Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Does Regulation Crowd out Private Ordering and Reputational Capital?

The crowdfunding portal Kickstarter commissioned an investigative journalist to write a report on the failure of Zano which had raised $3.5 million on that platform, and the report has now been published on Medium. I loved reading this report for the quality of the information and the balance in the conclusions. It left me thinking why London’s AIM market never published something similar on many of the failures among the companies listed there, or why NASDAQ never commissioned something like this after the dotcom bust, or why the Indian exchanges never did anything like this about the vanishing companies of the mid 1990s.

Is it because these highly regulated exchanges are protected by a regulatory monopoly and they can safely leave this kind of thankless job to their regulators? Or are they worried that an honest investigative report might be used against them because of the regulatory burden that they face? Does regulation have the side effect of crowding out the private ordering that emerges in the absence of regulation? Does regulation weaken reputational incentives?

In the context of crowdfunding, the reputational incentives and private ordering are well described in Schwartz’ paper on “The Digital Shareholder”:

These intermediaries [funding portals] want investors to have a good experience so they will return to invest again on their website, making them sensitive to a reputation feedback system. A funding portal with lots of poorly rated companies will find it difficult to attract future users to its site. Importantly, this appears to be an effective constraint for existing reward crowdfunding sites, such as Indiegogo, which take care to avoid having their markets overrun by malfeasance.

It is true that regulation does have positive effects, but the challenge in framing regulations is to avoid weakening private ordering.

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One response to “Does Regulation Crowd out Private Ordering and Reputational Capital?

  1. Gopal February 1, 2016 at 5:05 am

    Many scam operations in the UK continue their schemes and claim to be “regulated and authorised” by the FCA while in reality they only submit forms to the FCA and are not really regulated and or authorised by the FCA with the meaning that a lay man would associate with those words. So yes regulation does remove the private incentive but how does one regulate and not crowd out private ordering?

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