How can you oversee a system you don’t see?

I was intrigued by a post from a friend who had worked for a leading fund manager. Her boss was jailed for financial manipulation. In her words:

“I witnessed the effect of regulators on an innovative mind. Prior to jail, he was a financial trailblazer in encouraging companies to dream big, much like today’s venture capitalists. Prior to jail, he used new financial innovations, from leveraged buyouts to zero coupon debt to get companies money when investors didn’t want to think so far ahead. Prior to jail, he financed the United States’ lead in cellphone technology.

After jail, he’d think of a private company he’d like to own…and then think of the potential regulatory scrutiny. He didn’t pursue it. After jail, I researched and help write his textbook On Corporate Finance, but then he worried how it might be viewed. He never published it. After jail, he debated whether financial markets were efficient, arguably the most ground-breaking of all financial debates. He never released it.”

It made me think about all the things I’ve been blogging about lately: cancel culture, the worries of stepping over the line, the right to agree or to disagree and more.

First things first, it’s pretty obvious that if you go to jail, it will change your perspective. I’m lucky that I’ve never been sentenced but have spent a night or two in a jail cell when I was young (long story). It does change your behaviour and you try to stop doing the thing that you were not meant to be doing.

That’s a good thing as long it doesn’t go A Clockwork Orange. Watch that film if you haven’t already.

Second thing second: is it right for a regulator to jail innovation? I’m not so sure. There is always a friction between innovation and regulation, but the regulator needs to encourage change, not stifle it. That’s why it is so pleasing to see sandboxes blossom around the world for FinTech start-ups to try out ideas in partnership with banks. I guess the issue is what happens if they don’t blossom within a sandbox. Examples include payday loans firms and BNPL (Buy Now, Pay Later). It’s all well and good to unleash innovation in the wild, but if it is wild then it needs its’ wings clipped. The balance is a fine line.

Finally, if you meet an innovative mind, should you shut it down?

The comment above from my friend made me think. It made me think that she had encountered a brilliant mind. She had worked with someone who could truly see how to change markets, change economics, change the world. Unfortunately, his thinking ran counter to culture. But counter-culture thinking is not a bad thing. In fact, counter-culture thinking should be nurtured and supported. Thing is that his counter-culture thinking was unleashed into mainstream financial markets. I would suggest that counter-culture thinking should be unleashed into the sandbox.

Nevertheless, counter-culture thinking is a good thing. It challenges. It makes you think. And yes, it creates opportunity. In fact, a lot of counter-culture thinking is what financial institutions need. I always remember the comment in Michael Lewis’s book Liar’s Poker.

At one point, there is a conversation with the investment banks’ General Counsel. Asked what he focuses upon, the lawyer said something along the lines of:

My job is to find the chinks in the regulator’s armour

In other words, to find the weaknesses of the regulatory structures.

That’s how you make money.

You make money through regulatory arbitrage – hedging between markets – or through regulatory avoidance. The innovative mind is good at finding those gaps. The regulatory mind is good at keeping up. But when they catch up: should they shut down those thoughts or encourage them in a safe environment?

I guess that’s like saying if you catch a hacker or a cyberspy, should you jail them or ask them to carry on and show you what they’re doing?

I would rather take the latter approach as how can you oversee a system you don’t see?