek to recover through FINRA's arbitration forum. But winning a FINRA arbitration does not mean that an investor will always be paid. Roughly one third of arbitration awards now go unpaid because the FINRA members that do the most damage often go out of business.
The issue over unpaid awards matters because it cuts to a core premise behind self-regulation: self-regulation works well if the industry bears the costs of its misbehavior. Despite this, FINRA does not require its firms to acquire insurance to bear the costs of their operations or to maintain significant capital reserves. While FINRA does expel member firms that fail to pay arbitration awards, the individuals employed by those firms often simply relocate to another firm and continue with business as usual. While reform advocates have suggested creating a national compensation pool to address the issue, FINRA has not yet embraced the idea of internalizing the costs generated by FINRA members.
Senator Warren just introduced draft legislation to create a recovery pool and require FINRA's member firms to internalize the costs they generate. It calls for FINRA to create a pool to pick up the tab for unpaid arbitration awards. In past years, the fines FINRA assesses against its members would have covered all unpaid awards. This does not mean that fine revenues will always be sufficient. Many persons likely abandon all hope now when a FINRA member goes out of business. Since they couldn't recover, they never seek an arbitration award.
This legislation may attract some bipartisan support. Importantly, the U.S. Government does not pay these unpaid awards. FINRA and the industry will pay them. This lets the market set the right price for the privilege of self-regulation.