Value, Financial Innovation and Regulation - an Unholy Trinity?

Jeremy Josse

March 2015

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

VALUE

Could there really be value in a contract /

option to buy a Megalodon?• Brokers – generation of demand

• Control of supply

• Liquidity

• Arbitrage

• Habit

Gold

Diamonds

The $ bill

Contracts for Differences

Internet / social media stocks

Market value ‘v’ intrinsic value

Technical analysis ‘v’ fundamental analysis

The ‘efficient market hypothesis’

Behavioral finance

Shleifer, Shiller

Quantifying ‘irrationality’

Mispricing• CDOs/CLOs

• CDS

Complexity / lack of transparency

The nature of financial innovation

FINANCIAL INNOVATION

Rights

Contractual strings / permutations

“Epicycles upon epicycles”

“Legal fictions”

Loans

Stocks

Convertibles

Derivatives

Securitizations

CDS

Empirical testing – cf. a drug or a car

Deductive inference – cf. mathematics

No “social laboratory”

Macro-economic policy ‘v’ private financial

innovation

Financial innovation is• Critical, but

• Vulnerable

New innovation• CDOs/CLOs and CDS

Untested – hence … mispricing

One of the causes of the crisis• The nature of financial innovation itself

REGULATION

1970s

Emergence of a new asset class

Irregular patterns of behavior

Wild price movements

Now an established art form

Dysfunctional patterns of behavior

Value fluctuations – greed…

Distributive justice

Bubbles

Financial innovation

“The rule of law to the rule of lawyers…”

100 years of regulation

Micro-managing rules

Dodd Frank

“Living wills’

Regulatory failure

1930 1940 1950 1960 1970 1980 1990 2000 2010 Present

1931: Uniform Sale of

Securities Act

1932: Reconstruction

Finance Corporation Act

1933: Securities Act of

1933

1933: NYSE Requires

Audited Financial

Statements

1933: Glass-Steagall Act

1934: Securities

Exchange Act of 1934

1937: SEC Accounting

Series Release

1933: Maloney Act

1939: Trust Indenture Act

1939: NASD Created

1940: Investment

Company Act and

Investment Advisers Act

1940: NYSE Multiple

Trading Rule

1942: Rule 10b-5

Adopted

1944: Delaware

Limitations on

Shareholder Actions

1945: SEC Limits

Application of Accounting

Standard for Taxes

1946: Administrative

Procedure Act

1946: NASD Registration

of Broker Representatives

1947: Hoover

Commission Report

1951: Arizona Securities

Act

1951: Loss on Securities

Regulation

1953: Private Offering

Exemption

1953: First GAAP

Codification

1954: Proxy Rule

Amendments

1956: Uniform Securities

Act

1957: NYSE Rule 394

1957: Pooling-of-Interests

Accounting Sanctioned

1958: Deferred Taxes

Ruling

1963: Investment Tax

Credit Accounting

1964: Securities Act

Amendments

1964: “Come to Rest”

Abroad Offerings

1968: Williams Act

1970: Securities Investor

Protection Act

1973: International

Accounting Standards

Committee Formed

1974: Commodity Futures

Trading Commission

1974: Safe Harbor Rules

1974: ERISA

1975: Fixed Commissions

Eliminated

1975: Securities Act

Amendments

1975: Municipal

Securities Rulemaking

Board

1975: Voluntary

Disclosure Program

1976: Materiality Defined,

Sunshine Act

1977: Foreign Corrupt

Practices Act

1977: FASB Voting

1978: Rule G-15

1979: Specialized

Industry Accounting

1981: Central

Registration Depository

1982: Regulation D

1982: Futures Trading

Act

1982: Garn-St. Germain

Depository Institutions Act

1982: Shelf Registration

1984: Insider Trading

Sanctions Act

1985: Revised Uniform

Securities Act

1985: Poison Pill

1986: Tax Reform Act

1987: NASAA Model

Uniform Rules

1988: Rule 19c-4

1988: State Exemption

for Nasdaq Trading

1989: Rule 15c2-12

Regulates Municipal

Underwriters

1989: FIRREA

1990: Market Reform Act

1990: Regulation S

1990: Safe Harbor for

Resales

1990: Securities

Enforcement and Penny

Stock Reform Act

1992: Proxy Changes

1993: Investor Protection

Trust

1994: Uniform Voting

Standard

1995: Creation of SEC

Office of Municipal

Finance

1995: Private Securities

Litigation Reform Act

1996: National Securities

Market Improvement Act

1996: Rule G-38

1996: Nasdaq and NASD

Regulation

1997: Independence

Standards Board

1998: Plain English Rules

1998: Regulation ATS

1999: Gramm-Leach-

Bliley Act

2000: Regulation FD

2000: Commodity Futures

Modernization Act

2001: FASB Ends

Pooling-of-Interests

Accounting

2002: Sarbanes-Oxley

Act

2002:New Uniform

Securities Act

2002: Public Company

Accounting Oversight

Board

2003: NYSE Corporate

Governance Standards

2004: Net Capitalization

Rule Exemption

2005: Reform of Offering

Process

2005: Regulation NMS

2005: Ban on Municipal

Securities Dealer Use of

Consultants

2006: Credit Rating

Agency Reform Act

2006: 529 Plans

2006: Fair Value

Measurements

2006: FINRA

2009: Credit Card

Company Restrictions

2009: FASB GAAP

Codification

2010: Dodd-Frank Act

2010: Consumer

Financial Protection

Bureau

2010: Financial Stability

Oversight Council

2012: JOBS Act

Regulatory Exemption

2012: STOCK Act

2013: Volcker Rule

2013: Dark Pools

Disclosure

….and the story

continues…

Back Office

Crisis, Auditors

Under Siege

Nasdaq and

CBOE open

Y2K, Boiler

Room Scams.

WorldCom

Fraud, Enron

Scandal, Madoff

Scandal, Great

recession

Flash Crash

1968: Management's

Discussion and Analysis

Some major

events

Principles

Clarification of rules solely by judges

UK Takeover Code

Vexatious litigation

Form filling

CONCLUSIONS

Regulation

ValueFinancial

Innovation$