Regulation without the state: the example of financial services

There are frequent calls for financial markets to be more actively regulated. In nearly all cases it is assumed that regulation must come from state agencies such as the Financial Conduct Authority or the Prudential Regulation Authority. This analysis arises from neo-classical, market-failure approaches to economics which suggest that the market does not maximise welfare if certain (unachievable) conditions do not hold and that action by government is then necessary to move the market towards the welfare maximising position. Just as the assumptions do not hold for welfare maximisation in an entirely unregulated market, we cannot know whether government regulatory action will move us away from or towards the welfare maximising position unless we also make unrealistic assumptions about behaviour in regulatory agencies, amongst politicians and amongst the electorate as a whole. The neo-classical, market-failure approach therefore takes us down an intellectual rabbit hole. There is a long history of regulation being provided within markets. Indeed, so-called big bang and deregulation involved the prohibition by government of private regulators of securities markets (the London Stock Exchange) on the ground that regulation was anti-competitive. Independent professions, such as the accountancy profession, also developed in the nineteenth century as a result of market demand. They regulated behaviour, but without intervention by the state until the 1930s in the case of the US. It is possible to think of regulation as being part of the set of services that can be provided by the market rather than something that has to be done to the market ex-post. The discovery of regulatory organisations is part of the entrepreneurial market process. This does not only happen in areas such as finance. There is a long history of private regulatory bodies in a range of areas within the economy – perhaps most notably in sport, but more recently in areas such as taxi provision. Regulatory institutions evolving within the market are not simply nineteenth century (or earlier) historical curiosities. They continue to evolve, despite the attempts by government agencies to regulate markets in very detailed ways. Modern examples would include the International Swaps and Derivatives Association (ISDA) whose record during the financial crisis was faultless. There are disadvantages arising from private regulatory bodies and also situations where they may work less well. For example, they can encourage cartelistic behaviour. In addition, they may not be as effective where the economic activity that is being regulated gives rise to widespread social costs beyond market participants. Furthermore, private regulatory bodies may lack the means of enforcing their regulations. In relation to the first point, it should be noted that government regulators are monopolistic by design and it is normally illegal for people to practise in the relevant market unless they are approved by the regulator. In relation to the third point, restrictions on means of enforcement are generally imposed by government in the first place. We should reject market failure analysis and operate under the assumption that the market can provide regulatory services because they are valued by market participants. Where statutory regulation is used, it should generally be voluntary with products not regulated by the statutory regulator being clearly identified as such. Furthermore, the Competition and Markets Authority should conduct regular investigations into whether regulatory services provided by the state inhibit competition. To take one topical example, outside financial markets, Transport for London should not be able to establish a regulatory monopoly by being allowed to regulate or, still less, being allowed to prohibit Uber. TfL and Uber should be seen as alternative, competing regulatory bodies for ride services