Bureaucratic Discretion Risks Undermining Financial Innovation

By Ricardo Lesperance

For better or worse, the American financial system has been the most dominant in the world for generations. The driving force behind that hegemony has been the ingenuity with which financial institutions have used innovation to navigate, adapt to and overcome challenges in the financial market. When in the early 1960s the markets experienced a bout of volatility, including rising inflation, unpredictable interest rates, and rapid advancement in technology, financial institutions responded by undertaking drastic actions including developing new investment products to help weather the storm.[1] That formula proved so successful that, over time, financial innovation became the hallmark of American Capitalism.

Financial innovation refers to the process of creating and providing improved financial products, services or instruments that meet the needs and demands of financial system participants, at reduced costs and calculated risks.[2] Innovative products and services have significantly transformed the way the financial sector carries out its four core functions of enabling parties to conduct financial transactions with each other; mobilizing society’s savings; channeling those savings toward productive investments; and allocating risks to those who are willing and able to bear them.[3]

From Microfinance loans to Cryptocurrency, with Online Banking, Credit Cards, the Index Mutual Fund and Crowdfunding, in between, financial ingenuity has positively impacted the lives of everyone in the world, no matter their creed. That being said, it would be disingenuous to ignore the potentially devastating consequences that can ensue when innovation runs amok in the financial industry. Who can forget how Wall Street exotic products such as Collateral Debt Obligations (CDOs) and Credit Default Swaps (CDS) took the world to the brink of economic disaster in 2008?

It is hard to argue against the decision that Congress and the Obama Administration made in the aftermath of the market collapse to rein in Wall Street, by introducing a number of financial reform proposals which ultimately culminated in the enactment of the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[4]. Somebody needed to step in and clamp down on the rampant market abuse, reckless risk-taking and unconscionable predatory behavior that inundated the financial sector. However, the biggest casualty of financial regulations may have been innovation. Since the crisis, regulators look at new financial products with profound skepticism if not outright disdain. One need only look at the apprehension surrounding Bitcoin and its progenies to realize how uncomfortable market regulators are towards new investment instruments. Even successful products such as the Exchange Traded Funds (ETFs) which have been around for decades and have had a successful track record, are now facing crippling SEC censorship.

Since entering the U.S. markets 25 years ago, ETFs have been among the most impressive innovations in the industry, particularly in terms of stability and predictability of investment returns.[5] Thanks to their appealing features, including their ability to trade on securities exchanges constantly, with their prices being updated every few seconds throughout the day, ETFs quickly became one of the most attractive investment vehicles to both institutional and retail investors.[6] ETFs regularly boast over $1 trillion assets under management and launches of new ETFs range between several dozen to hundreds, in any particular year.

With ETFs operating on the basis of such a time-tested formula, one would think SEC bureaucrats would be a little more enthusiastic about the idea of Bitcoin ETFs. After rejecting several applications for bitcoin-based ETFs, including one by the Winklevoss twins back in 2013, on March 28, 2018 the SEC finally announced that it is considering a rule change that would allow bitcoin ETFs - Proshares Bitcoin ETFs and Proshares Short Bitcoin ETFs - to be listed on the NYSE Arca exchange. That announcement was welcome by many influential market participants, including the Chicago Board Options Exchange (CBOE), etc., which urged the SEC to stop being an impediment to such ETPs coming to market. Proponent of Bitcoin ETFs argue that regulated Bitcoin ETFs would likely add further liquidity to bitcoin markets by providing another venue for investors to get in on the cryptocurrency action and help tamp down price volatility by instituting controls and rules on their movement.

In reality, few people if any are really waiting with bated breath to see which path the SEC is going to take this time around. Many observers believe that as long as the agency insists on trying to find a solution to satisfy the demand for Bitcoin ETFs through the lenses of the Investment Company Act of 1940, bureaucratic discretion will continue to undermine financial innovation. The SEC’s chief concern with Bitcoin ETFs is that funds holding substantial amounts of cryptocurrencies and related products are currently unable to satisfy the requirements and the rules of the 1940 Act. It’s hard to know whether repeating this refrain every time the SEC issues a denial of Bitcoin ETFs is a reflex mechanism on the part of agency bureaucrats or pure laziness. What is undeniable however, is a complete refusal on the part of the SEC to contemplate other alternatives including the prospects of approving Bitcoin ETFs under the Securities Act of 1933.

Considering SEC representatives including its Chairman believe Bitcoins are Securities, it begs the question why the SEC has not yet contemplated regulating Bitcoin ETFs primarily under the Securities Act of 1933. Unlike the 1940 Act which places an incredible amount of discretion in the hands of SEC bureaucrats, the ’33 Act not only provides fairly clear regulatory guidelines and tests (Howey for instance) that can be used to determine whether a financial instrument is a security, the Act also outlines the steps that must be followed to remain in compliance. In other words, the SEC’s arguments that its reticence in approving Bitcoin ETFs is primarily due to a number of significant investor protection issues that need to be examined, does not withstand scrutiny. One of the ways to alleviate that concern would be to allow only sophisticated investors to venture into Bitcoin ETFs, at least initially. This wariness on the part of the SEC has far less to do with investor protection and is primarily driven by too much bureaucratic discretion.

[1] Frederic S. Mishkin (1990), Financial Innovation and Current Trends in U.S. Financial Markets. NBER Working Paper Series Reference No. 3323. Available at: http://www.nber.org/papers/w3323

[2] Josh Lerner and Peter Tufano (2011), The Consequences of Financial Innovation: A Research Agenda. NBER Working Paper Series Reference No 16780. Available at: http://www.nber.org/papers/w16780

[3] Robert E. Litan (2010), In Defense of Much, But Not All, Financial Innovation. Brookings Institute. Available at: https://www.brookings.edu/research/in-defense-of-much-but-not-all-financial-innovation/

[4] Simon Joseph and James Kwak (2012), Is Financial Innovation Good for the Economy? The University of Chicago Press Journals. Available at: https://www.journals.uchicago.edu/doi/abs/10.1086/663153

[5] ICI Research Prospective, Vol. 20 No. 5, September 2014

[6] Id.