The Meritocracy of an Unregulated Market

Is There a Need to Broaden Regulation?

Can humans achieve economic market efficiency without the “visible hand” or is the collateral damage of decisions an unfortunate reality in exchange for the freedom of unregulated markets. This article discusses the role of regulation in an unregulated market and potential shifts.

How do you measure ability when the parameters are not clearly defined? As valuation analysts, we determine the cost of capital using inputs such as return on regulated public markets. Restrictions of public securities markets are often set in place through governmental bodies which impose arguable economic checks and balances. The Securities Exchange Commission was established in 1934, yet there were successful public security markets in the United States as early as the 18^th century.[1] What were these markets like prior to more stringent regulatory oversight? Were these early trading markets like the unregulated markets of today, such as the cryptocurrency exchange, Futures Exchange (FTX)? Like FTX, unregulated markets, and markets in need of regulatory correction, often begin as innovative and disruptive and end in demise. Can humans achieve economic market efficiency without the “visible hand”[2] or is the collateral damage of decisions, such as those of Sam Bankman-Fried, an unfortunate reality in exchange for the freedom of unregulated markets?[3]

A meritocracy is the holding of power by people established upon the basis of their ability. In theory this concept seems logical and progressive in the fact that it does not presume to be overseen, or held back, by governmental regulations. To many that knew him, Sam Bankman-Fried (SBF) was destined for great power based upon merit. He graduated from MIT in 2014 and transitioned into one of the most well-known trading firms in the world, Jane Street Capital.[4] At Jane Street, SBF’s superiors ranked him the best trader in his class and, as he was going into his third year at the firm, he was expected to receive a $1 million bonus.[5] Although young, SBF was on the expedited path to success seemingly due to innate intelligence and altruism.

SBF wanted more than Jane Street could offer and saw endless opportunity through the unregulated cryptocurrency market. Once unshackled from the restraints of others, in short time, SBF achieved exceptional monetary reward from his entrepreneurial endeavors, which he often paid forward for the betterment of society. In essence, he became the poster child for Adam Smith’s The Wealth of Nations, wherein Smith theorized that one’s individual need to fulfill self-interests results in societal benefit.[6] FTX was established in May of 2019; by November 2022, FTX’s native token, FTT, drops 72%[7] and by December 2022, SBF is arrested for a plethora of financial crimes[8] resulting in the loss of more than $8 billion of his customers’ money.[9] It can be argued that SBF lost track of his moral compass due to youth; yet throughout history (recent and past),[10] those wielding power without regulatory checks and balances often began with good intentions and ultimately are taken down for the betterment of society. Is it possible to have an unregulated exchange, such as FTX, succeed long-term or will greed prevail without clear regulatory boundaries?

The Center for Research in Security Prices, LLC (CRSP) maintains the most comprehensive tracking of security price, return, and volume data, since 1926,[11] for prominent U.S. security exchanges (NYSE, AMEX, NASDAQ).[12] Review of the CRSP data clearly shows the impact of key regulatory historical events and the build-up leading to the governing overhauls.

• Crash of 1929—Causes:
  • Lack of Federal regulations: Rampant individual and financial institutions trading on margin at 10% cash down; inaccurate company reporting; and minimal capital reserves at banks.
  • Blue Sky Laws (state level laws) were weak and largely ineffective.
• Crash of 1929—Regulatory Aftermath:
  • The Securities and Exchange Commission (SEC) was established in 1934.
  • The Federal Deposit Insurance Corporation (FDIC) was established in 1933.
  • Glass-Steagall Act passed in 1933 which separated investment banking from commercial banking[13] (aka “Chinese wall”).
• Great Financial Crisis 2007–2008—Causes:
  • Overestimation of value of securities (collateralized debt obligations [CDO] and credit default swaps) not subject to regulatory oversight.[14]
  • Securities grading institutions, such as Moody’s,[15] assigning AAA-rated bonds to securities comprised of subprime mortgages of borrowers who were likely to default.
• Great Financial Crisis 2007–2008—Regulatory Aftermath:
  • Dodd-Frank Wall Street Reform and Consumer Protection Act established in 2010 to supervise sellers of credit cards and home mortgages more closely.
  • Basel III, a framework that set international standards for bank capital requirements, was published in 2010 and in effect in 2023.
  • In 2013, the Federal Reserve Board of Governors approved the U.S. version of Basel III’s Liquidity Coverage Ratio (LCR).[16]

Prior to 2008, as seen in the instance of Bernie Madoff,[17] the Federal Justice Department was often unable, or unwilling, to bring leading Wall Street executives in to face criminal charges. And yet, since the financial crisis of 2008, hurdles to prosecute the most senior corporate criminals in regulated markets have become often insurmountable.[18] Legal repercussions for fraudulent behavior at the executive level are, as was the case with SBF, often a result of flagrantly egregious misconduct on behalf of the defendant. Even with the continual imposition of new securities regulations at each new historical misfeasance, more than not, senior financial management is able to shield their behavior and/or displace it with the assistance of a costly litigation team.

CRSP Equity Risk Premium (ERP) and CRSP Size Premium are comprised of data collected from regulated publicly traded organizations and used in the determination of the estimated return on capital for privately held entities. Private companies are regulated, yet significantly less so than publicly held companies. In the build-up method (BUM), a CVA can get to an estimated cost of capital for a private company valuation through layering returns to ultimately arrive at a percentage return that a hypothetical buyer would demand for an investment in the hypothetical seller’s operations. The barrier to entry is low to establish a privately held entity, which is further evidenced by the failure rate. According to the Small Business Administration (SBA), approximately 33% of small businesses fail in the first two years and ~50% in five years. Whereas of the U.S. public-company exits in the past 20 years, 95 percent were a result of acquisition.[19] Perhaps with more regulatory oversight, fewer private enterprises would fail either because of governmental handholding and/or formation hurdles.

With respect to governmental regulatory implications to non-fiat markets in the wake of the collapse of FTX, there is little widely known. Undoubtedly, the Department of Justice is working behind the scenes to mitigate such financial catastrophes in the future.[20] I will continue to monitor the decentralized finance markets and be sure to discuss regulatory shifts as they come about.

In the meantime, I hope to be able to provide a second “adequate consideration” installment on the pending ESOP regulations in my next QuickRead.[21]

[1] https://www.investopedia.com/timeline-of-stock-market-crashes-5217820#:~:text=Prior%20to%20the%20Wall%20Street,299.5%2C%20a%2021%25%20decline

[2] https://www.adamsmithworks.org/documents/adam-smith-peter-foster-invisible-hand

[3] https://www.nytimes.com/2023/08/11/technology/sam-bankman-fried-jail.html#:~:text=Bankman%2DFried%20was%20arrested%20in,political%20donations%20and%20charitable%20initiatives

[4] https://en.wikipedia.org/wiki/Jane_Street_Capital

[5] https://www.shortform.com/blog/sam-bankman-fried-jane-street/#:~:text=After%20graduating%20from%20MIT%2C%20Bankman,a%20bonus%20of%20%241%20million

[6] Smith coined this concept as “the invisible hand” The Wealth of Nations | Summary, Themes, Significance, & Facts | Britannica

[7] TIMELINE-Rise and fall of crypto exchange FTX (yahoo.com)

[8] Timeline of Bankman-Fried downfall and FTX’s colossal failure | AP News

[9] Office of Public Affairs | Samuel Bankman-Fried Sentenced to 25 Years for His Orchestration of Multiple Fraudulent Schemes | United States Department of Justice

[10] Examples – Napoleon Bonaparte, Fidel Castro, Elizabeth Holmes

[11] The New York Stock Exchange began on December 31, 1925

[12] https://wrds-www.wharton.upenn.edu/pages/about/data-vendors/center-for-research-in-security-prices-crsp/

[13] Securities and Exchange Commission – SEC, Definition & Purpose (history.com)

[14] Some of the securities in question were three times removed from the underlying commodity (often home mortgages). Were Collateralized Debt Obligations (CDOs) Responsible for the 2008 Financial Crisis? (investopedia.com).

[15] Other Credit rating agencies include Standard & Poor’s and Fitch Group.

[16] Basel III – Wikipedia

[17] In May of 2000, financial analyst Harry Markopolos alerts financial regulators to Madoff’s fraud which is ignored (along with several other fraud alerts over the following years). In December of 2008, Madoff himself exposes the Ponzi scheme to his sons who then report their father to federal authorities. Timeline: Key dates in the Bernard Madoff case | Bernard Madoff | The Guardian. Madoff served as the NASDQ Chairman at one point and was a member of its board of governors.

[18] Black Edge, by Sheelah Kolhatkar, goes into amazing detail about the attempted prosecution and arrest of billionaire hedge fund manager Steven Cohen of SAC Capital. Although many of SAC’s employees were criminally charged, Mr. Cohen himself avoided all criminal charges.

[19] A closer look at trends in public company listings and IPOs | McKinsey

[20] Office of Public Affairs | Samuel Bankman-Fried Sentenced to 25 Years for His Orchestration of Multiple Fraudulent Schemes | United States Department of Justice. A “crypto” keyword search on the DOJ website procures 500+ links to arrests and investigations of fraudulent unregulated traded activity.

[21] As of April 30, 2024, the DOL has not yet put forth clear detail regarding the definition of adequate consideration.

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Trisch Garthoeffner, ABV, CVA, MAFF, EA, MAcc, has 20+ years of experience in providing business valuation and financial consulting services. She is an Accredited Business Valuator (ABV) through the AICPA, a Certified Valuation Analyst (CVA) and Master Analyst in Financial Forensics (MAFF) through the NACVA, an IRS representative (Enrolled Agent or EA), and a court certified expert witness. Additionally, she has her master’s in accounting with a concentration in business valuations (MAcc). In 2020, she was nominated as a NACVA Standards Board (SDB) member; in 2021, nominated vice-chair; in 2022, served as chair; and is a current Executive Advisory Board appointed advisor to the SDB. She is a past Florida State Chapter President for NACVA, a current member of the NACVA exam task force (providing teaching for the preparation of the CVA exam for valuation expert candidates nationwide), a board member and quarterly author for the QuickRead periodical, a past treasurer of the Florida Academy of Collaborative Professionals, and a past vice-president of the Southwest Florida Chapter of Collaborative Professionals and current member. In her spare time, she enjoys spending time with her daughter, antiquing, and fostering animals for the local Humane Society.

Ms. Garthoeffner can be contacted at (239) 919-3092 or by e-mail to trisch@anchorbvfs.com.