We continue the exposition of the proposal for a new market structure by Chris Cook, which we started yesterday.
Mutual trust is the glue that binds markets together. Regulation engenders trust, and the setting and enforcement of market standards of behaviour and propriety are the essence of successful regulation. At the dawn of markets — Market 1.0 — this trust was based upon self-regulation: upon subjective judgments by one individual of another, backed by a fundamental regulatory concept — ‘mutual reference’.
Mutual reference essentially consists of the collective experience of the market community in respect of their dealings with each other. Any individual who offended against accepted standards of market behaviour, and was thereby in breach of trust, would be judged by his peers and subject to penalties up to and including exclusion from the market — if not to a grimmer fate under the harsher laws of those times.
Intermediation and centralisation have led to centralised markets — Market 2.0 — and to centralised regulation, exemplified by Regulation 2.0 regulators such as the SEC/CFTC and the FSA.
In the UK the advent of self-regulatory organisations in 1987 — such as the AFBD and TSA — was remarkably successful in raising the standards of UK exchanges and financial intermediaries. This was because prior to that point no-one was looking at what the intermediaries were doing. That, on a global basis, is the position to which we have returned — the ‘Sumitomo Gap’ — no-one is looking at what the customers are doing.
Centralised national regulation — Regulation 2.0 — can go no further. There is no access to global market data; there are no global market standards; and even if there were, no-one has the ability to enforce them. A new architecture is required. Regulation 3.0 is a return to self-regulation, but this time by market participants themselves in the form of an ITA. An ITA will set market standards:
* the crucial market standard jurisdiction;
* standard contract terms (cf. ISDA, ISMA);
* standards of behaviour;
* standards of ‘fitness and properness’;
* standards of transparency.
The all-important regulatory ‘teeth’ derive from the fact that anyone suspended or expelled from an ITA has no access to the market, becoming an ‘outlaw’ consigned to the ‘outer darkness’.
Perhaps the most important regulatory tool in internet markets is the ‘mutual reference’ function. A good example of this function in action was, until 1995, the London Stock Exchange’s ‘Mutual Reference Society’. This was essentially a database of customer identities kept in card index files which LSE members were obliged to check when opening a new client account. While this was primarily aimed at clients who had defaulted in payment (whose card would be flagged appropriately), not all undesirable clients are unable or unwilling to pay, as the regulatory requirement for anti-money laundering ‘due diligence’ makes clear. Nevertheless, LSE closed down the mutual reference service, apparently on cost and data protection grounds and in view of the perceived prohibitive cost of automation.
However, the function, which is little more than the operation of a database to be maintained by brokers themselves, is perfect as an internet application and mutualreference.com was therefore set up in 1999 to meet the continuing regulatory requirement for due diligence by brokers.
One example will suffice of mutual reference in practice: where a proprietary ‘e-marketplace’ has evolved, by way of quality control, a form of genuine and effective self-regulation into its business model. eBay is a retail auction-based marketplace connecting individuals to a centralised server-based marketplace: in essence, a cross between an automated electronic car boot sale and an auction. There are literally millions of auctions, in every conceivable kind of goods, being operated by eBay at a given point in time, each probably lasting several days. In fact thousands of businesses, particularly in areas such as antiques and collectibles, operate exclusively on eBay.
As the business evolved it became apparent that there were some serious ‘conduct of business’ issues involved:
* were the goods actually the property of the seller?
* even if they were the seller’s goods, were they what he/she said they were?
* did the buyer have the money to pay for the goods?
* was he/she in a position to take delivery?
Beyond these issues were questions of public policy in relation to the nature of the items for sale, such as the offer for sale of securities, or firearms.
The regulatory model developed by eBay was based upon ‘feedback forums’ whereby buyers and sellers would post positive or negative feedback in respect of their dealings on eBay. This in turn has led to ‘star ratings’ whereby regular eBay users acquire a rating based upon the aggregate of feedback received, where +1 is a positive; 0 is neutral; and –1 denotes negative feedback. eBay then awards star ratings banded by the number of points received.
In addition actual feedback, in terms of comments, may be posted by buyers, sellers or both and these comments may be made publicly available with the consent of the person in receipt of the relevant comments. eBay actively encourages such disclosure. The outcome of this model can be fairly draconian in practice: miscreants are given short thrift by their peers.
Because markets are by definition open, there are important issues in relation to the enforcement and disciplinary process which may not apply to a proprietary system where someone unfairly excluded may perhaps take his business elsewhere. Clearly, ITAs would therefore have to take care in drafting their rules/user agreement to meet appropriate regulatory standards of fairness and transparency.