SYDNEY: 27 May - A key question for the current Financial System Inquiry is, should the regulatory philosophy articulated in Chapter 5 of the Wallis Committee report be revisited? 

Financial markets are sites of interaction between participants, where relationships between those participants arise.  The task for FSI is to envisage the character those relationships should have, and determine whether (and if so what) regulatory intervention is necessary to ensure the relationships maintain that essential character. 

Wallis proceeded on the basis that all of those relationships should be understood as if they were between autonomous and rational actors in transparent and liquid secondary markets.  Under this model, the primary purpose of regulation is to overcome market failure by correcting information asymmetries through disclosure, and by preventing fraud and other unfair practices.  This is the dominant paradigm of securities regulation; the efficient market hypothesis is that, so long as markets are free and competitive, they will produce an efficient allocation of resources through a process of price discovery that adequately reflects risk and reward.  Financial safety regulation, in the form of prudential regulation, was justified in only in situations of certain ‘high intensity’ financial promises; it goes to the capacity of the institution making the promise to perform that promise, and not to the terms of the promise itself.

How might FSI reframe this philosophy?  One option is to recognise that, rather than all having the same character, there might be different types of relationships that arise in financial markets that have different characters and that need different regulatory approaches to ensure that character is maintained.  Arguably, three conceptually distinct relationships arise in financial markets:

• Between the issuer and acquirer of financial products in primary markets,
• Between sellers and buyers of financial products in secondary markets, and
• Between clients and the financial services providers who act on their behalf in those markets.

Existing approaches to financial regulation are able conceptually to cope with the second and third types, but not the first. 

For the second type, the assumptions that underpin conduct and disclosure regulation in securities law both recognise and perfect this relationship.  Each party is free to act in its own interests so long as there is full disclosure and improper conduct such as fraud or market manipulation is prohibited. 

The third type of relationship - in which an agent such as a broker, dealer, personal financial adviser, investment manager or pension fund trustee undertakes to act on behalf of a client in circumstances where the client relies on the agent exercising discretions in the client’s interests – is fiduciary in character.  These relationships require the agent to act with care and to subsume its personal interest to the interests of the client in carry out the functions with which it is tasked.  

The proper character of the first type of relationship is more difficult to identify.  Leaving aside corporate securities that are traded on secondary markets, arguably the philosophy of financial regulation adopted by Wallis does not adequately respond to this type of relationship.  While private law ensures that the issuer must keep its promise, and prudential regulation addresses the institutional risk of non-performance by the issuer in certain promises, existing regulatory philosophy does not otherwise provide a framework for understanding or perfecting that relationship.  For example, should the relationship between the issuer and acquirer of a financial product, or between it and the financial system generally, require the issuer to ensure that in its design the product is fit for purpose and does not give rise to undue systemic risk?  Should the answer depend on whether the acquirer is a ‘retail’ customer? 

Understanding the proper philosophical foundation for regulating the relationship between product issuers and acquirers will be crucial to the next step in the development of financial regulation, and a necessary part of the work of FSI.