Market Self Regulation (with Tom Selman)

[0:00:00 Speaker 0] from the Salem Center for Policy at the University of Texas at Austin. Welcome to an episode of Policy and Pieces. I’m your host. Scott Bogus. I’m

[0:00:12 Speaker 1] a supporter of regulation. Best interest. But what troubles me about the background discussion that led up to regulation best interests but also continues with a question about a fishery standard is his view that basically commissioned business should be crushed and everybody should go with a fee based business. That’s the problem I have.

[0:00:33 Speaker 0] That was Tom Selman. He’s the former head of policy at FINRA, a self regulatory organization that operates alongside the SEC and the supervision of securities brokers and dealers. He explains what it does, how it came about and why it is important to the smooth functioning of markets. We also discuss regulation best interest, the meaning of a fiduciary duty, the challenges in protecting investors and the temptations of over regulating markets. By co host for today is UT Law student Sloan younger men. Tom, welcome to the show.

[0:01:06 Speaker 1] Thank you. Thanks for having me.

[0:01:08 Speaker 0] Or should I say

[0:01:09 Speaker 1] hook? Um,

[0:01:10 Speaker 0] UT Alum,

[0:01:11 Speaker 1] right?

[0:01:13 Speaker 0] And my co host today, Sloan on German from the U. T.

[0:01:17 Speaker 1] Law school song. Welcome. Thank you for having me.

[0:01:22 Speaker 0] So, Tom, we want to talk today about Finn, run financial markets. But before we do, I think there’s a lot of people out there that don’t know what FINRA is or what FINRA does. And we’re hoping you can explain at a high

[0:01:35 Speaker 1] level what

[0:01:36 Speaker 0] the answer to that is.

[0:01:38 Speaker 1] Sure, Scott, and thanks again for having me here. I really appreciate it. FINRA is a financial industry regulatory authority, and it is a strange hybrid. It’s a private company, a private, non profit company that has a regulatory responsibility that emanates from federal statute, so you might call it quasi governmental. In that sense, it’s directly regulated by the SEC, and its responsibility is to regulate broker dealers in the United States. It has a rather long history. Before the federal securities laws were enacted beginning in 1933 the stock exchanges were self regulatory, and they had a long tradition that dated back to the 19th century, even before actually the buttonwood agreement of regulating their own members. And most of that regulation had to do with concern about whether one member might rip off another member of the exchange. The purpose was to maintain a set of principles that all the members would comply with. Um, and that tradition continued and developed all the way through. Between 19 twenties with the Great Depression, Congress decided to create federal agencies dealing with financial regulation and in the 1933 Active Securities Act, authorize the FTC, the Federal Trade Commission to regulate securities markets. But in the following year in the Securities Exchange Act of 1934 created the Securities and Exchange Commission at the same time, and the 34 act it empowered formally. The exchange is the New York Stock Exchange, the American Stock Exchange and other stock exchanges to become what are known as self regulatory organizations. So they are responsible for formally regulating their members under the oversight of the SEC. So the rules were, and they still do. The rules have to be adopted by the SEC. They would have enforcement authority over their members to comply with those rules and the FCC rules. It was a whole second layer of regulation that allow the as you see, to impose more general regulation on the markets. The issue, though, was if there were an awful lot of broker dealers who didn’t have an exchange business. They were solely over the counter broker dealers, and they were directly regulated by the SEC. Um, this began to change with the Maloney Act, which was enacted in 1938 1938 authorized the creation of a national securities association, which is essentially, uh, S r o for the over the counter broker dealers. And that was the National Association of Securities Dealers. So the NTSB was created in 1939 and officially, um, and for many years, brokers didn’t have broker dealers didn’t have to belong to the NASD, or in exchange, they could choose to be regulated directly by the SEC. That changed in the eighties, when a broker dealer with only a few exceptions basically floor brokers. But all of the broker dealers had to be members of an exchange and typically every broker dealer in the country. Just about every broker dealer in the country is a member of FINRA, and then whatever exchange they want a membership on now, any SD um had a regulatory authority, But well, let me say in the seventies, and he said he had the idea of creating a new type of exchange that was an automated quotation service that was similar to an exchange but had different trading mechanisms. And that was NASDAQ, and it became really predominant in the Indians, the holding company. It was a huge part of the business of any SD and regulation almost took a side. It was almost side responsibility. This created a major problem. In 1996 the SEC brought an action against any SD finding that its regulatory efforts were woeful. Um, PTSD set up a separate group called NES Deregulation, which was separated off from NASDAQ and subsequently spun off NASDAQ. NASDAQ is a completely independent authority now, uh, organization now. Meanwhile, any of the regulation which was left merged with the New York Stock Exchange regulated regulatory group to create FINRA changed their name to the financial industry Regulatory authority. So through that long process, that’s how we end up with FINRA today. But the basic point to understand is that self regulation predated the creation of the SEC and became more and more important for the broker dealer industry over the 80 years following the Great Depression

[0:06:58 Speaker 0] back in 1996. Was that the audits scandal?

[0:07:02 Speaker 1] Yeah.

[0:07:03 Speaker 0] Oh, and that was a conflict perceived to be a conflict of interest between the NASD and the NASDAQ. And is that what motivated the separation?

[0:07:11 Speaker 1] Right. The allegation was that market makers are backing off of trades that didn’t you know that were within the spread. Essentially, um, and that the industry regulatory authority wasn’t aggressively enforcing its own rules and SEC rules concerning that activity.

[0:07:31 Speaker 0] So how did you end up with the S? You start at the N S D.

[0:07:36 Speaker 1] No, I didn’t. I started at Charlton Law Center. That’s where everybody starts. And then, uh, worked for a few years at a law firm in Dallas doing mergers and acquisition work, couldn’t stand long firm practice, went to Europe, worked for the European Commission for a year, then moved to the SEC for a few years, worked for a trade association, and then it ended up in at the N S. D. In 1996. There were at that point after the enforcement action by the SEC, the idiocy decide to bring in some people who had proven regulatory experience. They brought in me. They brought in Rick Ketchum. They brought in Mary Schapiro at that time, and that’s when I went. So one question I have for you is about FINRA and its mission. The Fender mission is to provide investor protection and promote market integrity. Unlike the SEC, there’s no mention of capital formation and market efficiency. How does that play out with the broker dealers to comprise the NRA membership? Well, that’s that’s a really good question. I mean, let me take this 2nd 1st. I think you know market efficiency is part of the federal mission. A market regulation is primarily done by the SEC, but there’s a huge market regulation department at federal that’s responsible for regulating the exchanges. And much of the regulation has to do with complying with making sure they comply with SEC rules. But certainly finer has its own market regulation rules. So I wouldn’t say that market efficiency is necessarily not part of thinners mission, even though it emphasizes market integrity capital formation. Now I think it’s primarily with the SEC because the SEC has a whole department corporate financing corporate finance department. The SEC, which is responsible for regulating public disclosure by public companies regulating private placements, providing exemptions that allow for private placement. So the whole capital formation process comes much. Much of it comes from that division, which doesn’t exist in the same way at federal. Federal does have a corporate financing department, but it’s a different animal. It’s not so much so much focus on capital formation as as how brokers perform their responsibilities. So it’s very hard to distinguish all that. I think they all have has responsibility for capital formation in some ways, and, as I said, market efficiency. But I’d say primarily the SEC is responsible for capital formation by regulated entities.

[0:10:33 Speaker 0] So that leads into my next question. I’m wondering how federal works with the SEC and let’s start with enforcement. Where does FINRA end in the SEC? Start when it comes to broker dealer regulation?

[0:10:47 Speaker 1] Well, that’s a good question, too. We are We finna is the front line regulator, in a sense that federal regulates the broker dealers directly examines them directly, as well as regulates them directly. The SEC also has a lot of rules under the exchange at their plight of broker dealers, the SEC also examines broker dealers, but the S U. C and actually the states as well, rely heavily on federal regulation so that their their tenor of regularly of examining broker dealers, for example, will be longer between examinations than federal. Federal regulates every broker dealer at least once every four years, but because it’s risk based, some are, you know, examined every year, and many are examined more often than every four years, whereas the S. U. C in the states, some states never going to look at a broker dealer they rely entirely on. And by the way, those are some of the states that are most critical of FINRA in terms of policy. But they regulate heavily on thin era for its exams, and the SEC also will tend to examine Finra’s examination of broker dealers almost at least as much if not more, than it’s direct examination of the broker dealers themselves.

[0:12:09 Speaker 0] Is there redundancy? There is FINRA and the SEC examining the same entities. Do they collaborate and do they coordinate and how they do that

[0:12:17 Speaker 1] they do coordinate. There is a history of redundancy and annoyance by broker dealers and having you know, multiple regulators come in. Um, but over the past 10 years, I’d say there has been much greater coordination between the two. It’s obviously good for both. There’s no reason for a foreigner to be second guessed by the SEC before or after an exam. And there’s no reason for the SEC to use the three sources when Fender is looking at the same entity. So there’s there’s much more coordination I should mention some big broker dealers. You know, the ones you’ve heard of. Morgan Stanley, JP Morgan Goal and Sex. They have dozens of regulators who come in because they have all the veteran. As you see, they have all the financial, the bank regulators. 0 cc F D I c, the Fed, the estates regulators, their global So their international regulators. So the number of regulators who come in and look at them is just mind boggling. And you really have to wonder about the inefficiencies that must create.

[0:13:24 Speaker 0] So I know the Fed actually has for the larger broker dealers staff on site that have offices on premises. Some of the larger players does finra do they just have a point in time. Every year they go in or do they have ongoing relations as their ongoing dialogue. Is there special treatment for the particularly high risk? BDs

[0:13:46 Speaker 1] yeah, special treatments. A nice way of putting it. Yeah, there’s there’s special treatment for the high risk ones, so the frequency of examinations will be higher. Obviously, the likelihood of the referral to the enforcement department and federal has full enforcement authority and sanction authority. They can borrow people from the N firms from the industry. So yes, they do tend to focus on some firms more because of a higher risk that they create. And they over the last 15 years made their risk analysis much more sophisticated so that he can much better gauge which firms are likely to create problems.

[0:14:27 Speaker 0] So what’s the difference in authority between FINRA and the SEC? You mentioned that Finra’s frontline and they can issue sanctions and bar players in the industry. Are there limitations to what they can do relative to the S E C. And if so, what are they?

[0:14:43 Speaker 1] Well, everything they do has to be well in terms of rule making. Everything they do has to be approved by the SEC, so their rule making authority is a big cumbersome because they will propose their own rule. They’ll adopt their own rules, and they’ve got a filing with the SEC, which it proposes it and adopts it. And then, of course, it can be challenged in court. So on the rulemaking side there, cry restricted on the enforcement side, one might argue that they actually they actually have much greater latitude than the SEC in some ways, because it’s technically, I mean, it’s a volunteer organization. You don’t broker. Dealer doesn’t have to be a broker dealer if they choose to be a broker dealer. Theoretically, they could create another. National Securities Association is not a monopoly. In that sense. It is the only one now in existence other than the exchanges. But you know, another one could be created. So because it’s a private company and because the members are members, it’s not limited, for example, by some of the due process restraints that occur in criminal law. Any any can demand information from broker dealers about having them, for example, plead the fifth so and it can. It can bar as barred individuals for not responding to requests for information. So I think in some ways the enforcement authority is a broader authority now there isn’t a whole pellet. A process that goes up through defender itself has its own appeal process. And then it can go up to the full, as you see and from that to the circuit courts. So there is a whole appellate process associated with their enforcement activity. But the SEC has the same thing. So I think in some ways the enforcement authorities broader. Are there any conflicts of interests that arise in general being funded by the registrant that overseas? Well, there’s That’s an that’s an issue that always has to be managed. As I said, 1996 SEC brought a case, arguing essentially that the conflicts of interests were undermining of Nesv’s enforcement efforts. The fingers then a lot, particularly since 96 to try to manage those issues by having a staff that’s totally independent as CEO. When I when I joined, for example, the chairman of the board was from a broker dealer, that’s not true anymore. Um, the CEO is an independence person. Robert Cook, who used to be head of the division of market regulation at the SEC, who came over the chairman of the board, is typically a non industry person and a majority of the board members are non industry so that right off the bat, the governance itself is now, although it includes broker dealers had certainly built in mechanism to limit those conflict issues. But it’s something that we always have to deal with, and it’s built into all the processes that the enforcement, the regulatory, the rulemaking, interpretive, because it’s it does no good, for example, to allow a conflict to undermine its enforcement and have a scandal break that hurts its reputation. So it’s it’s an issue that has to be managed. I think it does a very good job of doing that today.

[0:18:16 Speaker 0] So you you touched on policy. Let’s dig in a little bit there. At times, the broker dealer community is pushed back on the SEC in terms of SEC rules or things that Congress is contemplating. I’m curious. How does FINRA get

[0:18:31 Speaker 1] involved or

[0:18:32 Speaker 0] not? When there are controversies,

[0:18:36 Speaker 1] it really depends on what they are. You know, if there are controversies that are going to severely affect finra’s ability to manage its program, and that are controversies in which generous position coincides with that of the SEC, then federal would be more likely to go directly to Congress, assuming it’s a legislative issue, would be more likely to go to Congress and finally does obviously need to establish a rapport with those who are, particularly those who are on the committees of jurisdiction in both houses of Congress, so that they understand what Flannery is, what its responsibility is. If they have any concerns, fingers should hear about them, but it typically want, for example, get involved in legislation directly. Unless one of those issues exist, you know it’s going to implicate federal or filters regulation or if it has a strong investor protection interest in the outcome. So I was quite involved years ago and the whole fiduciary question, which came up not only in terms of whether broker dealers should be subject to do your dirty, but also to the flip side, which is hardly ever mentioned. And that is that investment advisors in the United States have a business. It’s very similar to the business of a broker dealer. The most individual financial advisors are licensed with a broker dealer, and they’re also licensed with an investment advisor. But there’s something to two different statutes an investment advisor, subject of fiduciary duty broker dealers not, but the flip side of that is investment advisors. Even the federally registered ones are never examined. For the most part, the average, as you see examination of a registered investment advisor, is once every 11 years or so, and it’s been that way for decades. So the flip side on the one side you have fiduciary standard for broker dealers the question of whether they should be subject to a fiduciary standard, rather. But the other question is, well, investment advisors are subject to figure out your duty, but they’re never examined, so we don’t know whether they’re complying with it. That was the context in which we became involved because we decided this is around the time of the financial crisis. Soon after that, we believe that there should be a fiduciary standard for broker dealers. But there also should be some mechanism to ensure that investment advisors are regularly examined. So what we had supported was legislation that was introduced in the House to create a S R. O for an investment for investment advisors, and we also supported the idea. As I said of a fiduciary standard for broker dealers. That was an example. I know I’m giving a very long answer, but I’m doing that to illustrate the type of legislation we might get involved in directly because that was a situation which we felt strongly that investors were not being protected on the Adviser Side Investment Advisors side. We felt strongly that brokered either could be subject to a higher standard. And for that reason we thought that these issues were compelling enough for us to get involved in the SEC. While they weren’t firmly in support of the sorrow idea, the staff did its own report, which suggested that there might be a good alternative until we felt comfortable urging that type of legislation.

[0:22:09 Speaker 0] When you say we does that refer to finra FINRA staff, you know, thinking about these issues or does it reflect lobbying by broker dealers are members and channeling their views through FINRA to issues like this?

[0:22:25 Speaker 1] It was it was our own view. But you know, I’m not going to deny that our views were informed by the perspectives of the broker dealers, which, by the way, are incredibly diverse. We tend to think of broker dealers is a single entity. But the vast majority of broker dealers in the US for example, our shops of 10 employees or fewer the ones we think the ones I mentioned earlier, the Goldman Sachs, Morgan Stanley JPMorgan. Those are huge wire houses that are the small minority in terms of numbers. So when we had federal would talk to firms, we’re probably talking much more to the small firms and getting their different views. And there’s a huge variety of perspectives. Having said that, we would listen to their perspectives and decide which ones had good public policy points and which ones would protect investors and which ones wouldn’t really protect investors. The fiduciary position we took, for example, was opposed by a lot of broker dealers. They did not think that was particularly useful position to take. So, you know, we listened to them, and then we came up with our own suggestion. Is there a perception that cameras captured by the industry in the same way that the SEC is sometimes accused of being captured? Well, yeah, that’s an interesting question. I mean, people will always confused, always accused of regulator being captured by the industry. Um, and it’s interesting as a sidebar on the left side of the political spectrum, There’s an accusation that industry captures a regulator on the right side of the political spectrum. There is often an accusation that certain elements of an industry will capture regulator to discourage competition. So they’ll use regulation, too. As a as a protective means. I think that risk exists for any regulator. But I really, in my long experience, I think it’s frankly overblown. I have a lot of complaints about how regulation occurs. I don’t really feel like it’s never really felt like it was particularly captured by industry. That that is, I think it’s similar to the it’s related to the conflicts. Issue us earlier. Federer needs to manage the questions of how much influence a broker dealer can have, or any broker dealer or the industry as a whole can have over its regulatory decision making. And the only way to do that is to have certain processes in place that insulate the staff and the decision making and the rule making so that he can listen to the views, the legitimate views of the industry as well as the legitimate abuse of consumer advocates but make its own independent decision about what’s right.

[0:25:27 Speaker 0] So let’s shift gears a little bit and talk about Finra’s relationship with exchanges. You mentioned that it was formed out of the N S D and merger with the N. Y C. But those organizations still have their own, necessarily responsibilities. And over the past 10 years, the SEC has been working with the exchanges and FINRA on something called a consolidated audit trail. How is that developed? And what is the world of S, R. O s and exchanges look like today?

[0:25:57 Speaker 1] Well, it’s interesting. It’s it’s a it’s a relationship that’s always a bit influx. But essentially, the exchanges have delegated much of the regulatory responsibilities to finish run. So that was the original creation of Thinner, as I said was the New York Stock Exchange regulatory authority merged with in his in his deregulatory authority so that they created federal out of the combination. But Federal took over the New York’s change nearer side changes regulation of the exchange, and sometimes this is, have this happens to direct delegation under the Exchange act. Sometimes it happens by agreement. The idea of CAT is essentially to have trading information and an audit trail of trading information. It spans across all markets and all brokerage activities so that the various regulators can have insight into trading patterns much of the basis for cat to rise from hope about the uses of artificial intelligence, for example, and machine learning to understand trading patterns better so that previously in correlated activities can view be viewed as having some correlation that would have been missed before. There has been interest by some of the exchanges in becoming more active in their own regulation. Uh, I think that’s a that’s something that fluctuates from time to time, but it’s usually fitness still has primary responsibility for regulating exchange trading activity.

[0:27:35 Speaker 0] Have a question about your own personal views on market regulation. You recently wrote a 3 60 law piece on commissioner per speech about the conflict between government power and personal liberty, and in particular, protecting investors by prohibiting activity removes freedom, even if it prevents costly mistakes like losing your retirement accounts. And I’m just wondering, what are your personal views on the role of regulators and regulation, and how was that shaped or formed or comport with your time at FINRA

[0:28:12 Speaker 1] Uh, well, it’s a good question, and generally my views comported with the public views of FINRA. But I had disagreements with people inside. Sometimes I I thought we had to be a lot tougher, and sometimes I thought we were being unreasonable. But I think I think that article reflects my perspective. And my perspective in general is I am skeptical of regulation. New regulation. I’m skeptical that new regulation necessarily will add much to the regulation that already exists. I’m not skeptical of regulation as a whole. I should say I think regulation is necessary. I mean, I’ve spent my whole life in it. What? I’m talking about his new regulations. So when somebody says, Oh, we need a rule on that my first temptation was always too. Say well here 5.25 different rules that already applied to the activity. And then I usually heard a reason why they didn’t quite apply completely. But I’m a tend to be skeptical of that new rule making, and moreover, I think in today’s political climate, which is an older person, I find incredibly woeful. I think it’s really important to be pragmatic and to understand how the other side feels. So. One reason I wrote that article was to say, Okay, you have somebody like Hester Purse who tends to be closer to the libertarian side of regulation if that’s not an oxymoron, but anything. She is more of a free market person and some of her fellow commissioners. And then you have commissioners on the other side by Commissioner Lee, for example, and probably chairman Gensler when he’s appointed, who are going to feel much more strongly that new regulation will be important in various areas. And I think it’s important in this political climate to try to find, to try to understand how the other side feels, see the bona fides in their position, because usually they are made in good faith and see if they can be somehow resolved. So what I suggested. That article was not necessarily reflective of my personal views about new regulation, but does explain how I think those two views can be compromised in a positive way, not in a negative way, but how they can together create new types of regulation that would allow for greater freedom but also ensure that regulation is incredibly effective. Let’s

[0:30:46 Speaker 0] talk about new rules. There was a really big one under the Trump administration under Chairman Clayton, it was regulation best interest, and you spoke a little bit previously about federal involvement in the fiduciary standard and possibly examining investment advisors and create a fiduciary standard for broker dealers. Can you just give us some insight on what regulation best interest is and what it does and how we got there?

[0:31:15 Speaker 1] Well, I’m a supporter of regulation. Best interest because it’s to me clarifies the duties and responsibilities that broker dealers already have now. I could certainly have made the same argument about that, that I was just alluding to my concern about new regulation. Why isn’t the old regulation enough? Because we did have a suitability standard. We did have all sorts of self practice rules that Funeral had adopted years ago, and the SEC has its own self practice rules, and arguably those would have been enough. And I think in many cases they were enough. But regulation best interests imposes a set of duties on broker dealers, and it also imposes specific compliance requirements, specific requirements on looking at conflicts of interests that I think are quite useful to have in one regulation in many ways will supplant the older requirements. So, for example, the suitability standards for retail investors are largely supplanted by a regulation best interest. So that for that reason, I think it’s useful. I will say that the background of regulation best interest in the background of the larger fiduciary complaint. You’ve probably heard from your last speaker, Barbara Roper, that the fiduciary standard still is more important for investors and regulation best interests, and she would probably still support a fiduciary standard. The background of all of that debate, in my view, has to do with latent skepticism about the commission business and the belief that there is no commission business which can really pass muster in this day and age. And that’s actually what I was always more troubled with the idea that if you earn a fee, whether it’s a one time fee is an investment advisor are a fee based on your assets under management. As an investment advisor, you are inherently more likely to act in the customers’ best interest. And if you receive a commission based on a transaction, and I just don’t think that is economically true and it’s not ethically true, and I don’t think it’s a good moral position to take. So I’m a supporter of regulation. Best interest. But what troubles me about the background discussion that led up to regulation best interests but also continues with a question about the fiduciary standard is his view that basically commissioned business should be crushed and everybody should go with a fee based business. That’s the problem I have

[0:33:50 Speaker 0] is there, You know, we keep saying fiduciary duty and best interest. Is there a one sentence definition for each?

[0:33:58 Speaker 1] Well, I mean the fiduciary standard. They’re very similar, actually. And it’s a good question that one question to always ask those who support a fiduciary standards will. What exactly would it add? Because best interests the regulation best interests imposes a set of duties that are, you know, a duty of loyalty and duty of character, the duty of good faith that are essentially the elements of the fiduciary standard for investment advisors. So they’re very similar, you might ask, Well, why not just impose a fiduciary standard? It’s a really good question. I think the basic reason for that for not doing that is again that It’s very hard, I think, to impose a Stroup your fiduciary standard on a commission business because once I’m paid two finish, you know, settle the transaction with you, and I don’t get paid unless I settle that transaction. It’s hard to cabin that kind of relationship in a fiduciary standard. So I think that maybe the best reason for not imposing the fiduciary standard, but really the difference the substantive difference between the advisor’s fiduciary standard and regulation best interests are infant is more, Um, as a matter of fact, I can explain some ways in which regulation best interest is actually more onerous than the fiduciary standard for investment advisors. Do you think that the average investor, those that are the most need of investor protection understands the difference between all these standards of care and beauty? That’s a really good question. At one point, I argued quite vociferously, but more or less lost, and I argue this more generally. But here’s a good example is that consumers shouldn’t have to know what the legal standards are because the point of the legal standards is to make sure that the regulator can protect the consumer and if the consumer has to understand that somebody is under fiduciary standard or somebody’s under a Rugby I and make a decision accordingly. Then there were all admitting that the standards are. Somehow they may not be protected as well. Under one is under the other, and then we’re going to leave it up to the investor to figure that out. That approach doesn’t make any sense to me. I think we ought to decide, either. We believe in the regulation behind an investment advisors business, and we believe in the regulation behind a broker, dealers business and then the it shouldn’t matter to the consumer. The consumer should feel that whatever arrangements best financially for the consumer should be the one that the consumer picks are. We should figure out where those standards lack protection and we should fix them. But it doesn’t make any sense to me to say that we need to disclose now. Obviously, the consumer wants to know there should be a requirement to tell them, but I don’t know why we need to burden the consumer with decisions about legal standards.

[0:37:06 Speaker 0] So you mentioned Barbara Roper. She was indeed a guest on a previous episode, and she had some criticism that the SEC didn’t go far enough to define the best interest standard that wasn’t enough to rein in abusive conduct. And then she also had some doubts on the effectiveness of a new form, CRS, that was designed to help on investors understand potential conflicts with their advisors and brokers. Are these fair criticisms? Do you have your own views?

[0:37:37 Speaker 1] I’m not sure exactly what has you criticized from CRS, but that’s actually another example of the point that I’ve made. What do you think about it? I think it’s interesting to require disclosure of conflicts. Two consumers, but and and certainly again, there should be a requirement that a financial service firms should disclose conflicts that are requested by the consumer. But once you require disclosure of conflicts, you’re raising the question of whether the firm is actually managing them. So as a regulator has, let me put it this way, Rigby. I already says every broker dealer who’s dealing with the retail investors stick by with certain duties has to act in the best interests of the customer, has to analyze its conflicts, and it does say, disclose, mitigate or eliminate those conflicts In the case of an individual rep, they actually have to either mitigate or eliminate them. Disclosure isn’t enough. So the question is, will, Once you say disclosure, are we saying that the firm doesn’t mitigate them enough? Is a firm actually mitigated? Looked at the conflicts, determined it was complying with its duties under Rugby I and eliminated the conflicts that it can’t mitigate it? Theoretically, there should be no need to disclose anything to the customer. I know this sounds crazy because we’re all used to saying that consumers need information, consumers and information. I think if we’re honest with ourselves, we know that it’s highly unlikely that the consumers read that, that they appreciated that they care. They’ve already decided through their financial advisor is. And I think there’s a real temptation by regulators to rely on conflicts disclosure as a proxy for what really should be done, which is mitigation. I think it’s inevitable that firms have conflicts of interest. I just think that they need to be expected to deal with them, and maybe the way to deal with them is to say the conflicts just aren’t that great. You know, they’re not going to the potential for harm is to minimal by the way we’ve mitigated them. But I just think I’m not a huge fan of disclosure of things that conflict. It goes back to my earlier principle, which is to say that regulation is working well. The better regulation works, the less effort is required of the consumer.

[0:40:13 Speaker 0] I think you make a good point, and that raises a question I’ve always wondered. And even if you disclose a conflict to a customer, and even if they understand that conflict doesn’t matter to them. And

[0:40:26 Speaker 1] you know what

[0:40:28 Speaker 0] is the what is the effect of transparency in disclosing conflicts with someone who maybe has already decided, no matter what, they’re going to use a particular advisor? Does it have an effect?

[0:40:38 Speaker 1] Right? And I think it again. Um, it misapprehensions the relationship between a financial advisor and a customer, which is not too different from your relationship with a lawyer relationship with the doctor. I mean, if I if I have a internist and I’ve been visiting the internist for five years, and suddenly the internist has to disclose a conflict that he might have with a pharmaceutical company, and he gives me a piece of paper and I read it. Am I really going to go to a different internist? Am I really going to decide that I’m not gonna take that medication? Um, there’s just a certain point where it doesn’t matter, and I think it’s It’s not particularly harmful to give it to them. But once regulators and firms begin to rely on conflict disclosure, they I think they get lazy, and the hard work of mitigation of those conflicts is missed. So do you think that the SEC should do anything more that the Biden administration will do anything more on whether there will be a fiduciary duty in coming for broker dealers? Well, I’m not very good at predicting, Um, I don’t If I were to bet which I wouldn’t I would say that they are less likely to do anything by rulemaking is they are to do something by enforcement and examination. Rigby. I is written away. That’s that it contains. It contains broad principles and there principles that need interpretation. And it’s easy enough for the commission staff to interpret those principles in ways that are more investor focused, investor oriented. And perhaps they could be numbers. They’re all their choices that the staff can make on how it interprets any element of rugby. I think it’s more likely that if they’re going to be more consumer oriented in its interpretation, that they’ll just do that through the interpretation and not the rule making.

[0:42:44 Speaker 0] So let’s shift gears a little bit and ask you about a current event about a company called Gamestop. And it’s been widely reported that a Reddit user group called Wall Three Bets has pushed up the prices almost 10 fold and just a couple of days. And the purported motivation was simply to squeeze the shorts and not based on fundamentals. In fact, most would argue that the fundamentals couldn’t support this particular price increased. And I just want to get your to start like What is your your reaction to this? Like when you saw this, What did you think?

[0:43:21 Speaker 1] Well, essentially, the first thing I thought was I didn’t realize game stops were still in malls. Um, and I also wondered, why in the world aren’t they raising capital? But as to the basic issue, you know, I haven’t looked at the data, but I had two questions that maybe somebody like you could help answer. The first question is, how different is this short squeeze from short squeezes? It occasionally happened and have always occasionally happened, since short sales were possible on exchanges. Is it different in quality or on quantity? Is it more volatile and more extreme than usual, or is there something qualitatively different now? The argument is that it is different because it’s so, so much driven by the retail market. But that’s my second question. How much is it really driven by the retail market and certainly the Reddit site, The Reddit platform has been mentioned and diversity. Every news report is a source for the short squeeze. What I have looked for and at least as of a couple of days ago I haven’t found is the average purchase sized for these transactions. I assume they’re very small, and I assume, given the reaction by the big retail firms like Robin Hood, that there is a huge amount of activity by their customers. But I would be interested in how much of this has been going on on the institutional side. And certainly the latest reports are that the institutions that jumped in. So how much of it actually is driven by the retail market and how much it isn’t, You know, in terms of of one of the first pieces I saw was a piece that referred to the Twitter fees that were saying, Well, you see, the efficient market theory is bogus. First of all, nobody really understands the official market there, except for people who are steeped in it like you would be. But moreover, I just think there’s sometimes when stocks trade like commodities and they don’t trade based on under under underlying value, they trade on expected price. Quantitative hedge funds are designed in many cases to do that. If algorithms that our momentum driven and price driven, they’re not looking at fundamental evaluation of an asset. So I think this is an example of that. And again, my question is how qualitatively different is this and is the consensus view that this is retail driven, actually true?

[0:46:07 Speaker 0] Yeah, So you make a good point that wherever he is jumping to the conclusion that it’s the retail investors pushing this. And as economists would say, it’s an empirical question and regulators have the data and they can certainly look at it and see if that’s true. But it was assuming that it is true. Does it surprise you that retail investors can move prices in this way and not an insignificant size stock? It’s not a This is not a classical pump and dump in a penny stock. I mean, this is a, uh, you know, market cap of 30 billion at the at the height type stock. Does it surprise you that retail investors, when acting in coordination, can have this sort of effect?

[0:46:48 Speaker 1] I guess it doesn’t let me give you two reasons which have nothing to do with each other and maybe a little bit off the wall. The first is that we’ve all been kind of become accustomed to the wisdom of the crowds. I mean, when we buy something on Amazon, at least I look at the star rating first, and I read something on air and B and B. I look at the star rating first, and I look at the more people who have raided, the better I feel it’s kind of similar acceptances in the magnitude of millions of bits of activity and bits of data, but it’s another example of the wisdom of the crowd, the other. The reason I’m not surprised is that I have a theory of human psychology that’s 2020 based, and that is that I think, in times of plague people to all sorts of crazy stuff. And I would attribute some of the crazy stuff last year, maybe to the pandemic. And it may be that some of this is attributable to the pandemic. It maybe in 10 or 15 years behavioral scientists will look back at this period say, Wow, we can now understand some of the sociological effects of the pandemic on human behavior, and it may be that you got a bunch of people who have a lot of money. We’re sick of being inside, and this is a great way to gamble. I don’t know if you heard. But yesterday, Robin Hood and other brokerages attempted to put a stop to all this and Games thoughts, as well as a handful of other equities featured on the Reddit page. By restricting trading, specifically prohibiting buys while still permitting Selves, do they need regulatory approval for this kind of action? And do you think they confer within or the S E. C. Before making these moves. Yeah, I’m not familiar with exactly what the different broker dealers did. I mean, I’ve read a little bit. I heard an interview with somebody from TD Ameritrade with things, said All we did was limit margin positions and prohibited short sales. I guess some of the reports on Robin Hood seemed to say that they prohibited some new purchases. They’ve riveted on new purchases. Yeah, that that that was where it was reported. And it was, and I I’m you know, it’s a good question. Whether they’re limiting what they can do, I would be suspicious that I would be skeptical that they are limited for the simple reason that much much of the regulation of broker dealers has to do with their capital and liquidity positions. And that’s true not only the Robin Hoods and the TD Ameritrade’s who have the trading activities with their customers, but also the clearing firms, the ones that actually clear their trades for them. They have their own capital requirements and on liquidity requirements, so the firm feels that it’s in any kind of financial stress, even if it’s not. But if the possibility exists I would expect there to be quite a bit of leeway for them to take appropriate action. And even aside from that, you know, if they’re undergoing a lot of reputational risk, and they think that reputational risks arise from harm that their own customers are inflicting on themselves, they’re private companies. I’m not sure that they are prohibited from telling the customers. Okay, we’re going to protect you in this way. I just tried to transfer money between two bank accounts, one integer from firms yesterday. Well, the bank imposed a limit on how much I can transfer. It’s a pretty small limit that they want to do that to protect me from possible invasion and fraud into my account. I didn’t ask him to do that. It restricts my freedom to move money between accounts, but it protects me, and I’m not sure that broker dealers are going to be viewed as being too restricted and being able to do that. Having said that again, I don’t know exactly what they all did, and it may well be that some of the activities engaged and have a creative problem under existing rules. I’m curious whether you see any problems with shutting out retail investors from the market, particularly creating the asymmetric pricing pressure on the retail cycle. Institutions are still allowed to act the trade and these equities well, it’s a good question because, um, you know politics enters into all of this. And it’s interesting because you have people who previously were so concerned about retail investors that they didn’t think they should be able to buy anything or hire broker dealers on a commission basis, suddenly saying they need full access to the market and they should never be slowed down on their ability to buy Gamestop. And then you’ve got people who are strong believers in the free market who think the private business should be able to make their own decisions, saying, Well, we’re not sure the broker dealers should be able to shut retail investors out, and we’re going to look, we think the SEC should look into this. The bottom line is a broker dealer that’s primarily a retail firm is going to have to make its own decisions about its economic position, its financial condition and what’s good for its customers. Um, I doubt that many broker dealers who have a mixed business, say a broker dealer that is 50% institutional and 50% retail of such a broker dealer even exists would say words going to favor the institutional side and not the retail side. What tends to happen is you have institutional broker dealers and retail broker dealers, and then somewhere the mix in between and the ones who are focusing on right now are the heavily heavily retail broker dealers. Now that senses say they’re only businesses retail, they have a lot of, you know, large private network customers and family offices, things like that. But we’re really talking about the retail business, and they’re not in As far as I’m aware, they’re not saying, Well, we’re gonna let the hedge funds still trade through us. We’re just going to shut out the retail.

[0:53:06 Speaker 0] So you alluded to in the initial part of the response that it wasn’t clear to you if there was actually a problem

[0:53:13 Speaker 1] with

[0:53:14 Speaker 0] this an enforceable action and maybe I’m putting words into your mouth. You can clarify. But the SEC yesterday issued a statement saying we will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by federal securities law. And so I want to touch back on this idea. Is there an enforcement action? Um, do you think based on what you’ve seen not holding you to this, given that you don’t have all the facts, that this looks like manipulative behavior in the sense that it should be a prohibited activity either now or perhaps in the future?

[0:53:51 Speaker 1] Yeah. I want to make you very clearly as a regulator. I’m not strongly believe in regulation, and I just don’t know enough of the facts of what they did to know whether they violated any rules. And if there was manipulation, then I mean, whoever did it should be shut down completely. Based on the reports, I’m not sure how there could be manipulation, because it seems as if it was a coordinated effort by the crowd, not by somebody who has domination and control of the market. But having said that, like I said, I really don’t know the facts well enough. But if there was manipulation or serious violation, I think whoever did it should be barred from trading.

[0:54:35 Speaker 0] So let’s move to Robin Hood for a second. You mentioned them, or maybe slow mentioned them. We had Dan Gallagher, there, chief legal officer on a couple weeks ago, and maybe he wouldn’t have come on if this episode had occurred. You don’t want to talk about it, but certainly they’ve been the center of attention. Um, and they’ve been challenging the established orthodoxy on on investing, and they’ve had a lot of critics, and one of the criticism has been Gamification, and you have a lot of trading now that might be due to different factors that previously existed before. You had a really cool trading app, and I’m wondering, Do you have any views? Is it too easy and fun to trade stocks? And should we be concerned? And is it related to this current episode?

[0:55:22 Speaker 1] Well, I’m not going to comment on Robin Hood because I haven’t been on the Robin Hood site too much, really. But I think it is a problem. I don’t think it’s necessarily a regulatory problems. There may be some regulatory solutions that could be imposed, but I think it’s really a problem for investors. If if they confuse trading with investing, I mean, I guess I don’t have an inherent problem with trading stock like commodities. I just would never do it, and I think in the long term you’re not gonna make any money doing that. I don’t have a problem with going to Atlantic City or to Vegas to gamble, but if you think you’re going to come out after six months of doing that every day, all day and come out ahead, I think you’re sadly mistaken. So to me it is a problem. But it’s a problem in terms of educating consumers and making sure that they understand the difference between trading and investing. It’s like the difference between, you know, snorkeling and scuba diving. Basically, I mean, one is a cheap thrill, and one is actually doing some serious work, which has much more long term benefit. I don’t know if that’s a good metaphor, but so when I came up with anyway going off of that metaphor, I was curious about your thoughts. A lot of it has been tied to Robin, but also more generally, the ease of access to options trading approval that we’ve seen in the past few years and I don’t know if you heard this summer. There were some stories about significant losses and unfortunate actions in the hole. And so I was curious what? How you thought that plays into the whole Gamification, and whether investors think of it investing more a gamble, you know, um, again, I guess I have the same answer. There may be some room for regulation in that area. Um, not just options, but any kind of derivative trading. But to me, the issue and that was incredibly tragic case. But the issue really is whether people who are engaged in any activity, including trading options, understand them. For example, there are options strategies that are quite complex and that expand the risk, the risk of the you know, of engaging in a particular activity. But much of the options trading is actually a form of insurance. It’s a way of limiting risk and one reason. Frankly, I’m just speaking. Personally, I don’t engage in a lot of options. Activity is that once I decided to buy a financial asset, I don’t really want to buy insurance on it because I’ve made my decision about the prospects for the asset. And for that reason, I don’t really feel the need to invest in options but a lot of people don’t look at options as insurance. They look at it as a way to get leverage on a trade. And much as my answer concerning the data stream, trading and investing reflects a concern about what people understand when they do it. I feel the same with options. I think if but retail investor understands okay, the best way to use an option in your position, given your net worth than your where you are in your life. If you’re going to use it, use it as insurance in this way and let me teach you how to do it. Maybe with a c F A charter. That’s great. But as soon as somebody begins to do it as leverage, the harm that they’re going to create by trading frequently is just magnified by the leverage. And that’s what I’m really concerned about.

[0:59:14 Speaker 0] Can we tie this back to regulation best interests at all? Is there a role for rugby I and anything that we’re seeing in markets today?

[0:59:21 Speaker 1] Well, there would be, and there is if any of these strategies are recommended. But most of what we’re reading about probably is not recommended. It’s self induced craziness by investors or traders, Really? But certainly, you know, which is another interesting point on the whole fiduciary discussion, which I hadn’t thought of. A huge amount of market activity wouldn’t be a would be subject to the fiduciary standard anyway, because there’s no recommendation. There’s no financial advice being provided its people, you know, pointing a pistol at themselves and pulling the trigger. So I don’t know that there’s a huge. I think most of the ideas that I could see coming out of this regulatory concepts coming out of this would be more of the long lines of disclosure our gates that people would have to go through before they could engage in certain activities. Do you think the democratization investing has seen in the disappearance of training fees and account minimums necessitates any of these changes or other adaptations and regulation? You know, I think it, I think the democratization of investing It’s fantastic because, you know, in my in my parents’ generation, even my grandparents generation, if they were lucky to save, they were lucky. If they were lucky to save in a insured account that would pay a low interest rate, then At least they had that security few of them had. We’re lucky enough to buy assets like stocks are, you know, the old mutual funds that would increase with value as the economy grew. Now everybody has that ability. So I think the democratization of this type of investing is fantastic because everybody, everybody is kind of the king of their or queen of their own kingdom and give some control and responsibility. The thing I’m concerned about is the democratization of trading, which is unavoidable. If you get one, you’re going to get the other. But I’m again worried about how well educated people are when they’re engaged in trading. If they’re gonna treat it like gambling and they’re gonna, you know, control themselves and, you know, invest $50 at a time or trade $50 at a time. That’s one thing. But if they feel that their life savings could be subject to such trading activity, I think it’s a terrible tragedy.

[1:01:58 Speaker 0] Tom, you’ve been with us for a while. You’ve answered a lot of our questions, and we appreciate your time with us, and I’m going to turn to Sloan and let him have the last question.

[1:02:12 Speaker 1] So do you have any advice you would like to do? Young professionals interested in financial regulation? Yes, I would recommend assuming it’s securities. Baking is a different issue. I would recommend getting either a PhD in economics or a law degree with a lot of financial regulatory substance in their coursework, getting a CFA charter and going to work for the SEC, preferably if you’re going to go work for the SEC. Do what I do, which is Go work for the general counsel’s office because I think when you go into a particular division of the S, u C or any other regulator, you tend to be cabin into what they’re doing. And you may not understand what the other divisions or departments are doing. So the General Office, like the general counsel’s office today as you see your similar offices and other regulators, gives you a broader perspective of the whole area. Uh, and I think gives you more opportunity to learn about different parts of regulations.

[1:03:20 Speaker 0] Tom, Thanks for being with us.

[1:03:21 Speaker 1] Thank you. Really appreciate it.

[1:03:24 Speaker 0] Mhm. Uh huh. We hope you enjoyed this episode. If you did, please tell others about it. Future episodes will continue to explore topics in financial market regulation. Our aim is to make the issues both interesting and understandable. The production is brought to you by the Salem Center for Policy. How’s the McCombs School of Business at the University of Texas at Austin? If you’d like to learn more about this center, visit Salem center dot org. Our student executive producers are Abby Sawyer and Zoe Tar from the Moody’s College of Communication, my co host for this episode of Slowing Younger Men from the U. T Law School