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“Rethink needed” on market regulators’ role; “more collaborative approach” required

Posted 30 April 2010 - 10:57am by Craig McGlashan

Market regulators should have clearer objectives and take a more collaborative approach to dealing with market participants, according to a leading finance academic.

Abraham Lioui, professor of finance at Edhec Business School, was speaking to GSL.tv following the publication of an article he wrote for the Financial Times on the new short selling circuit breaker rule in the US.

Lioui had been critical of the rule in his article, and elaborated further to GSL.tv, explaining that the rule is “inconsistent”. He explained: “You want to stop any vicious circle of downward pressure with this rule. But who says that when a stock goes up by more than 10% it is related to fundamentals? If you are the SEC [US Securities and Exchange Commission] you are supposed to regulate all the market so if you want to do something when the stock goes down by 10% you should also do something when it goes up by more than 10%. It should go both ways.”

In addition, Lioui warned that simply banning short sellers when a threshold is reached will not stop downward pressure – even once short sellers are taken out the running, as “the market got the signal and the people who are long just sell the stock so in the end you get exactly the same effect”.

However, Lioui suggested that the inadequacy of the new rule is part of a deeper problem regarding exactly what role market regulators should fulfil.

“I don’t think enough thinking has gone into what the objective function of a market regulator should be. If part of their objective function is, for example, to influence the direction of the market, we have to think about this. Is it good? If yes, we have to also think about what should be the instrument we give them to be able to fulfil this objective. If you think of central banks, they have to control for inflation but they can let the inflation go if the trade-off is less unemployment. They have a device to do this – the interest rate.

“They have to think of an instrument that will be available for the authority to achieve this objective, to stop the vicious circle when the market goes down, or the creation of a bubble when it goes up.”

However, he also felt that market regulators could learn from central banks in other ways. “I think that central banks are credible because they explain their actions and they don’t see market participants as enemies. They are partners, while the SEC, for example, has acted as if the traders are the enemy and have to be fought.

“Regulators need to be more collaborative and be part of the process.”

Looking at the specific example of the temporary short selling ban in Greece, announced this week, he likened it to the ban on short selling seen in the US in September 2008, explaining that many of the firms on the list of banned stocks asked to be removed, as being listed was “not a good signal” to the market.

On Greece, he said: “I think what was a mistake is that when you ban short selling you clearly signal that you are in a panic, because you have no other means to stop the downward pressure. I don’t like this. Changing the rules of the game in this way signals a lack of professionalism, a lack of credibility on the part of the regulatory authority, which is very problematic for the rest of the time.”

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Market regulators should have clearer objectives and take a more collaborative approach to dealing with market participants, according to a leading finance academic.

Abraham Lioui, professor of finance at Edhec Business School, was speaking to GSL.tv following the publication of an article he wrote for the Financial Times on the new short selling circuit breaker rule in the US.

Lioui had been critical of the rule in his article, and elaborated further to GSL.tv, explaining that the rule is “inconsistent”. He explained: “You want to stop any vicious circle of downward pressure with this rule. But who says that when a stock goes up by more than 10% it is related to fundamentals? If you are the SEC [US Securities and Exchange Commission] you are supposed to regulate all the market so if you want to do something when the stock goes down by 10% you should also do something when it goes up by more than 10%. It should go both ways.”

In addition, Lioui warned that simply banning short sellers when a threshold is reached will not stop downward pressure – even once short sellers are taken out the running, as “the market got the signal and the people who are long just sell the stock so in the end you get exactly the same effect”.

However, Lioui suggested that the inadequacy of the new rule is part of a deeper problem regarding exactly what role market regulators should fulfil.

“I don’t think enough thinking has gone into what the objective function of a market regulator should be. If part of their objective function is, for example, to influence the direction of the market, we have to think about this. Is it good? If yes, we have to also think about what should be the instrument we give them to be able to fulfil this objective. If you think of central banks, they have to control for inflation but they can let the inflation go if the trade-off is less unemployment. They have a device to do this – the interest rate.

“They have to think of an instrument that will be available for the authority to achieve this objective, to stop the vicious circle when the market goes down, or the creation of a bubble when it goes up.”

However, he also felt that market regulators could learn from central banks in other ways. “I think that central banks are credible because they explain their actions and they don’t see market participants as enemies. They are partners, while the SEC, for example, has acted as if the traders are the enemy and have to be fought.

“Regulators need to be more collaborative and be part of the process.”

Looking at the specific example of the temporary short selling ban in Greece, announced this week, he likened it to the ban on short selling seen in the US in September 2008, explaining that many of the firms on the list of banned stocks asked to be removed, as being listed was “not a good signal” to the market.

On Greece, he said: “I think what was a mistake is that when you ban short selling you clearly signal that you are in a panic, because you have no other means to stop the downward pressure. I don’t like this. Changing the rules of the game in this way signals a lack of professionalism, a lack of credibility on the part of the regulatory authority, which is very problematic for the rest of the time.”