When Does Regulation Work?

When Does Regulation Work?

Markets are never entirely free. Rules, regulations, and referees shape the playing field, in the form of municipal codes and international trade agreements, tax incentives and penalties, an alphabet soup of agencies and voluntary industry standards. And players of all kinds try to gain advantage by influencing the creation of rules and their enforcement.

Yale Insights talked with experts in three markets where regulation plays a significant role: hedge funds, pharmaceuticals, and organic food and beverages. Among the themes that emerged: Regulation can engender trust among market participants, whether they are investors or consumers purchasing medicine. And good regulation requires collaboration between business and government.

Investing: Eli Combs, President and Co-Founder, Meehan Combs

By definition, investing involves risk. Regulation often aims to contain this risk, or at least direct it away from innocent bystanders. But in this fast-developing industry, the regulations often seem a step behind, perhaps because they were shaped in response to the last scam, scandal, or crisis.

Hedge funds typically seek to nimbly exploit market opportunities. Because they aren’t open to retail investors, hedge funds have been exempt from many regulations that cover investment vehicles such as mutual funds. Such funds have been prevented from advertising for the last 80 years, in an effort to limit the market to wealthy, sophisticated investors. But that rule was recently lifted.

Eli Combs ’01, president and co-founder of the hedge fund Meehan Combs, discusses the pros and cons he sees in some of the regulations facing his field.

Regulation of banks is crucial for the efficiency of transactions, for maintaining reasonable real interest rates, and for the transmission of monetary policy into the real economy. Banks have a unique position in our economy and benefit from this unique position by being explicitly supported by our government. As such, regulation is fair and reasonable.

In our industry, we have strong relationships with banks as counterparties, prime brokers, custodians, etc. Faith and trust in their operations reduces the cost of doing business with them. Having regulated entities in formal relationships with our company helps reinforce trust in our business. We directly benefit from the fact that they are regulated.

On the other hand, I believe that direct regulation of private investment funds is unnecessary, and the cost of compliance prevents formation of new businesses and thus is a disservice for investors because it limits choices and perpetuates the growth of the largest funds (which are often the least able to profitably exploit investment opportunities). I believe that markets and counterparties should “regulate” our industry through ongoing market decisions.

Our industry is most beneficial when we are allowed to take risk with the least amount of non-investment-based cost (in terms of dollars and time). This risk-taking has a direct benefit to society. It is different from banking in that we are not quasi-governmental entities and do not have a backstop from the government.

People and businesses regulate their behavior every day by the choices they make in what they buy and sell, and with whom they do business. I think it best to remember that lack of political/governmental regulation does not mean that businesses do not have scrutiny and are not regulated by their customers and suppliers. Regulation should not replace trust, and in fact should not be allowed to encourage people to forget trust.