Thursday, January 25, 2007

Developing financial markets

Last week I wrote about the importance of regulations, and referred specifically to OLINT and Cashplus, which have been the focus of many discussions over the past few months. The debate around these investment schemes have heightened over the past week and seems to have climaxed with statements from David Smith, explaining that he does not guarantee 10% per month, and Errol Ennis, stoutly defending his right to operate and lambasting the Financial Investigations Division.

This is exactly what I saw coming, and why I wrote the article last week. The fact is that if we do not (1) have a proper regulatory environment in place; and (2) rule quickly on contentious issues then there will be contradiction. This does nothing more than waste our energies on matters that should be solved by preset structural processes. I drew a parallel with a company, where the HR structure and rules are not in place. What happens is that you end up managing multiple personalities and hence waste precious time dealing with HR issues, which really are not solvable without a defined set of acceptable behaviours, while the competition focuses on making money.

This is precisely what will happen to us as a country. While we debate, through our emotions and self interest, whether or not OLINT or Cashplus is legitimate, our international competitors are busy developing their own financial markets and raising their productivity levels. The fact is that we take much too long to make rulings one way or the other on issues because we fail to objectively analyze and put the proper rules in place to deal with them.

Creative ideas
Financial markets do not develop by maintaining the same products and services for eternity. We have seen the development of our own capital markets through the introduction of commercial paper and money market transactions. Internationally also when derivatives were developed many thought that these may be a problem simply because it was not fully understood. So if we want to develop markets we must continue to encourage creative thought. Every successful company starts with an idea, and for every successful company there are five failures. What we must never do though is discourage creativity, or what the Americans refer to as invention.

As this creativity is being encouraged though, the regulators have a very important balancing act to play. While they must not interfere to the extent of killing creativity, they need to ensure that new ideas do not have the intention of defrauding investors, and that all relevant information is made available to the public. Even after all of that, however, investors will always be free to make their own decisions and take as much risk as they want once they have all available information and understand it. For example if I want to gamble all my money on a donkey running against stallions in a race, and I understand the risks, then it should be my business to do so.

It is therefore a very delicate tightrope that regulators must walk, but they must do so. In other words instead of fuelling the debate by not ruling on the matter, let us put it to rest. In any event, while we wait there are many persons who are putting their monies into currency trading, and risky hedge funds, and even fraudulent internet schemes, by just turning on their computer. Are we going to protect these persons by taking away their computers and banning DSL connections? What we must do is understand the risks, document it, and communicate it to the public, and where we believe that further protection is needed, legislate it. Investors can also protect themselves from risky investments through portfolio diversification, but there is always a place for high risk investments.

Even if the regulators choose to legislate against certain activities, however, this is no guarantee that the public will not participate. Today we have something called the internet. This has opened up access to global markets and makes the job of regulators difficult in protecting the investing public. The only way to really address this is by education. This was a point referred to by Errol Ennis in an interview on Nationwide News.

Internet access
While I was a Commissioner at the Betting, Gaming & Lotteries Commission, I was charged by the chairman with the responsibility of looking into the then new advent of Internet Gaming. One point the regulators found difficulty with was, when doing a transaction on the internet, in what jurisdiction does it occur. Does it have jurisdiction (a) where the server is located, which could be in a different location from where both parties to the transaction are; (b) where the payment originates or terminates; (c) the location of the buyer; or (d) the location of the seller? And where does the acceptance of the offer occur, forming the binding contract? Which regulator therefore has jurisdiction over the transaction?

The United States spent years looking at this, as they sought to ban Internet Gaming in their country, without much success. Until the president recently signed legislation outlawing the provision of Internet Gaming services in the US, these organizations flourished, and with the signing of the legislation into force one company was reported as writing off US$350 million, having to sell the company for US$1. In my opinion though this will still not stop the average American from gambling on internet sites. All it will do is force the activity underground but it will still happen. Just as law enforcement has realized that the best way to fight drug use, including the legal drugs, is by education to stem demand, so too they will eventually have to educate to control Internet Gaming.

If we intend on carrying on a market economy then we must understand that it is important for capital markets to develop. That development, however, will not happen by becoming complacent with what we have, but always looking for that next new idea that will spur greater growth. Last week comments were made by Milton Brady that there is no reason why financial institutions should today be saying that falling interest rates have reduced their profitability. He lamented the fact that the Finance Minister gave the sector two years warning that rates, and margins, on GOJ paper would be coming down. He further stated that some financial institutions have failed to wean themselves off GOJ paper and still invests an average of 35% of assets in it. Naturally therefore net interest income and profits must fall.

The Jamaican public, like every other national, rationally continues to seek higher returns. In the US this has led to the explosion of hedge funds and private equity schemes. These hedge funds have lost and earned a lot of money, and have made upwards of 40% in 2006, playing with billions of US$ on bets such as where oil prices will go. What the regulators ensure is that they play by the rules and investors are aware of the risks. It is through the creation of new ways of thinking that capital markets expand making way for much needed equity for new businesses.

My main concern remains that we do everything to protect the Jamaican market while developing it. What I do know is (1) the world is not waiting on us to sort out our challenges, just as they have leap frogged us in economic development while we tried to grapple with globalization and our politics; (2) we cannot afford another “FINSAC”; (3) we must develop our capital markets with new ideas; and (4) regulators will not be able to forcibly protect investors against themselves with the internet. The ball is in the court of the regulators.

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