Securities Intermediaries in the Internet Age and the Traditional Principal-Agent Model of Regulation: Some Observations from the EU's Markets in the Financial Instruments Directive

• Author: Iris Chiu
• Position: Lecturer, Faculty of Law, University of Leicester, UK. LLB (Singapore), LLM (Cambridge).
• Pages: 38-46

Key words: securities, securities intermediaries, brokers, broker-dealers,agency, asymmetrical information, Alternative Trading Systems.

A version of this paper was published in Kierkegaard, S. (2006) Business Law and Technology Vol.1 and presented in the 2006 IBLT Conference, Denmark.

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1. Introduction

The regulation of securities intermediaries such as brokers and broker-dealers has hitherto been based on agency issues arising out of the client-intermediary relationship. The rise of the financial intermediary was characterized by Professor Clark as representing an advanced stage of capitalism in the development of modern capitalistic civilization. In this stage, capital suppliers concentrate on whether they should relinquish their funds to a particular intermediary, and the intermediary to a greater or lesser extent would be competent to advice on investment choice. The intermediary's brokerage services is essential to match suppliers and issuers of capital in the modern economy and securities intermediaries are in a position of relative trust and confidence vis a vis their capital supplying clients. The rise in financial intermediation has been empirically studied to bear a direct correlation with economic development, as financial intermediation is closely related to the growth of capital markets. (Chen (2006), Gorton and Winton (2002))

The nature of the intermediary as agent inexorably raises questions of whether the agency relationship may give rise to concerns that require regulation. The "traditional" model of regulation of the principal-agent relationship in securities transactions is based on the following rationales: agency issues arising out of asymmetrical information, fraud, insolvency and custodianship. As insolvency and custodianship deals with how the law regards assets held by intermediaries if they should become insolvent, bearing in mind that many assets may include client assets and borrowed stock, the discussion in this area is very specialized and would not be dealt with in this paper. This paper focuses on the ongoing relational aspects of client-intermediary interactions and the regulation pertaining to such. The two issues in the relational aspect of client-intermediary interactions that warrant regulation of the relationship are asymmetrical information and fraud. (Pacces ,2000)

Information asymmetry refers to the client's relative weaker position in knowledge vis a vis the intermediary, in terms of the investment activity i.e. the mechanics of buying or selling a security product, in terms of the intermediary's interest in the client's activity, whether there may be any conflict of interest, and in terms of the information surrounding the investment product the client may be interested in, i.e. corporate information and execution information. Such information asymmetries, in the absence of regulation, may result in the intermediary abusing the superior position of knowledge. For example, an intermediary may make "buy" recommendations to a client where it has also underwritten a particular securities issue. As to fraud, in the absence of regulation, breaches of trust could occur. For example, intermediaries could claim commission for non-existent trades. Therefore, regulation is provided to ensure the integrity of client order-handling and Page 39 the accounts and receipts of the intermediary. It may be argued that intermediaries could be relied on to self- regulate as they would protect their own reputations. (Choi, 2000) Reputational capital is important to intermediaries and it may be argued that the intermediaries' own drive towards reputational protection acts as a form of control on abusive behaviour against clients. However, research reveals that reputational pressures alone do not prevent wrong-doing. (Shell ,1991)

Intermediary regulation is necessary for investor protection and ensuring that intermediaries provide an honest, fair and competent standard of service. Besides investor protection, such regulation could also achieve the wider benefit of avoiding the "lemons situation" which refers to a situation where investors are left to discern for themselves which lemons are good, and which are bad, and when they cannot tell the difference, they may become risk averse and withdraw capital. (Pacces , 2000).

The regulation of agency problems in client-intermediary relationships is an important foundation for investor confidence and investment activity. Part 2 of this paper briefly discusses the rise of the Internet as a form of "disintermediation", and examines if the Internet age has removed the need for the principal-agent model for intermediary regulation. Part 3 queries as to how interactions over the Internet may put into question the traditional assumptions in principal-agent regulation. The limitation of words upon this paper makes it impossible to address in detail all aspects of intermediary activity and this paper will make general arguments with specific examples drawn from a selected discussion of intermediary activity. Part 4 then looks into the recently enacted Markets in Financial Instruments Directive ("MIFID" 2004/39/EC, OJ 2004 L145/1) and examines whether the MIFID addresses these modalities and provides for appropriate regulation in the examples raised.

2. The Internet Age, Disintermediation and the Relevance of Principal-Agent Models in Client-Intermediary Relationships

With the rise of the Internet and increasing access to it, hypotheses have been made as to the ultimate disintermediation in many transactions. This is largely because intermediation imposes extra layers of cost (Benjamin and Wigand ,1995) and if the Internet levels the playing field for many market actors, then market actors may seek to avoid intermediary costs by using the Internet as a new means of reaching ultimate suppliers and buyers.(Peake , 2001)

Empirical research has pointed out that the existence of the Internet itself and widened information access does not mean that intermediaries are not needed. Empirical research points out that markets cannot be fully automated as trade execution is a discretionary decision and not capable of complete automation (Picot et al, 1995). Thus, intermediaries remain relevant to the discretionary aspects of securities trading. The extent of intermediary relevance to transactions depends on what kind of function or functions intermediaries serve. As intermediaries often serve a bundle of functions (Schmitz (2000), Sarkar, Butler and Steinfield (1995) and Giaglis, Klien and O'Keefe (2002)), and those functions remain relevant to electronic transactions, intermediaries simply evolve to adapt to the Internet medium ("reintermediation"), or create new functions based on the Internet medium ("cyberintermediation").

In terms of investment services, there are 3 aspects of intermediation based on the typology of intermediary services set out by Schmitz. He argues that intermediaries could offer a bundle of 3 types of services, namely, to hold inventory for immediate execution of trades, second, to gather information and tailor advice to client's specific needs, and third, to provide familiarity as a counterparty in execution of transactions, in order to establish a reputation so as to facilitate trading confidence and trade.

This typology, although not used specifically to describe the investment intermediary, provides a good overview of the investment intermediary's services to his client. The Internet allows electronic market-places to be set up so that investors could "meet" sellers and buyers directly (Coffee, 1997); and the Internet is a repository of much information that investors can retrieve and use to inform investment decisions. (Langevoort, 1985) However, these opportunities for the investor do not immediately translate into discontinuation of the need for an intermediary. Professor Coffee mentioned that an intermediary may provide a buffer against counterparty risk and guarantees execution of trade once an order is put in. An electronic venue for meeting other buyers and sellers does not give such a guarantee. Intermediaries also mediate risks associated with settlement and clearing after trades. Besides, market-making intermediaries provide continuous liquidity, whereas electronic market-places may not be able to find the perfect match for an order that quickly. In this respect, the "inventory" function of the intermediary is likely to be needed, and it is unlikely that investors would discontinue the use of intermediaries altogether.

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Second, many investors look to intermediaries to organise the multitude of corporate information available on potential investments, and to give advice on suitable investments. This has been argued to apply not only to retail type investors (Clemons and Hitt, 2000) but also to sophisticated investors (Langevoort, 1996). It has been opined that sophisticated investors such as pension funds and unit trusts deliberately refrain from amassing too much knowledge of corporate information, as this may tip them over into insider dealing liability if they are found to have traded on certain corporate information (Schmitz , 2000). The widened access to information...