Tuesday, October 21, 2008

Definition v. Regulation

I wish I had finished the "Rich Theory" project. One of the themes I wanted to develop in the project was the distinction between definition and regulation.

By "definition" I mean that the government works to make sure that the rules are well defined and understood by the players in the game. By "regulation" I refer to situations where the bureaucrats themselves become players in the game and actively play the role of deciding who can do what and when.

IMHO, the government needs to take an active role in defining the financial instruments that are on the market, but should avoid situations where politicians play the role of deciding who can do what and when. When bureaucrats actively play in the market, they often end up making decisions for political reasons.

There are many things in the current market that scream out for greater regulation. The prime examples are short selling and credit default swaps. The fact that these financial instruments are screaming out for regulation tells me that either they need better defintion, or they should be excluded altogether.

Credit default swaps are essentially a side bet placed on a loan. The justification for the financial instrument is that they help save banks the risk of loans. The actual results of the financial instrument is that they externalized and consequentially magnified risks.

Short selling was a creation of regulators. Short selling allows brokerages to artificially increase the float of a stock when there is insufficient stock on hand in the exchange to meet demand. Modern communication technology has pretty much eliminated all of the blocks that would have once stiffled the ability to trade shares on the market. Today short selling exists primarily as a tool for hedging risks or for taking wild speculative gambles.

The fact that short selling is screaming out for regulation tells me that perhaps we should be thinking of defining the process out of existance.

As traders are adamant that shorting be allowed to continue, an alternative approach to the market would be to create a real time exchange which accounted for every share on the market. In this exchange a person could trade stock for an IOU from a short seller. They would not be allowed to sell themselves until after the short seller replaced the stock.

Such as system would not require a regulation from a bureaucrat because the actual material regulates the actions of the short seller.

In other words, when ever we feel that there is a compelling need for regulators in the market, we probably could find a way to define the market in ways that is inherently self regulating.

NOTE, I joined a site called Fotolia which has a decent prices on stock images for use on blogs and web sites. This is my first shot at buying stock. The image below put me back $1.00.

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