July 20, 2010
Dodd-Frank Forum: What would Brandeis think?
Posted by Mike Guttentag

Louis Brandeis famously coined the metaphor (“sunlight is the best policeman”) that provided the philosophy underpinning the first federal securities acts (disclosure, disclosure, and more disclosure).  I thought it might be fun to run a thought experiment:  what would the intellectual father of federal securities regulation think of the Dodd-Frank Act? 


On initial review, Brandeis might be proud of his metaphor's place in the new Act.  An entire section of the Dodd-Frank Act (Section VII) goes by the name: “Wall Street Transparency and Accountability.”  But on closer inspection, the ways in which disclosure rules are used in the Dodd-Frank Act deviate substantially from the Brandeis’ tradition and are clearly secondary to the new Act’s main interventions.  This is, however, as it should be.  Notwithstanding the many add-ons, the Dodd-Frank Act is fundamentally an act about prudential regulation, and public disclosure is not a tool that is specially tailored to address prudential regulation.


Why disclosure of prices in derivatives markets?


The application of disclosure rules in Section VII of the Dodd-Frank Act is focused on facilitating price discovery in the derivatives markets.  This is an odd place to worry about price discovery. In general, uncertainty about prices allows a seller to carry out price discrimination (think of trying to get a good deal at your local mattress store, when the mattresses at every store have a different name).  The effect of price discrimination is to transfer consumer surplus from buyer to seller, but there is no economic efficiency cost.  So, in requiring public markets in derivatives, we are seeing a form of “consumer” protection, but this time for sophisticated investors.  Why protect one group of sophisticated investors from another group of sophisticated investors?  Aha: truth be told, the legislation implicitly recognizes that many of these so-called sophisticated investors really may benefit from legislated investor protection (perhaps, for the reasons that Gordon’s post highlights).


Another possible justification for requiring public trading of derivatives is that price information may generate positive externalities.  Public information about derivatives pricing can be used to price the option component of a portfolio.  What if you are planning to replicate a put strategy on the market by executing a portfolio insurance program?  One way to see how much such a strategy is likely to cost is to look up the prices of the publicly traded derivatives necessary to replicate your strategy. But federal intervention is almost certainly not necessary for this purpose, since the required derivatives price information is generally already publicly available.


Disclosure is secondary here (as it should be)


A second aspect that might strike Brandeis as surprising on reviewing the Dodd-Frank Act is just how far the main thrust of regulatory intervention has moved away from disclosure requirements.  The preferred approach of the Dodd-Frank Act appears to be: require a study and a set of regulations to be written, as noted by others in their posts.  On this score, I tend to agree with Brett that the drafters of the Dodd-Frank Act are probably doing the correct thing.  At the most general level, regulating systemic risk and imposing leverage restrictions are jobs for a prudential regulator, not a fully informed public market or a legislator.

Nothing for the shadow banking system?


So we have a new disclosure scheme to help so-called sophisticated investors, and we have an expanded bureaucracy aimed at hunting and destroying systemic risk. What about the huge grey area that Erik describes as a shadow-banking system or what Bret identifies as the “systemic collapse [that] can occur when many medium-size institutions in linked markets follow similar investment strategies?”  First, I have a hard time distinguishing concerns about a shadow-banking system from concerns about securities markets generally.  So this leads to the question of how we prevent securities markets from getting “overheated.”


Why doesn’t the Dodd-Frank Act do a better job of dealing with potentially problematic shadow banking system/securities markets weaknesses?  The answer is simple.  Just as we don’t really quite know how to legislate effective prudential regulation, no one has yet offered a particularly good answer on how to regulate securities markets in a way that appropriately mitigates booms and busts.


My guess would be that Brandeis would fall back to his old favorite (disclosure) as the best place to start.  He would continue to insist on full and honest disclosure in all transactions for a host of reasons.  In this respect, he would probably applaud the Goldman Sachs case brought by the SEC more than the Dodd-Frank Act.  In the Goldman Sachs case, Brandeis would see that the SEC got it just right.  Implicit in the Dodd-Frank Act is the realization that many sophisticated investors may need to be protected too.  With sophisticated investors, the federal government might not be in the business of dictating exactly what needs to be disclosed, but the SEC is still right to apply two general criteria to determine which disclosures are necessary: requiring both full disclosure of any potential conflicts of interest (“agency” information as Paul Mahoney aptly refers to it) and full disclosure of all relevant accuracy enhancing information.  Both types of information are material, even if the effect of requiring disclosure of the former is only to deter untoward behavior, not to increase the accuracy of securities prices.


In conclusion, with the original securities acts, we had a relatively simple prescription – more disclosure – to address a host of ailments.  With the Dodd-Frank Act, we are given a host of prescriptions in an attempt to deal with one seemingly perennial problem: the eventual demise of prudential regulation.  My bet is Brandeis would insist that we not forget to continue to rely on well-enforced disclosure rules, in addition to panoply of new rules to protect against a future that may well ultimately be determined by unexpected market dynamics.  There may some wisdom in such an approach.

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