Home > Primacy of Society, Public Service > Crowdsourcing SEC enforcement could better align incentives and allow investors to protect themselves

Crowdsourcing SEC enforcement could better align incentives and allow investors to protect themselves

An interesting proposal from Marcia Kramer and Paul Hinton in the Harvard Business Review involves unleashing the power of the public on the investment industry.  Fraud detection, a function currently vested in the SEC, could be vastly more effective if it were crowdsourced:

Fraud detection is a tedious task that can involve sifting through large amounts of data seeking a signature pattern of discrepancies. This is a task in which crowdsourcing, the chief concept underlying Wikipedia, may be quite useful…

Assessing investment advisor performance claims and reviewing tips are two of the major tasks on Chairman Schapiro’s plate that lend themselves to (crowdsourcing). The investment community possesses crucial skills and information that could supplement the SEC’s efforts. These private sector resources go far beyond what is available to the SEC…

You might be wondering how even a large number of laypersons could produce the type of effective enforcement that the SEC does.  Indeed, the vast majority of consumer-facing investment activity is done aboveboard.  However, it turns out that many of the tasks that SEC takes upon itself to enforce securities regulations are quite simple, and the fact that most investment activity is perfectly lawful almost certainly has less to do with effective SEC enforcement than it does with the fact that, generally, people act within the (admittedly somewhat elastic) standards of our common moral code.  It’s the same reason you and I can walk down the street without being mugged every single day.

But how simple could the analysis really be?  Take Bernie Madoff for example.  Nothing that he did was particularly complicated; indeed the aftermath produced more questions about how it could have passed unnoticed than it did questions about how he pulled it off.  It was a straight Ponzi scheme.  It’s nothing we haven’t seen before.

The Madoff case is not unique in that it could have been detected with sufficient information and very little analysis.  The SEC Report referenced the fact that Madoff’s fraud could have been easily detected if the regulators had bothered to call the clearing company.  DTCC, or the Depository Trust and Clearing Corporation, provides clearing and settlement services for the equities industry, and it keeps a log of trading activity therein.  Madoff reported billions in trading activity that never happened, but the SEC never bothered to look at the DTCC records to see if those purportedly massive trades were actually taking place.  Any lay investor with enough wherewithal to notice that two numbers don’t match up would have and could have caught it, just as the SEC should have caught it.  But the SEC didn’t look.

Kramer and Hinton propose making those records accessible, but they wouldn’t stop there:

Crowdsourcing could also help the short-staffed SEC identify patterns and connect the dots among the hundreds of thousands of tips that it receives annually. This system could extend beyond investment advisors to also cover brokers, public companies, underwriters, municipal issuers, and products.

It’s an intriguing theory, and I recommend reading the article for their counterpoints to what they view as the common objections.  But I think it’s important to highlight a primary reason why, intellectually at least, a crowdsourced platform could be desirable.  In a word, incentives.

Where regulators are tasked with finding and solving problems, they will act in their own best interests, and generally this means establishing a hegemonic power structure that is symbiotic with governmental (read: political) interests.  When brokerage companies are tasked with regulating themselves, they will act in their own best interests, and generally this means maximizing profit – not a bad thing in and of itself – but economic considerations cannot be given primacy over justice.

However, where investors are allowed to effectively protect themselves, investors ultimately get protected.  Giving people a transparent system by which they may look out for their own interests, uncolored by the interests of other parties, would solve the problem of ultimate accountability.  And for the skeptical, it bears noting that accountability has been enforced where this has been tried before:

The concept has already proven itself in Britain where The Guardian newspaper created an online database of 700,000 expense claims by UK members of Parliament for anyone to search; the erroneous and outrageous expenses identified by some 20,000 participants fueled a national scandal.

Perhaps there remains a role for the SEC, but that is a question for another day.  In any case, people should first be given the opportunity to protect themselves before we contemplate intervention in the name of protection.

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